2015 – Solved Question Paper | Indian Financial System | Final Year – Masters of Commerce (M.Com) | Dibrugarh University

2015

COMMERCE

Paper: 205

(Indian Financial System)

Full Marks: 80

The figures in the margin indicate full marks for the questions.

1. (a) Give an overview of Regulatory Framework of Indian Financial System. (16)

-> The services that are provided to a person by the various Financial Institutions including banks, insurance companies, pensions, funds, etc. constitute the financial system.

Given below are the features of the Indian Financial system:

· It plays a vital role in the economic development of the country as it encourages both savings and investment

· It helps in mobilizing and allocating one’s savings

· It facilitates the expansion of financial institutions and markets

· Plays a key role in capital formation

· It helps form a link between the investor and the one saving

· It is also concerned with the Provision of funds

· The financial system of a country mainly aims at managing and governing the mechanism of production, distribution, exchange and holding of financial assets or instruments of all kinds.

Components of Indian Financial System

There are four main components of the Indian Financial System. This includes:

1. Financial Institutions

2. Financial Assets

3. Financial Services

4. Financial Markets

Let’s discuss each component of the system in detail.

1. Financial Institutions

The Financial Institutions act as a mediator between the investor and the borrower. The investor’s savings are mobilized either directly or indirectly via the Financial Markets.

The main functions of the Financial Institutions are as follows:

· A short term liability can be converted into a long term investment

· It helps in conversion of a risky investment into a risk-free investment

· Also acts as a medium of convenience denomination, which means, it can match a small deposit with large loans and a large deposit with small loans

The best example of a Financial Institution is a Bank. People with surplus amounts of money make savings in their accounts, and people in dire need of money take loans. The bank acts as an intermediate between the two.

The financial institutions can further be divided into two types:

• Banking Institutions or Depository Institutions – This includes banks and other credit unions which collect money from the public against interest provided on the deposits made and lend that money to the ones in need
• Non-Banking Institutions or Non-Depository Institutions – Insurance, mutual funds and brokerage companies fall under this category. They cannot ask for monetary deposits but sell financial products to their customers.

Further, Financial Institutions can be classified into three categories:

• Regulatory – Institutes that regulate the financial markets like RBI, IRDA, SEBI, etc.
• Intermediates – Commercial banks which provide loans and other financial assistance such as SBI, BOB, PNB, etc.
• Non Intermediates – Institutions that provide financial aid to corporate customers. It includes NABARD, SIBDI, etc.

2. Financial Assets

The products which are traded in the Financial Markets are called Financial Assets. Based on the different requirements and needs of the credit seeker, the securities in the market also differ from each other.

Some important Financial Assets have been discussed briefly below:

• Call Money – When a loan is granted for one day and is repaid on the second day, it is called call money. No collateral securities are required for this kind of transaction.
• Notice Money – When a loan is granted for more than a day and for less than 14 days, it is called notice money. No collateral securities are required for this kind of transaction.
• Term Money – When the maturity period of a deposit is beyond 14 days, it is called term money.
• Treasury Bills – Also known as T-Bills, these are Government bonds or debt securities with maturity of less than a year. Buying a T-Bill means lending money to the Government.
• Certificate of Deposits – It is a dematerialized form (Electronically generated) for funds deposited in the bank for a specific period of time.
• Commercial Paper – It is an unsecured short-term debt instrument issued by corporations.

3. Financial Services

Services provided by Asset Management and Liability Management Companies. They help to get the required funds and also make sure that they are efficiently invested.

The financial services in India include:

• Banking Services – Any small or big service provided by banks like granting a loan, depositing money, issuing debit/credit cards, opening accounts, etc.
• Insurance Services – Services like issuing of insurance, selling policies, insurance undertaking and brokerages, etc. are all a part of the Insurance services
• Investment Services – It mostly includes asset management
• Foreign Exchange Services – Exchange of currency, foreign exchange, etc. are a part of the Foreign exchange services

The main aim of the financial services is to assist a person with selling, borrowing or purchasing securities, allowing payments and settlements and lending and investing.

4. Financial Markets

The marketplace where buyers and sellers interact with each other and participate in the trading of money, bonds, shares and other assets is called a financial market.

The financial market can be further divided into four types:

• Capital Market – Designed to finance the long term investment, the Capital market deals with transactions which are taking place in the market for over a year. The capital market can further be divided into three types:

(a) Corporate Securities Market

(b) Government Securities Market

(c) Long Term Loan Market

• Money Market – Mostly dominated by Government, Banks and other Large Institutions, the type of market is authorized for small-term investments only. It is a wholesale debt market which works on low-risk and highly liquid instruments. The money market can further be divided into two types:

(a) Organized Money Market

(b) Unorganized Money Market

• Foreign exchange Market – One of the most developed markets across the world, the Foreign exchange market, deals with the requirements related to multi-currency. The transfer of funds in this market takes place based on the foreign currency rate.
• Credit Market – A market where short-term and long-term loans are granted to individuals or Organizations by various banks and Financial and Non-Financial Institutions is called Credit Market.

(b) Discuss the role of Financial Institutions in Economic Development of a country like India. (16)

-> Roles Performed by Financial Institution

Financial institutions play a pivotal role in every economy. They are regulated by a central government organization for banking and non-banking financial institutions. These institutions help in bridging the gap between idle savings and investment and its borrowers, i.e., from net savers to net borrowers.

Following are the list of roles performed by Financial Institutions –

1. Regulation of Monetary Supply

2. Banking Services

3. Insurance Services

4. Capital Formation

5. Investment Advice

6. Brokerage services

7. Pension Fund Services

8. Trust Fund Services

9. Financing the Small and Medium Scale Enterprises

10. Act as A Government Agent for Economic Growth

Let us discuss each one of them in detail –

1 – Regulation of Monetary Supply

Financial institutions like the central bank help in regulating the money supply in the economy. They do it to maintain stability and control inflation. The central bank applies various measures like increasing or decreasing repo rate, cash reserve ratio , open market operations , i.e., buying and selling government securities to regulate liquidity in the economy.

2 – Banking Services

Financial institutions, like commercial banks , help their customers by providing savings and deposit services. They provide credit facilities like overdraft facilities to the customers for catering to the need for short-term funds. Commercial banks also extend several kinds of loans like personal loans, education loans, mortgage or home loans to their customers.

3 – Insurance Services

Financial institutions, like insurance companies, help to mobilize savings and investment in productive activities. In return, they provide assurance to investors against their life or some particular asset at the time of need. In other words, they transfer their customer’s risk of loss to themselves.

4 – Capital Formation

Financial institutions help in capital formation, i.e., increase in capital stock like the plant, machinery, tools and equipment, buildings, means of transport and communication, etc. They do so by mobilizing the idle savings from individuals in the economy to the investor through various monetary services.

