Active and passive foreign capital
Foreign capital flows into a country in one of two forms. The active form is foreign direct investment, FDI: the investing entity participates in decision making and drives the business it has invested in. The passive form is foreign portfolio investment, FPI: investment in markets, equity or bonds, by foreign portfolio investors, with no involvement in management and no part in the decision-making process.
| FDI | FPI | |
|---|---|---|
| Form | Active: participates in decisions and drives the business | Passive: buys equity or bonds in the market, no management role |
| Horizon and stability | Long-term, stable capital | Hot money that can be pulled out at any time |
| Limits | Sector rules apply (chapter 14 territory) | Upper limits on individual and combined FPI holdings in a company's paid-up capital |
| Risk to the economy | Low; welcomed by developing economies | Sudden exit can create systemic risk |
Why FDI is welcomed
Every developing economy welcomes FDI, because beyond bringing capital into the country it brings four other things.
- 1Job creation.
- 2New technologies.
- 3New managerial skills.
- 4New products and services.
A foreign auto maker builds a plant, hires two thousand people and brings its production system: FDI, here for decades. A foreign fund buys shares of a listed auto maker on the exchange: FPI, which may be sold next week if the fund's view or its home-market conditions change. Both are foreign capital; only one can vanish overnight.
FDI is long-term and stable. FPI money is considered hot money because it can leave at any time, creating systemic risk. An option calling FDI hot money, or describing FPI as participating in management, has the two swapped.
- Foreign capital arrives in active form as foreign direct investment, where the investor participates in decision making and drives the business, or in passive form as foreign portfolio investment in equity or bonds with no involvement in management.
- There are upper limits on the individual and combined holdings of FPIs in the paid-up capital of Indian companies.
- Developing economies welcome FDI because beyond capital it brings job creation, new technologies, new managerial skills, and new products and services; it is long-term and stable.
- FPI money is hot money: it can be pulled out at any time, which can create systemic risk for the economy.