One minister holding finance and commerce portfolios could create new synergy

17 Jun, 2014, 05.24AM IST

By Manoj Pant

The new government seems to have hit the ground running. One of the issues in the new "cluster" approach to
ministries is to combine the portfolios of commerce and finance under one minister holding independent charge
of the first while sharing junior responsibility in the ministry of finance. This is supposed to create " synergy" in the
case of overlapping functions.

In this article, I will argue that this could be a worthwhile objective, especially in the context of trade and foreign
direct investment (FDI). As I will argue, some administrative reorganisation seems to be merited given the nature
of both trade and FDI flows.

While the term "trade" is easily understood, there seems to be some confusion about what is FDI. The definitional
issues are not inconsequential. Here is where the synergies are useful. FDI refers to financial flows from an
enterprise in one country to another "related" enterprise in another country.

The crucial issue is to distinguish FDI from other financial flows between unrelated entities. This is now what we
call FIIs in India and portfolio investment in general.

This was clearly recognised in the Industrial Policy of 1991, which stated that FDI is to be preferred to other forms
of financial capital flows. The logic was that FDI flows are more stable and not related to short-term swings in
interest rates or growth rates. So, one distinction is clearly drawn: FDI and foreign institutional investment (FII)
are two different entities altogether.

Why does this matter? For one, measures to attract FII and FDI are radically different. While FII flows are actually
determined by intercountry differences in interest or exchange rates, this is clearly not true of FDI. Second,
recognising the relation of FDI flows to production capacities, most direct tax treaties between countries give a
favourable treatment regarding the withholding tax rates applied on dividends or royalty payments among
"related" companies.

Clarity Before Vision

Yet, it has taken the ministry of finance a long time to define FDI flows. Recently, there seems to have been
some clarity when FDI flows were to be those where the investing company owns at least 10% of the equity of
the recipient company.

Second, an issue not really appreciated so far is that trade and FDI are really two sides of the same coin. So, FDI
is simply another way of engaging in trade. An entity in one country can engage with another country
through trade, that is, export or import. However, where there is a strong technology component, FDI is
the preferred form of engagement. In fact, about 60% of world trade is between "related" companies.

As world trade is increasingly in inputs and intermediate goods, this intra-firm trade is now the dominant form. So,
FDI simply combines the three elements of trade in goods, trade in services for instance, managerial services
and international technology flows. In fact, there is a near-perfect correlation between the bilateral FDI of
countries and their total trade.

Closer home, China's trade is almost completely driven by FDI-dominated firms. The phenomena of Indian
pharmaceutical and software companies acquiring companies in Europe and elsewhere (through FDI)
coincides with the high export growth in these sectors. More generally, it is impossible to trade
internationally without being part of the world "supply chains" that are linked by FDI between firms some
of which are actually quite small.

Yet, in India, there is a bureaucratic separation of FDI and trade. While the ministry of finance determines the
definition of FDI, the policies and control of FDI are with the department of industrial policy and promotion (Dipp),
which is a department in the ministry of commerce and industry.

Left Hand, Meet Right Hand

On the other hand, trade policy and so on is the preserve of the trade policy division of the commerce ministry.
So, while one wing liberalises trade, the other makes FDI policy more restrictive, thus negating all export efforts.
At the same time, wrangling over the definition of FDI in the ministry of finance leads to incoherent investment
climate for foreign investors.

Tech-Driven Trade

Similarly, while some technology dominated exports may need firms with high investment capacities, such
investment has to go through the route of the Foreign Investment Promotion Board (FIPB) that itself requires
consultations among an even large set of departments.

Today, trade is determined more by technology than by the traditional access to cheap labour and other inputs.
The emerging globalisation of production makes it imperative to be part of these international "supply chains".

The recent reorganisation in the ministry of finance and commerce must respond to this by creating a separate
wing that deals simultaneously with the issues of taxation of FDI and trade and FDI policies. World trade is on the
upswing. Let us not miss the boat again.