5 – Investment Advice

There are a number of investment options available at the disposal of individuals as well as businesses. But in the current swift changing environment, it is very difficult to choose the best option. Almost all financial institutions (banking or non-banking) have an investment advisory desk that helps customers, investors, businesses to choose the best investment option available in the market according to their risk appetite and other factors.

6 – Brokerage services

These institutions provide their investors access to a number of investment options available in the market that ranges from stock, bonds (common investment alternative) to hedge funds , and private equity investment (lesser-known alternative).

7 – Pension Fund Services

Financial institutions, through their various kinds of investment plans, help the individual in planning their retirement. One such investment options is a pension fund, where the individual contributes to the pool of investment set up by employers, banks, or other organizations and get the lump sum or monthly income after retirement.

8 – Trust Fund Services

Some financial organization provides trust fund services to their clients. They manage the client’s assets, invest them in the best option available in the market, and take care of its safekeeping as well.

9 – Financing the Small and Medium Scale Enterprises

Financial institutions help small and medium scale enterprises set up themselves in their initial days of business. They provide long-term as well as short-term funds to these companies. The long-term fund helps them in the formation of capital, and short-term funds fulfill their day to day needs of working capital.

10 – Act as a Government Agent for Economic Growth

Financial institutions are regulated by the government on a national level. They act as a government agent and help in the growth of the nation’s economy as a whole. For example, to help out an ailing sector, financial institutions, as per the guidelines from the government, issue selective credit line with lower interest rates to help the sector overcome the issues it is facing.

2. (a) What do you mean by Depository System? Discuss the role played by Indian Depositors in Indian Capital Market. (6+10=16)

-> It is a system whereby the transfer and settlement of scrips take place not through the traditional method of transfer deeds and physical delivery of scrips but through the modern system of effecting transfer of ownership of securities by means of book entry on the ledgers or the depository without the physical movement of scrips.

The new system, thus, eliminates paper work, facilitates automatic and transparent trading in scrips, shortens the settlement period and ultimately contributes to the liquidity of investment in securities. This system is also known as ‘scripless trading system’.

There are essentially four players in the depository system:

(i) The Depository

(ii) The Participant

(iii) The Beneficial Owner, and

(iv) The Issuer.

(i) The Depository:

A depository is a firm wherein the securities of an investor are held in electronic form and who carries out the transactions of securities by means of book entry. The depository acts as a defecto owner of the securities lodged with it for the limited purpose of transfer of ownership. It functions as a custodian of securities of its clients.

The name of the depository appears in the records the issuer as the registered owner of securities.

At present there are two depositories in India:

(a) National Securities Depository Ltd. (NSDL), and

(b) Central Depository Services (India) Ltd. (CDSL).

National Securities Depository Limited which commenced operations during November 1996 was promoted by IDBI, UTI and National Stock Exchange (NSE). Central Depository Services (India) Limited commenced operations during February 1999. It was promoted by Mumbai Stock Exchange in association with Bank of Baroda, Bank of India, State Bank of India and HDFC Bank.

(ii) The Participant:

A participant is an agent of the depository. He functions as a bridge between the depository and the beneficial owners. He maintains the ownership records of every beneficial owner in book entry form. Both the depository and the participant have to be registered with the Securities and Exchange Board of India.

SEBI grants necessary approval for the same only on the satisfaction of the condition that adequate systems and safeguards are available in such companies in order to ensure against manipulation of records and transactions.

(iii) The Beneficial Owner:

Beneficial owner means a person whose name is recorded as such with a depository. A beneficial owner is the real owner of the securities who has lodged his securities with the depository in the form of book entry. He has all the rights and liabilities associated with the securities.

(iv) The Issuer:

The issuer is the company which issues the security. It maintains a register for recording the names of the registered owners of securities, the depositories. These issuers send a list of shareholders, who opt for the depository system, to the depositories.

(b) What do you mean by New Issue Market (NIM)? Discuss in brief about functions of any two types Prime Financial Institutions offering services in NIM. (4+12=16)

3. (a) Write a brief note on banking sector reforms during the post economic liberalization period. (16)

-> Banking is an ancient business in India with some of oldest references in the writings of Manu. Bankers played an important role during the Mogul period. During the early part of the East India Company era, agency houses were involved in banking. Modern banking (i.e. in the form of joint-stock companies) may be said to have had its beginnings in India as far back as in 1786, with the establishment of the General Bank of India. Three Presidency Banks were established in Bengal, Bombay and Madras in the early 19th century. These banks functioned independently for about a century before they were merged into the newly formed Imperial Bank of India in 1921. The Imperial Bank was the forerunner of the present State Bank of India. The latter was established under the State Bank of India Act of 1955 and took over the Imperial Bank.

The Swadeshi movement witnessed the birth of several indigenous banks including the Punjab National Bank, Bank of Baroda and Canara Bank. In 1935, the Reserve Bank of India was
established under the Reserve Bank of India Act as the central bank of India. In spite of all these developments, independent India inherited a rather weak banking and financial system marked by a multitude of small and unstable private banks whose failures frequently robbed their middle-class depositors of their life’s savings. After independence, the Reserve Bank of India was nationalized in 1949 and given wide powers in the area of bank supervision through the Banking Companies Act (later renamed Banking Regulations Act). The nationalization of the Imperial bank through the formation of the State Bank of India and the subsequent acquisition of the state owned banks in eight princely states by the State Bank of India in 1959 made the government the dominant player in the banking industry. In keeping with the increasingly socialistic leanings of the Indian government, 14 major private banks, each with deposits exceeding Rs. 50 crores, were nationalized in 1969. This raised the proportion of scheduled bank branches in government control from 31% to about 84%. In 1980, six more private banks each with deposits exceeding Rs 200 crores , were privatized further raising the proportion of government controlled bank branches to about 90%. As in other areas of economic policy-making, the emphasis on government control began to weaken and even reverse in the mid-80s and liberalization set in firmly in the early 90’s. The poor performance of the public sector banks, which accounted for about 90% of all commercial banking, was rapidly becoming an area of concern. The continuous escalation in non-performing assets (NPAs) in the portfolio of banks posed a significant threat to the very stability of the financial system. Banking reforms, therefore, became an integral part of the liberalization agenda.
The first Narasimham Committee set the stage for financial and bank reforms in India. Interest rates, previously fixed by the Reserve Bank of India, were liberalized in the 90’s and directed lending through the use of instruments of the Statutory Liquidity Ratio was reduced. While several committees have looked into the ailments of commercial banking in India, but major work has been done according to the Narsimham committee reports.
– the Narasimham committee I (1992) and II (1998)

Liberalization
Liberalization (or liberalization) refers to a relaxation of previous government restrictions, usually in areas of social or economic policy. In some contexts this process or concept is often, but not always, referred to as deregulation. In the arena of social policy it may refer to a relaxation of laws restricting. Most often, the term is used to refer to economic liberalization, especially trade liberalization or capital market liberalization.

