• UGI USER
  • May 17, 2024
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INVESTMENT MODELS

Introduction and Concept of Investment

Investment is the act of allocating resources, usually money, with the expectation of generating an income or profit. This can be done through various channels, both directly and indirectly, across different sectors of the economy such as the primary (agriculture, mining), secondary (manufacturing), and tertiary (services) sectors, as well as in financial securities including shares, debentures, and mutual funds. The underlying goal of investment is to enhance production capabilities or achieve financial gains by investing in assets that offer potential returns.

Investment Models Used in India Since Independence

Phase Time Period Description
Phase 1: State-led Development 1951-1969 During this period, the Government of India (GoI) employed both internal and external methods to mobilize the necessary resources for development. The focus was on infrastructure and the social sector. This era saw the implementation of the Mahalanobis Plan, along with regulations across the financial system, taxation, and fiscal policy to maximize government revenue for its financial planning goals.
Phase 2: Inclusion of Private Capital 1970-1973 The GoI introduced the Industrial Policy of 1970, deciding to incorporate “private capital” into the planned development process. This move aimed to encourage the private sector to enter markets previously inaccessible to them due to technological and financial constraints.
Phase 3: Introduction of Foreign Capital 1974-1990 The enactment of the Foreign Exchange Regulation Act (FERA) in 1974 marked the government’s first initiative to use “foreign capital” for development planning. Post-1985, there was a push towards more active resource mobilization, with Planning Commissions advocating for the economy to open up and allow private and foreign investments in sectors traditionally reserved for the government.
Phase 4: Economic Restructuring 1991 onwards Facing a severe Balance of Payments crisis and the aftermath of Gulf War I, India turned to the International Monetary Fund (IMF) for financial assistance. This led to a decision to “restructure” the economy, initiating a series of reforms in 1991 that opened up various sectors to private and foreign investment, significantly altering India’s economic landscape.

The Need for Investment in Infrastructure

  • Infrastructure development is inherently capital-intensive and presents a significant challenge for governments, particularly in situations where fiscal constraints such as deficits limit the availability of public funds. India, for example, has experienced fiscal deficits exceeding 5% of GDP, with figures spiking to around 9% during the COVID-19 pandemic. Such financial limitations hinder the government’s capacity to finance large-scale infrastructure projects independently.

Present Status of Investment Models

  • The Government of India (GoI) acknowledges the constraints of the existing public-led investment models and proposes to transition towards a system that enables and enhances private sector participation. The current strategy aims to unbind the private sector’s latent potential by establishing an appropriate financial system, legal framework, and labor regulations conducive to investment and economic growth.

Prominent Investment Models Used
Harrod-Domar Model

Premise and Implications

  • The Harrod-Domar Model investigates the dynamic nature of capital and investment to understand economic instability. It suggests that balanced economic growth is not an automatic outcome due to influences like population growth, natural resource depletion, and technological progress on investment rates and the capital-output ratio.
  • The model posits that increased savings lead to heightened investments, thereby raising the capital stock and enhancing economic growth.

Limitations

  • In low-income countries, raising the savings ratio is challenging due to a generally low propensity to save.
  • The lack of a robust financial system in many developing countries impedes the conversion of increased savings into investment.
  • It’s difficult to achieve efficiency gains that reduce the capital/output ratio, leading to capital usage inefficiencies.
  • Underinvestment in R&D contributes to market failures by not improving the capital/output ratio.

Rao-Manmohan Model

Premise and Implications

  • Introduced during India’s economic crisis in 1991, this model aimed at liberalizing the economy by easing import restrictions, enhancing managerial professionalism, improving public sector operations, and facilitating access to foreign direct investment.
  • It marked a significant shift towards globalization by lifting licensing in most industries and allowing greater autonomy and foreign equity participation.

Limitations

  • While the model spurred growth, increasing GDP growth rates, it failed to address equity adequately, primarily benefiting the corporate sector.
  • The entry of multinational corporations and adoption of a capital-intensive development pattern limited its impact on equity, employment, and poverty eradication.
  • The agricultural sector and smaller Indian businesses faced challenges due to the model’s focus on globalization and liberalization.

