Anti-China Investment Rule: A Tale Of Unintended Consequences

Prior to 1991, India suffered the consequences of conservative FDI laws as compared to other Asian economies that welcomed foreign investment. Governments since then have recognised the importance of foreign direct investment as a key source of capital for the country’s growth and consistently liberalised the rules governing FDI to facilitate foreign investment. Data also reflects a positive correlation between FDI and GDP. As the economic effects of the Covid-19 crisis become more apparent, India needs to encourage and attract FDI more than ever.

In April this year, India joined the ranks of several countries seeking to protect domestic companies from foreign takeovers in light of dwindling valuations caused by the rapidly unfolding pandemic. Through the issue of a press note followed by an amendment to the rules governing FDI, the central government mandated government approval for foreign investment from countries which share a land border with India, as well as foreign investment having ‘beneficial ownership’ from such countries. Amid global suspicions about Chinese investment strategy and its underlying security concerns, the government made this move to protect against opportunistic Chinese investments long before the unprovoked killing of our soldiers on the border sharpened anti-Chinese sentiment.

Unintended Consequences

In its simplicity, the amendment has multiple ambiguities which have kept investors, investees and advisors guessing. The most conspicuous is the absence of guidance on what constitutes ‘beneficial ownership’.

Existing Indian laws dealing with beneficial ownership in India set out a threshold, ranging from 10% to 25%, above which it is considered relevant to look beyond a corporate entity to its ultimate beneficial individual owner.

A key class of capital most affected by this ambiguity is private equity/venture capital controlled by managers in countries mentioned above, who may have minority Chinese investors, but are far removed from control or espionage concerns.

Venture capital is a critical, and possibly the only source, of capital for early-stage companies. Our burgeoning start-up industry, which has already spawned globally reputed unicorns, relies heavily on the backing of foreign investment to fuel innovation and development. Similarly, mid-stage companies look to private equity investors for much needed capital for growth and expansion, and in Covid-19 times, survival. Since 2017, India has seen a record rise in private equity/venture capital investment, having received $26 billion in 2017, $37 billion in 2018, and $48 billion in 2019 which accounted for ~1.7% of the India’s GDP for the relevant year.

Also affected are listed companies with broad based shareholding which often have minority shareholding that may be traced back to restricted countries, but such companies have no control over the acquisition of minority interests in them given their listed status. Such investor entities are usually from jurisdictions which are compliant with the Financial Action Task Force and International Organisation of Securities Commissions, and are likely regulated in their home countries. There is little merit in holding them to the same threshold as companies which may be owned and controlled by the Chinese government/nationals.

Another casualty of the amendment are large global transactions with limited operations in India -- such as IT support, manufacturing facilities, back offices or R&D facilities. India has been an attractive destination to establish such operations, which in turn generate employment across the country. Subjecting such global transactions to Indian government approval on account of minority Chinese investment in the acquirer would only discourage global corporations from setting up offices or facilities in India.

The amendment is also ambiguous on whether it applies only to Chinese citizens or even residents. Extending it to residents would impact capital flows from Hong Kong, one of the world’s largest financial hubs and home to key global investors (which by being a special administrative region of China, is a restricted territory). Residents in Hong Kong who are not citizens of restricted countries, including non-resident Indians, do not pose the threat the amendment seeks to address.

Apart from the absence of guidelines for determining ‘beneficial ownership’, there are no exemptions for transactions that clearly do not constitute ‘opportunistic takeovers’ or pose any threat. For example, follow-on minority investments by existing Chinese investors in Indian start-ups who are already suffering from the lack of capital at the time when they need it most.

Need for Clarity

The government needs to urgently provide clarity regarding the ambit of its anti-China rule to ensure that FDI flows are not irretrievably damaged, including in relation to the following:

• Beneficial Ownership Threshold: Setting a 10% or 25% threshold (rules for determination of which are already available under existing Indian laws) for beneficial ownership from restricted countries in a foreign investor for triggering the need for prior government approval for investment in Indian companies.

• Clear and Time-Bound Process: A structured process to consider investments seeking approval would improve efficiency, along with an outer time limit for approval or rejection. Since the amendment, several applications are pending, leaving signed deals in the lurch with large amounts of much-needed funds one step away from Indian bank accounts. In exceptional cases, like the process in Australia, the government can extend the time.

• Nodal Agency: Instead of investors having to pursue multiple ministries for approval and getting tied up in red tape, it is imperative that a nodal agency, like the erstwhile Foreign Investment Promotion Board, administer the approval process. This will enhance accountability, reduce processing time and provide much needed certainty. The CFIUS in the U.S. and the Foreign Investment Review Board in Australia are global examples of such nodal agencies.

• Transparent Decision-Making: It would prove useful to specify sectors or characteristics of investments which will see stricter scrutiny. In Canada, rules around FDI have been tightened for public health and critical goods and services industries, while in the U.S., the scope of review is for ‘national security’. We have always had sensitive sectors (defence, telecom and space, to name a few) and the government could clarify that investment from restricted countries in these sectors will not be permitted.

• Citizenship Test: Individuals should be restricted on the basis of citizenship only and not residence, to avoid impacting investments from a key financial hub like Hong Kong.

• Exceptions: The following exemptions should be introduced to enable low-risk investments:

Acquisition Threshold: Passive investments of less than 10% could be allowed irrespective of the identity of the investors subject to there being no control. Indian laws provide no special rights of note to a sub-10% shareholder that could be of concern.

Start-ups: Early-stage companies in non-sensitive sectors should be exempted. Chinese investments in start-ups have been key to their sustainability and growth.

Follow-on Investments: Subsequent investments into India by existing investors who receive no incremental shareholding or rights could be exempt.

Regulated Entities: Large international companies and global funds, which are already regulated in their home countries, as described above, should be exempted from having to seek approval.

Global Transactions: Global transactions having an insignificant Indian element (in terms of revenue and/or assets) should also be exempted.

Certainty is Key

With the increasing strain on Indo-China diplomatic relations, the government has taken various steps to stem what is seen as China’s economic imperialism, including banning various Chinese apps. These steps may well be justified to protect our national interests.

Whilst protectionist measures against China are no doubt required, we need to ensure that we do not cut off our nose to spite our face.

India competes with many other destinations (including other members of BRICS, China, Vietnam, Indonesia) for investment from global pools of capital. The amendment in its current form prejudices our ability to attract much needed FDI, and it is important the government urgently clarify the same to negate at least the unintended consequences.

Ashwath Rau is Senior Partner, Pranav Atit is a Senior Associate and Chitrangda Singh is an Associate of AZB & Partners.

The views expressed here are those of the authors, and do not necessarily represent the views of BloombergQuint or its editorial team.