Liberalization in Indian Banking Sector-
Liberalization in Indian banking sector was begun since 1992, following the Narsimham Committee Report (December 1991). The 1991 report of the Narasimham Committee served as the basis for the initial banking sector reforms .In the following years, reforms covered the areas of interest rate deregulation, directed credit rules, statutory pre-emptions and entry deregulation for both domestic and foreign banks. The objective of banking sector reforms was in line with the overall goals of the 1991 economic reforms of opening the economy, giving a greater role to markets in setting prices and allocating resources, and increasing the role of the private sector. The Narsimhan Committee was first set up in 1991 under the chairmanship of Mr. M. Narasimham who was 13th governor of RBI. Only a few of its recommendations became banking reforms of India and others were not at all considered. Because of this a second committee was again set up in 1998.As far as recommendations regarding bank restructuring, management freedom, strengthening the regulation are concerned, the RBI has to play a major role. If the major recommendations of this committee are accepted, it will prove to be fruitful in making Indian banks more profitable and efficient.

Problems Identified By the Narasimham Committee

1. Directed Investment Program: The committee objected to the system of maintaining high liquid assets by commercial banks in the form of cash, gold and unencumbered government securities. It is also known as the Statutory Liquidity Ratio (SLR). In those days, in India, the SLR was as high as 38.5 percent. According to the M. Narasimham’s Committee it was one of the reasons for the poor profitability of banks. Similarly, the Cash Reserve Ratio- (CRR) was as high as 15 percent. Taken together, banks needed to maintain 53.5 percent of their resources idle with the RBI.

2. Directed Credit Program : Since nationalization the government has encouraged the lending to agriculture and small-scale industries at a confessional rate of interest. It is known as the directed credit programme. The committee opined that these sectors have matured and thus do not need such financial support. This directed credit programme was successful from the government’s point of view but it affected commercial banks in a bad manner. Basically it deteriorated the quality of loan, resulted in a shift from the security oriented loan to purpose oriented. Banks were given a huge target of priority sector lending, etc. ultimately leading to profit erosion of banks.

3. Interest Rate Structure: The committee found that the interest rate structure and rate of interest in India are highly regulated and controlled by the government. They also found that government used bank funds at a cheap rate under the SLR. At the same time the government advocated the philosophy of subsidized lending to certain sectors. The committee felt that there was no need for interest subsidy. It made banks handicapped in terms of building main strength and expanding credit supply.

4. Additional Suggestions: Committee also suggested that the determination of interest rate should be on grounds of market forces. It further suggested minimizing the slabs of interest.

Along with these major problem areas M. Narasimham’s Committee also found various inconsistencies regarding the banking system in India.

Narasimham Committee Report I – 1991
The Narsimham Committee was set up in order to study the problems of the Indian financial system and to suggest some recommendations for improvement in the efficiency and productivity of the financial institution.

The committee has given the following major recommendations:-

1. Reduction in the SLR (Statutory Liquidity Ratio) and CRR (Cash Reserve Ratio) : The committee recommended the reduction of the higher proportion of the Statutory Liquidity Ratio (SLR) and the Cash Reserve Ratio (CRR). Both of these ratios were very high at that time. The SLR then was 38.5% and CRR was 15%. This high amount of SLR and CRR meant locking the bank resources for government uses. It was hindrance in the productivity of the bank thus the committee recommended their gradual reduction. SLR was recommended to reduce from 38.5% to 25% and CRR from 15% to 3 to 5%.

2. Phasing out Directed Credit Programme: In India, since nationalization, directed credit programmes were adopted by the government. The committee recommended phasing out of this programme. This programme compelled banks to earmark then financial resources for the needy and poor sectors at confessional rates of interest. It was reducing the profitability of banks and thus the committee recommended the stopping of this programme.

3. Interest Rate Determination: The committee felt that the interest rates in India are regulated and controlled by the authorities. The determination of the interest rate should be on the grounds of market forces such as the demand for and the supply of fund. Hence the committee recommended eliminating government controls on interest rate and phasing out the concessional interest rates for the priority sector.

4. Structural Reorganizations of the Banking sector: The committee recommended that the actual numbers of public sector banks need to be reduced. Three to four big banks including SBI should be developed as International banks. Eight to Ten Banks having nationwide presence should concentrate on the national and universal banking services. Local banks should concentrate on region specific banking. Regarding the RRBs (Regional Rural Banks), it recommended that they should focus on agriculture and rural financing. They recommended that the government should assure that henceforth there won’t be any nationalization and private and foreign banks should be allowed liberal entry in India.

5. Establishment of the ARF Tribunal: The proportion of bad debts and Non-performing asset (NPA) of the public sector Banks and Development Financial Institute was very alarming in those days. The committee recommended the establishment of an Asset Reconstruction Fund (ARF). This fund will take over the proportion of the bad and doubtful debts from the banks and financial institutes. It would help banks to get rid of bad debts.

6. Removal of Dual control: Those days banks were under the dual control of the Reserve Bank of India (RBI) and the Banking Division of the Ministry of Finance (Government of India). The committee recommended the stepping of this system. It considered and recommended that the RBI should be the only main agency to regulate banking in India.

7. Banking Autonomy: The committee recommended that the public sector banks should be free and autonomous. In order to pursue competitiveness and efficiency, banks must enjoy autonomy so that they can reform the work culture and banking technology upgradation will thus be easy.

Some of these recommendations were later accepted by the Government of India and became banking reforms.

Narasimham Committee Report II – 1998
In 1998 the government appointed yet another committee under the chairmanship of Mr. Narsimham. It is better known as the Banking Sector Committee. It was told to review the banking reform progress and design a programme for further strengthening the financial system of India. The committee focused on various areas such as capital adequacy, bank mergers, bank legislation, etc.

It submitted its report to the Government in April 1998 with the following recommendations.

1. Strengthening Banks in India: The committee considered the stronger banking system in the context of the Current Account Convertibility (CAC). It thought that Indian banks must be capable of handling problems regarding domestic liquidity and exchange rate management in the light of CAC. Thus, it recommended the merger of strong banks which will have ‘multiplier effect’ on the industry.

2. Narrow Banking: Those days many public sector banks were facing a problem of the Non-performing assets (NPAs). Some of them had NPAs were as high as 20 percent of their assets. Thus for successful rehabilitation of these banks it recommended ‘Narrow Banking Concept’ where weak banks will be allowed to place their funds only in short term and risk free assets.

3. Capital Adequacy Ratio: In order to improve the inherent strength of the Indian banking system the committee recommended that the Government should raise the prescribed capital adequacy norms. This will further improve their absorption capacity also. Currently the capital adequacy ration for Indian banks is at 9 percent.

4. Bank ownership: As it had earlier mentioned the freedom for banks in its working and bank autonomy, it felt that the government control over the banks in the form of management and ownership and bank autonomy does not go hand in hand and thus it recommended a review of functions of boards and enabled them to adopt professional corporate strategy.

5. Review of banking laws: The committee considered that there was an urgent need for reviewing and amending main laws governing Indian Banking Industry like RBI Act, Banking Regulation Act, State Bank of India Act, Bank Nationalisation Act, etc. This upgradation will bring them in line with the present needs of the banking sector in India.

Apart from these major recommendations, the committee has also recommended faster computerization, technology upgradation, training of staff, depoliticizing of banks, professionalism in banking, reviewing bank recruitment, etc.

Changes due to the recommendations made by the Narsimham committee are-
1. Statutory pre-emptions: The degree of financial repression in the Indian banking sector was significantly reduced with the lowering of the CRR and SLR, which were regarded as one of the main causes of the low profitability and high interest rate spreads in the banking system. During the 1960s and 1970s the CRR was around 5%, but until 1991 it increased to its maximum legal limit of 15%.The reduction of the CRR and SLR resulted in increase flexibility for banks in determining both the volume and terms of lending.

2. Priority sector lending: Besides the high level of statutory pre-emptions, the priority sector advances were identified as one of the major reasons for the below average profitability of Indian banks. The Narasimham Committee therefore recommended a reduction from 40% to 10%. However, this recommendation has not been implemented and the targets of 40% of net bank credit for domestic banks and 32% for foreign banks have remained the same.

3. Interest rate liberalization: Prior to the reforms, interest rates were a tool of cross-subsidization between different sectors of the economy. To achieve this objective, the interest rate structure had grown increasingly complex with both lending and deposit rates set by the RBI. The deregulation of interest rates was a major component of the banking sector reforms that aimed at promoting financial savings and growth of the organized financial system. The lending rate for loans in excess of Rs200, 000 that account for over 90% of total advances was abolished in October 1994. Banks were at the same time required to announce a prime lending rate (PLR) which according to RBI guidelines had to take the cost of funds and transaction costs into account.

4. Entry barriers: Before the start of the 1991 reforms, there was little effective competition in the Indian banking system for at least two reasons. First, the detailed prescriptions of the RBI concerning for example the setting of interest rates left the banks with limited degrees of freedom to differentiate themselves in the marketplace. Second, India had strict entry restrictions for new banks, which effectively shielded the incumbents from competition. Through the lowering of entry barriers, competition has significantly increased since the beginning of the1990s. Seven new private banks entered the market between 1994 and 2000. In addition, over 20 foreign banks started operations in India since 1994. By March 2004, the new private sector banks and the foreign banks had a combined share of almost 20% of total assets. Deregulating entry requirements and setting up new bank operations has benefited the Indian banking system from improved technology, specialized skills, better risk management practices and greater portfolio diversification..

5. Prudential norms: The report of the Narasimham Committee was the basis for the strengthening of prudential norms and the supervisory framework. Starting with the guidelines on income recognition, asset classification, provisioning and capital adequacy the RBI issued in 1992/93, there have been continuous efforts to enhance the transparency and accountability of the banking sector. The improvements of the prudential and supervisory framework were accompanied by a paradigm shift from micro-regulation of the banking sector to a strategy of macro-management .

6. Public Sector Banks: At the end of the 1980s, operational and allocative inefficiencies caused by the distorted market mechanism led to a deterioration of Public Sector Banks’ profitability. Enhancing the profitability of PSBs became necessary to ensure the stability of the financial system. The restructuring measures for PSBs were threefold and included recapitalization, debt recovery and partial privatization.

Despite the suggestion of the Narasimham Committee to rationalize PSBs, the Government of India decided against liquidation, which would have involved significant losses accruing to either the government or depositors. It opted instead to maintain and improve operations to allow banks to create a good starting basis before a possible privatization.

(b) What do you understand by Mutual Fund? Discuss the salient features of the SEBI (Mutual Funds) Regulations 1996. (6+10=16)

-> Mutual funds are one of the most popular investment options these days. A mutual fund is an investment vehicle formed when an asset management company (AMC) or fund house pools investments from several individuals and institutional investors with common investment objectives. A fund manager, who is finance professional, manages the pooled investment. The fund manager purchases securities such as stocks and bonds that are in line with the investment mandate.

Mutual funds are an excellent investment option for individual investors to get exposure to an expert managed portfolio. Also, you can diversify your portfolio by investing in mutual funds as the asset allocation would cover several instruments. Investors would be allocated with fund units based on the amount they invest. Each investor would hence experience profits or losses that are directly proportional to the amount they invest. The main intention of the fund manager is to provide optimum returns to investors by investing in securities that are in sync with the fund’s objectives. The performance of mutual funds is dependent on the underlying assets.

Types of Mutual Funds

Mutual funds in India are broadly classified into equity funds, debt funds, and balanced mutual funds, depending on their asset allocation and equity exposure. Therefore, the risk assumed and returns provided by a mutual fund plan would depend on its type. We have broken down the types of mutual funds in detail below:

1. Equity funds, as the name suggests, invest mostly in equity shares of companies across all market capitalizations. A mutual fund is categorized under equity fund if it invests at least 65% of its portfolio in equity instruments. Equity funds have the potential to offer the highest returns among all classes of mutual funds. The returns provided by equity funds depend on the market movements, which are influenced by several geopolitical and economic factors. The equity funds are further classified as below:

i. Small-Cap Funds

Small-cap funds are those equity funds that predominantly invest in equity and equity-linked instruments of companies with small market capitalization. SEBI defines small-cap companies as those that are ranked after 251 in market capitalization.

ii. Mid-Cap Funds

Mid-cap funds are those equity funds that invest primarily in equity and equity-linked instruments of companies with medium market capitalization. SEBI defines mid-cap companies as those that are ranked between 101 and 250 in market capitalization.

iii. Large-Cap Funds

Large-cap funds are those equity funds that invest mostly in equity and equity-linked instruments of companies with large market capitalization. SEBI defines large-cap companies as those that are ranked between 1 and 100 in market capitalization.

iv. Multi-Cap Funds

Multi-Cap Funds invest substantially in equity and equity-linked instruments of companies across all market capitalizations. The fund manager would change the asset allocation depending on the market condition to reap the maximum returns for investors and reduce the risk levels.

v. Sector or Thematic Funds

Sectoral funds invest principally in equity and equity-linked instruments of companies in a particular sector like FMCG and IT. Thematic funds invest in equities of companies that operate with a similar theme like travel.

vi. Index Funds

Index Funds are a type of equity funds having the intention of tracking and emulating the performance of a popular stock market index such as the S&P BSE Sensex and NSE Nifty50. The asset allocation of an index fund would be the same as that of its underlying index. Therefore, the returns offered by index mutual funds would be similar to that of its underlying index.

vii. ELSS

Equity-linked savings scheme (ELSS) is the only kind of mutual funds covered under Section 80C of the Income Tax Act, 1961. Investors can claim tax deductions of up to Rs 1, 50,000 a year by investing in ELSS.

2. Debt Mutual Funds

Debt mutual funds invest mostly in debt, money market and other fixed-income instruments such as treasury bills, government bonds, certificates of deposit, and other high-rated securities. A mutual fund is considered a debt fund if it invests a minimum of 65% of its portfolio in debt securities. Debt funds are ideal for risk-averse investors as the performance of debt funds is not influenced much by the market fluctuations. Therefore, the returns provided by debt funds are very much predictable. The debt funds are further classified as below:

i. Dynamic Bond Funds

Dynamic Bond Funds are those debt funds whose portfolio is modified depending on the fluctuations in the interest rates.

ii. Income Funds

Income Funds invest in securities that come with a long maturity period and therefore, provide stable returns over time. The average maturity period of these funds is five years.

iii. Short-Term and Ultra Short-Term Debt Funds

Short-term and ultra short-term debt funds are those mutual funds that invest in securities that mature in one to three years. These funds are ideal for risk-averse investors.

iv. Liquid Funds

Liquid funds are debt funds that invest in assets and securities that mature within ninety-one days. These mutual funds generally invest in high-rated instruments. Liquid funds are a great option to park your surplus funds, and they offer higher returns than a regular savings bank account.

v. Gilt Funds

Gilt Funds are debt funds that invest in high-rated government securities. It is for this reason that these funds possess lower levels of risk and are apt for risk-averse investors.

vi. Credit Opportunities Funds

Credit Opportunities Funds mostly invest in low rated securities that have the potential to provide higher returns. Naturally, these funds are the riskiest class of debt funds.

vii. Fixed Maturity Plans

Fixed maturity plans (FMPs) are close-ended debt funds that invest in fixed income securities such as government bonds. You may invest in FMPs only during the fund offer period, and the investment will be locked-in for a predefined period.

3. Balanced or Hybrid Mutual Funds

Balanced or hybrid mutual funds invest across both equity and debt instruments. The main objective of hybrid funds is to balance the risk-reward ratio by diversifying the portfolio. The fund manager would modify the asset allocation of the fund depending on the market condition, to benefit the investors and reduce the risk levels. Investing in hybrid funds is an excellent way of diversifying your portfolio as you would gain exposure to both equity and debt instruments. The debt funds are further classified as below:

i. Equity-Oriented Hybrid Funds

Equity-oriented hybrid funds are those that invest at least 65% of its portfolio in equities while the rest is invested in fixed-income instruments.

ii. Debt-Oriented Hybrid Funds

Debt-oriented hybrid funds allocate at least 65% of its portfolio in fixed-income instruments such as treasury bills and government securities, and the rest is invested in equities.

iii. Monthly Income Plans

Monthly income plans (MIPs) majorly invest in debt instruments and aim at providing a steady return over time. The equity exposure is usually limited to fewer than 20%. You can decide if you would receive dividends on a monthly, quarterly, or annual basis.

iv. Arbitrage Funds

Arbitrage funds aim at maximizing the returns by purchasing securities in one market at lower prices and selling them in another market at a premium. However, if the arbitrage opportunities are not available, then the fund manager may choose to invest in debt securities or cash equivalents.

4. Write short notes on: (any two) (8×2=16)

a) Certificate of Deposit.

-> Certificate of deposit (CD) is an agreement between the depositors and the authorized bank or financial institution. This agreement is for a specific period of time with a certain amount of money to invest where the financial institution pays interest. You can redeem at the time of maturity of the instrument. Hence, you cannot withdraw before the completion of the tenure.

CDs are issued in a dematerialized form. It is a promissory note that a bank or financial institution issues. Federal Deposit Insurance Corporation (FDIC) insures it. And Reserve Bank of India (RBI) regulates it. The RBI lays the guidelines regarding the investments in CDs.

At the time of maturity of a CD, the depositor gets a grace period of 7 days to decide about the matured amount. In case the depositor does not withdraw within the seven days grace period, the maturity amount is reinvested. Furthermore, one can also withdraw the matured amount after the grace period by paying the penalty. Otherwise, the actual investment cannot be redeemed on demand or penalty payment.

CDs were introduced in the year 1989 to increase the range of money market instruments . This enables investors to manage short term funds more effectively.

Features of Certificate of Deposit

One should understand the salient features of Certificate of deposit before investing.

Eligibility

RBI authorizes only a few selective banks and financial institutions to issue CDs. There are specific guidelines that RBI issues for the purchase of CDs. Banks can issue CDs to individuals, mutual funds, trusts, insurers and pension funds.

Maturity Period

Commercial Banks issue CDs which have a tenure ranging from 7 days to one year. However, financial institutions issue Certificate of deposits with different maturity dates. They can be 1year CD upto 3year CD.

Minimum Investment

The Certificate of deposits CDs are issued in the multiples of Rs.1lakh, and the minimum size of investment is also Rs. 1lakh.

Transferability

An electronic certificate of deposit is transferable through endorsement or delivery. However, certificates in the demat account are transferable as per the guidelines of the demat securities.

Loan against Certificate of Deposit

Banks do not grant loans against CDs since these certificates do not have a lock-in period. Banks cannot buy back CDs before maturity.

Discount on Certificate of Deposit

Certificate of deposit is issued at a discount on face value. Also, financial institutions, banks and credit unions can issue Certificate of deposits on a floating rate basis. The method of calculating the floating rate is market-based

Advantages and limitations of investing

Though Certificate of deposits are one among many useful investment options , they have their benefits and limitations of investing

Advantages

Safety

Investment in the stock market or debt funds is very volatile. However, one considers investment in Certificate of deposits as safe because banks or financial institutions issue them. Further, they invest in safe instruments that generate growth.

Returns

The Certificate of deposits CD rate is pre-determined throughout the investment tenure. Hence, they offer better returns when compared to the savings account. Also, staying invested for a longer duration in a certificate of deposit generates higher returns. Hence, financial institutions issue Certificate of deposits with different maturity periods like 1year CD up to 3year CD.

Flexibility

One can choose the duration and issue price of CDs they want to invest. However, the bank sets the parameters. One can also opt for monthly, annual or a lump sum payout at the time of maturity of the CD. Therefore, investors can select based on their investment planning and financial plan objectives.

Grace Period

On maturity of CDs, investor’s get a grace period of 7 days which help them decide about their maturity amount. One can continue to reinvest or withdraw the same.

Limitations

Returns

Compared to other stock market or debt fund investment options, Certificate of deposits yield lower returns. The government backs them. Usually, CDs are issued at a discount value and redeemed at face value. Therefore, irrespective of the economic condition of the country, the returns earned by investors though Certificate of deposits remains fixed.

Limited Liquidity

One can only redeem the matured amount after the grace period by paying a withdrawal penalty. Otherwise, one cannot redeem the actual investment amount on demand or penalty payment. Hence, Certificate of deposits has limited liquidity.

b) Derivative instruments.

-> A financial instrument is a document that has monetary value or which establishes an obligation to pay. Examples of financial instruments are cash, foreign currencies , accounts receivable , loans , bonds , equity securities , and accounts payable . A derivative is a financial instrument that has the following characteristics:

· It is a financial instrument or a contract that requires either a small or no initial investment;

• There is at least one notional amount (the face value of a financial instrument, which is used to make calculations based on that amount) or payment provision;
• It can be settled net , which is a payment that reflects the net difference between the ending positions of the two parties; and

· Its value changes in relation to a change in an underlying, which is a variable, such as an interest rate , exchange rate , credit rating , or commodity price, that is used to determine the settlement of a derivative instrument. The value of a derivative can even change in conjunction with the weather.

In essence, a derivative constitutes a bet that something will increase or decrease. As such, a derivative can be used in two ways. Either it is a tool for avoiding risk, or it is used to speculate. In the former case, derivatives are used to offset expected changes in the value of an asset or liability, so that the net effect is zero. In the latter case, an entity accepts risk in order to possibly earn above-average profits. Speculation using derivatives can be extremely risky, since a large adverse movement in an underlying could trigger a massive liability for the holder of a derivative.

d) Short term sources of finance.

-> Short-term financing may be defined as the credit or loan facility extended to an enterprise for a period of less than one year.

It is a credit arrangement provided to an enterprise to bridge the gap between income and expenses in the short run. It helps the enterprise to manage its current liabilities, such as payment of salaries and wages to labors and procurement of raw materials and inventory.

The availability of short-term funds ensures the sufficient liquidity in the enterprise. It facilitates the smooth functioning of the enterprise’s day-to-day activities.

The various short-term sources of finance are as follows:

Source 1. Trade Credit:

Trade credit refers to the credit extended by the supplier of goods or services to his/her customer in the normal course of business. It occupies a very important position in short-term financing due to the competition. Almost all the traders and manufacturers are required to extend credit facility (a portion), without which there is no business. Trade credit is a spontaneous source of finance that arises in the normal business transactions without specific negotiation, (automatic source of finance).

In order to get this source of finance, the buyer should have acceptable and dependable creditworthiness and reputation in the market. Trade credit is generally extended in the form of open account or bills of exchange. Open account is the form of trade credit, where supplier sends goods to the buyer and the payment to be received in future as per terms of the sales invoice.

As such trade credit constitutes a very important source of finance, represents 25 per cent to 50 per cent of the total short-term sources for financing working capital requirements.

Getting trade credit may be easy to the well-established, but for a new or a firm with financial problems, will generally face problems in getting trade credit. Generally, suppliers look for earnings record, liquidity position and payment record while extending credit. Building confidence in suppliers is possible only when the buyer discusses his/her financial condition, future plans and payment record. Trade credit involves some benefits and costs.

Advantages of Trade Credit:

The main advantages are:

(i) Easy availability when compared to other sources of finance (except financially weak companies)

(ii) Flexibility is another benefit, as the credit increases with the growth of the firm’s sales.

(iii) Informality as stated in the above that it is an automatic finance.

Costs of Trade Credit:

The above discussion on trade credit reveals two things:

(i) Cost of trade credit is very high beyond the cash discount period, company should not have cash discount for prompt payment.

(ii) If the company is not able to avail cash discount it should pay only at the end of the last day of credit period, even it can delay one or two days if it does not affect the credit standing.

Source 2. Accruals:

Accrued expenses are those expenses which the company owes to the other, but not yet due and not yet paid the amount. Accruals represent a liability that a firm has to pay for the services or goods, it has received. It is spontaneous and interest-free source of financing. Salaries and wages, interest and taxes are the major constituents of accruals. Salaries and wages are usually paid on monthly and weekly base, respectively.

The amounts of salaries and wages are owed but not yet paid and shown them as accrued salaries and wages on the balance sheet at the end of the financial year. The longer the time lag in^–payment of these expenses, the greater is the amount of funds provided by the employees. Similarly, interest and tax are accruals, as source of short-term finance. Tax will be paid on earnings.

Income-tax is paid to the government, on quarterly basis and some other taxes may be payable half- yearly or annually. Amount of taxes due as on the date of the balance sheet but not paid till then are shown as accrued taxes on the balance sheet. Like taxes, interest is paid periodically in the year but the funds are used continuously by a firm. All other such items of expenses can be used as a source of short-term finance but shown on the balance sheet.

The amount of accrual varies with the level of activities of a firm. When the level of activity expands, accruals increase and automatically they act a source of finance. Accruals are treated as “cost free” source or finance, since it does not involve any payment of interest.

But in actual terms it may not be true, since payment of salaries and wages is determined by provisions of law and industry practice. Similarly, tax payment is governed by laws and delay in payment of tax leads to penalty. Hence, a firm must note that use of accruals as a source of working capital paying may not be possible.

Source 3. Deferred Income:

Deferred income is income received in advance by the firm for supply of goods or services in future period. This income increases the firm’s liquidity and constitutes an important source of short-term finance. These payments are not showed as revenue till the supply of goods or services, but showed in the balance sheet as income received in advance.

Advance payment can be demanded by firms which are having monopoly power, great demand for its products and services and if the firm is manufacturing a special product on a special order.

Source 4. Commercial Papers (CPs):

Commercial paper represents a short-term unsecured promissory note issued by firms that have a fairly high credit (standing) rating. It was first introduced in the USA and it is an important money market instrument. In India, Reserve Bank of India introduced CP on the recommendations of the Vaghul Working Group on Money Market. CP is a source of short-term finance to only large firms with sound financial position.

Features of CP:

1. The maturity period of CP ranges from 15 to 365 days (but in India it ranges between 91 to 180 days).

2. It is sold at a discount from its face value and redeemed at its face value.

3. Return on CP is the difference between par value and redeemable value.

4. It may be sold directly to investors or indirectly through dealers.

5. There is no developed secondary market for CP.

Source 5. Public Deposits:

Public deposits or term deposits are in the nature of unsecured deposits, are solicited by the firms (both large and small) from general public primarily for the purpose of financing their working capital requirements.

Regulations:

Fixed deposits accepted by companies are governed by the Companies (Acceptance of Deposits) Amendment Rules, 1978.

The main features of this regulation are:

1. A firm cannot issue public deposits for more than 25 per cent of its share capital and free reserves.

2. The public deposits can be issued for a period ranging from a minimum 6 months to maximum 3 years, only for an amount up to 10% of the company’s share capital and free reserves. Maximum period of 5 years allowed for non-banking financial corporation (NBFC’s).

3. The company that has raised funds by way of issue of public deposits is required to set aside, a deposit and/or investment, by the 30^th April each year an amount equal to 10 per cent of the maturity deposits by the 31^st March of the next year. The amount, so set aside can be used only for repaying the amount of deposits.

4. Finally, and importantly, a company soliciting and accepting the public deposits from the public is required to disclose true, fair, vital and relevant facts in regard to its financial position and performance.

4. (a) What do you mean by foreign capital inflow? Write briefly about advantages and disadvantages of foreign capital. (6+10=16)

-> Foreign direct investment (FDI) occurs when an individual or business owns at least 10% of a foreign company. When investors own less than 10%, the International Monetary Fund (IMF) defines it simply as part of a stock portfolio. Whereas a 10% ownership in a company doesn’t give an individual investor a controlling interest in a foreign company, it does allow influence over the company’s management, operations, and overall policies.

FDI is critical for developing and emerging market countries. Companies in developing countries need multinational funding and expertise to expand, give structure, and guide their international sales. These foreign companies need private investments in infrastructure, energy, and water in order to increase jobs and salaries.

There are various levels of FDI which range based on the type of companies involved and the reasons for the investments. An FDI investor might purchase a company in the targeted country by means of a merger or acquisition, setting up a new venture, or expanding the operations of an existing one. Other forms of FDI include the acquisition of shares in an associated enterprise, the incorporation of a wholly-owned company, and participation in an equity joint venture across international boundaries.

Investors who are planning to engage in any type of FDI might be wise to weigh the investment’s advantages and disadvantages.

Advantages of foreign direct investment:

• Economic growth

The creation of jobs is the most obvious advantage of FDI, one of the most important reasons why a nation (especially a developing one) will look to attract foreign direct investment. FDI boosts the manufacturing and services sector which results in the creation of jobs and helps to reduce unemployment rates in the country. Increased employment translates to higher incomes and equips the population with more buying powers, boosting the overall economy of a country.

• Human capital development

Human capital involved the knowledge and competence of a workforce. Skills that employees gain through training and experience can boost the education and human capital of a specific country. Through a ripple effect, it can train human resources in other sectors and companies.

• Technology

Targeted countries and businesses receive access to the latest financing tools, technologies, and operational practices from all across the world. The introduction of newer and enhanced technologies results in company’s distribution into the local economy, resulting in enhanced efficiency and effectiveness of the industry.

• Increase in exports

Many goods produced by FDI have global markets, not solely domestic consumption. The creation of 100% export oriented units help to assist FDI investors in boosting exports from other countries.

• Exchange rate stability

The flow of FDI into a country translates into a continuous flow of foreign exchange, helping a country’s Central Bank maintain a prosperous reserve of foreign exchange which results in stable exchange rates.

• Improved Capital Flow

Inflow of capital is particularly beneficial for countries with limited domestic resources, as well as for nations with restricted opportunities to raise funds in global capital markets.

• Creation of a Competitive Market

By facilitating the entry of foreign organizations into the domestic marketplace, FDI helps create a competitive environment, as well as break domestic monopolies. A healthy competitive environment pushes firms to continuously enhance their processes and product offerings, thereby fostering innovation. Consumers also gain access to a wider range of competitively priced products.

• Climate

The United Nations has also promoted the use of FDI around the globe to help combat climate change

Disadvantages of foreign direct investment:

• Hindrance of domestic investment

Sometimes FDI can hinder domestic investment. Because of FDI, countries’ local companies start losing interest to invest in their domestic products.

• The risk from political changes

Other countries’ political movements can be changed constantly which could hamper the investors.

• Negative exchange rates

Foreign direct investments can sometimes affect exchange rates to the advantage of one country and the detriment of another.

• Higher costs

When investors invest in foreign counties, they might notice that it is more expensive than when goods are exported. Often times, more money is invested into machinery and intellectual property than in wages for local employees.

• Economic non-viability

Considering that foreign direct investments may be capital-intensive from the point of view of the investor, it can sometimes be very risky or economically non-viable.

• Expropriation

Constant political changes can lead to expropriation. In this case, those countries’ governments will have control over investors’ property and assets.

• Modern-day economic colonialism

Many third-world countries, or at least those with history of colonialism, worry that foreign direct investment would result in some kind of modern-day economic colonialism, which exposes host countries and leave them vulnerable to foreign companies’ exploitation.

• Poor performance

Multinationals have been criticized for poor working conditions in foreign factories.

(b) Write notes on: (8×2=16)

1) External Commercial borrowing.

-> External Commercial Borrowing as it is known in its extended form is an instrument that helps Indian firms and organizations raise funds from outside India in foreign currencies. Indian corporate is permitted by the Indian government to raise funds using External Commercial Borrowing in an effort to help the companies expand their current capacity. External Commercial Borrowing can also be used to bring in fresh investments.

The sources similar to ECBs include Foreign Currency Convertible Bonds (FCCBs) and Foreign Currency Exchangeable Bonds (FCEBs). While the main purpose for the issuance of FCCBs is to raise capital, External Commercial Borrowing is applicable to commercial loans that can include securitized instruments, bank loans, suppliers’ credit, buyers’ credit, and bonds that are availed from lenders that are not Indian residents. The minimum maturity of these instruments, on average, is three years.

Benefits of External Commercial Borrowing

The following are some of the main benefits of raising funds using ECB:

· The value of funds is generally lower when borrowed from external sources. For instance, there are economies that have a lower interest rate, and Indian firms and organizations can borrow money at lower interest rates from the Eurozone and the United States as the rates are comparatively low.

· Since the markets are larger when raising funds through ECB, companies can meet larger requirements from international players in comparison with what can be achieved through domestic players.

· External Commercial Borrowing is basically just a way to take a loan. It does not necessarily have to be of equity nature, and therefore the company’s stakes will not be diluted. Borrowers can essentially raise funds without relinquishing control as debtors will not have any voting rights in the company.

· The investor base can be diversified by the borrower.

· ECB offers access to global markets so that borrowers have greater exposure to worldwide opportunities.

· ECB offers benefits to the economy as well. Inflows can be directed into the sector by the government of India, thereby increasing its potential for growth. For instance, a greater percentage of funding through ECB can be allowed by the government for the SME and infrastructure industry. This aids significantly in the overall growth of the country.

· Companies can become increasingly profitable through ECB.

Disadvantages of External Commercial Borrowing

The following are the main disadvantages of raising funds through ECB:

· The company could develop a lax attitude as the funds are available at lower rates. Companies could borrow excessively due to this and it could eventually lead to higher debt on the company’s balance sheet, thereby adversely affecting financial ratios.

· Rating agencies see companies with higher debt on their balance sheets in a negative light, which could lead to a potential downgrade of such companies. Eventually, this could enhance the company’s cost of debt, thereby destroying the image of the company in the market. Furthermore, the shares of the company could also be subject to a decline in market value over a period of time.

· Considering the fact that raising funds through External Commercial Borrowing is done in foreign currencies, the principal as well as the interest will have to be paid in foreign currencies. As such, the company is exposed to risks associated with exchange rates. Hedging costs may have to be incurred by the company, thereby leading the company to incur heavy losses.

2) Foreign Direct Investments (FDI).

-> Foreign direct investment (FDI) is where an individual or business from one nation, invests in another. This could be to start a new business or invest in an existing foreign owned business. For instance, Mr Bloggs from the US has $1 million and wants to start a new company in Germany. He invests this, creating a new clothing manufacturing firm in the country. This would classify as a FDI.

However, the definition is slightly different when it comes to investing in a foreign companies assets. According to the IMF , a foreign direct investment is where the investor purchases over a 10 percent stake in the company.

Anything under this amount is classed as part of a ‘stock portfolio’. For instance, this covers the small amount of stocks that the average citizen may have invested. Essentially, anything too small to influence any level of control of the firm.

Types of Foreign Direct Investment (FDI)

Horizontal FDI

Horizontal FDI is where funds are invested abroad in the same industry. In other words, a business invests in a foreign firm that produces similar goods. For instance Nike, a US based firm, may purchase Puma, a Germany based firm. They are both in the industry of sportswear and therefore would be classified as a form of horizontal FDI.

Vertical FDI

Vertical FDI is where an investment is made within the supply chain, but not directly in the same industry. In other words, a business invests in a foreign firm that it may supply or sell too.

For instance, Hersheys, a US chocolate manufacturer, may look to invest in cocoa producers in Brazil. This is known as backwards vertical integration because the firm is purchasing a supplier, or potential supplier, in the supply chain.

We then have forwards vertical integration. So this is where a firm invests in a foreign company that is further along in the supply chain. For instance, Hersheys may look to purchase a share in Alibaba; where it sells its products.

Conglomerate FDI

Conglomerate FDI is where an investment is made in a completely different industry. In other words, it is not linked in any direct way to the investors business. For instance, Walmart, a US retailer, may invest in BMW, a German automobile manufacturer.

This may seem strange to some but offers big businesses an opportunity to expand and diversify into new areas. To explain, some big businesses come to a point where the demand for its fundamental business starts to decline. In order to survive, it must invest in new ventures. Even big businesses with strong demand may look to new industries where growth and return on investment are significantly larger.

Benefits of Foreign Direct Investment

1. Boost to International Trade

Foreign direct investment promotes international trade as it allows production to flow to parts of the world which are more cost effective. For instance, Apple was able to conduct FDI into China to assist with the manufacturing of its products.

However, many of the components are also shipped in from elsewhere, generally from the region of Asia. For instance, the camera is made by Sony, which sources its manufacturing in Taiwan . There is also the case of the flash memory, which is sourced by Toshiba in Japan . We also have the touch ID sensor which is made in Taiwan, and the chipsets and processors, which are made by Samsung in South Korea and Taiwan.

These are but a small handful of the components, but demonstrate how inter-connected the supply chain has become between countries. Both Samsung And Song have conducted investment in the likes of Taiwan, China, and Japan. As a result, it has created new jobs in the region and boosted trade between the nations.

2. Reduced Regional and Global Tensions

As we have seen with the Apple example, a supply chain is created between countries. In part, this is created by the division of labor. For instance, South Korea may make the batteries, Taiwan the ID sensors, and Japan the cameras. As a result, they are all dependent on each other.

If there is a revolt in Taiwan, the whole process could fall apart. Without the ID sensors, the final product cannot be made, so the need for other components is also reduced. This means workers in Japan and South Korea are also affected.

As a result of this interconnected supply chain, it is in the interest of all parties to ensure the stability of its trading partners. So FDI can create a level of dependency between countries, which in turn can create a level of peace.

To use a famous metaphor, you don’t bite the hand that feeds you. In other words, if nations are reliant on each other for their income, then the likelihood of war is also reduced.

3. Sharing of Technology, Knowledge, and Culture

Foreign direct investment allows the transfer of technology, knowledge, and culture. For instance, when a firm from the US invests in another from India, it has a say in how the firm is run. It is in its interest to ensure the most efficient use of its resources.

4. Diversification

From the businesses perspective, foreign direct investment reduces risk through diversification. By investing in other nations, it spreads the companies exposure. In other words, it is not so reliant on Country A. For instance, Target derives its entire revenues from the US. Should an economic recession hit Stateside, it’s almost guaranteed to harm its profits.

By diversifying and investing in foreign markets, it allows businesses to reduce domestic exposure. So if a US firm invests in new stores in Germany, the level of risk is reduced. This is because it is not reliant on one market. Whilst there may be a decline in demand for one, there may be growth in another. To use an analogy, it’s similar to placing a bet in roulette on both red and black.

5. Lower Costs and Increased Efficiency

Foreign direct investments can benefit from lower labor costs. Often, businesses will off-shore production to nations abroad that offer cheaper labor. Now there is an ethical element to this than is often debated, but we will leave that aside for now. Whether it is ethical or not is irrelevant as it is a benefit to the business.

6. Tax Incentives

Reduced levels of corporation tax can save big businesses billions each and every year. This is why big firms such as Apple use sophisticated techniques to off-shore money in international subsidiaries.

Countries with lower tax regimes are usually those that are favored. Examples include Switzerland, Monaco, and Ireland, among others.

Furthermore, there are also tax incentives by which the foreign government offers tax breaks to investors in a bid to encourage FDI.

7. Employment and Economic Boost

When money is invested in another country, it creates jobs, new companies, and new factories/buildings. This brings about new opportunities for local residents and can stimulate further growth.

With greater levels of employment being made available, it creates a greater level of purchasing power in the wider economy. If we couple this with the fact that big corporations often pay above the average to attract the best workers, we can see a spill-over effect.

With employees earning more money, they also create demand for other goods in the economy. In turn, this stimulates employment in other markets and industries.

Disadvantages of Foreign Direct Investment

1. Foreign Control

One of the main fears, particularly among developing nations, is that they can essentially be brought and controlled by foreign powers. Land, labor, and capital are relatively cheap in countries such as Vietnam or Taiwan. Therefore the US or other developed nations can come in with significant sums and buy up vast sums of the country.

This is why some countries place strict restrictions on FDI. Often, investors must join a partnership with a local business in order to enter. This way there is still a level of domestic control

2. Loss of Domestic Jobs

When significant sums of money are transferred to another, it is an investment that would have been used in the home market. Consequently, FDI may boost employment in foreign nations, but may temporarily reduce it at home.

Instead of the funds being invested in new factories and creating jobs, it is sent abroad instead.

As we have seen in the US, manufacturing jobs have been lost to the likes of Mexico, which can manufacture motor vehicles at a lower cost. Whilst this provides cheaper goods for the consumer, it can come at the cost of domestic jobs.

3. Risk of Political or Economic Change

When investing abroad, particularly in developing nations, there is huge risk that is associated. For instance, there may be huge political upheaval, or a regional war. This may consist of a new government that is not so favorable to investors.

Consequently, there is an element of significant risk. With that said, those countries and regions that have been marred with instability are usually the last to be considered for investment. We only need to look at the Middle East and Africa as examples.

Nevertheless, even in many Asian countries, there is a possibility of the unknown. With rising tensions between China and Japan, there are risks of conflict as well as political uncertainty. All of which present a higher risk.