Factors Affecting Investment

  • National Income or GDP: A rise in GDP typically increases consumption and investment opportunities as people spend more on consumer goods.
  • Inflation: High inflation reduces purchasing power and demand, negatively impacting industrial performance and investment scope.
  • Population: A growing population expands the consumer market, thereby increasing demand and stimulating investment.
  • Tax Rates: High taxes can dampen investment by reducing disposable income and corporate profits.
  • Government Policies: Positive interventions, such as subsidies and incentives, can encourage investment.
  • Agriculture: The agricultural sector supports industry by providing raw materials.

Sources of Investment

  • Internal Funding: Profits from government businesses or industries, including disinvestment proceeds.
  • Borrowing: Government borrowing from banks or issuing financial assets.
  • Issuing Shares: Raising funds through public offerings, like Initial Public Offering (IPO) or Secondary Equity Offering (SEO).

Models Used in the Investment Process

  • Importance of Investment Model: The Union budget 2022-23 emphasized investment-led growth, highlighting the role of investments in providing opportunities for large-scale production, technology transfer, industrialization, urbanization, and employment generation.
  • Public Investment Model: Focuses on government-financed investment, which, despite its limitations due to inadequate revenue generation, can significantly boost economic performance and aggregate demand. This model was prevalent before the liberalization, privatization, and globalization (LPG) reforms of 1991.

Towards Attaining Public Investment-Led Growth

  • Capital Investment: Enhances employment opportunities and supports sectors like agriculture through improved infrastructure.
  • Innovative Financing: Offers incentives to sunrise sectors to stimulate growth.
  • Infrastructure Development: Facilitated by initiatives like the PM Gati Shakti scheme, which aims to boost multimodal logistics facilities.

Challenges in Public Investment-Led Growth      

  • Inflation and Interest Rates: High public investment can lead to inflation and rising interest rates, complicating the investment climate.
  • Industrial Growth Slowdown: The industrial growth rate has experienced fluctuations, highlighting the need for sustainable investment strategies.
  • Limited Labor Demand: The demand for labor resulting from public investment in infrastructure may be constrained if the investment is not profit-motivated.

Private Investment Model

Introduction to Private Investment

  • Private investment represents funds invested by non-government entities, including individuals, companies, and foreign investors. This can enter a country as Foreign Direct Investment (FDI) or Foreign Portfolio Investment (FPI), providing a crucial alternative to public sector investment, especially when government revenue falls short.

Importance of Private Investment

  • Economic Growth: Private investment is a key driver of GDP growth, contributing significantly to aggregate demand and accounting for a considerable portion of the total investment and GDP during 2017-2020.
  • Employment Creation: It plays a vital role in creating jobs and improving human capital.
  • Public Investment Complement: Helps reduce the fiscal burden on the government by supplementing public investment.
  • Boost to Startups: The encouragement of entrepreneurial ventures, supported by policies like tax exemptions announced in Budget 2022-23.
  • Foreign Investment Attraction: The last eight years have seen further liberalization, making India a preferred destination for global investors with record FDI inflows.

Reasons for Low Private Investment

  • Lack of Funds: Many sectors face a decrease in credit off-take due to funding issues.
  • Monetary Policy Transmission Issues: Banks’ reluctance to lend despite lower repo rates.
  • Increasing NPAs: A significant portion of bank loans in India are stressed, affecting lending.
  • Government Borrowing: High levels of government borrowing crowd out private investment.
  • Household Savings vs. Fiscal Deficit: The savings rate of households is overshadowed by the fiscal deficit, leaving little room for private sector borrowing.

Public-Private-Partnership (PPP) Model

  • A PPP is a collaborative agreement between a government agency and a private party, sharing risks, rewards, skills, expertise, and finance to achieve desired outcomes. This model is particularly suited for large-scale projects like infrastructure development and public services.

Features of PPP

  • Risk Sharing: The private sector takes on a significant portion of project risk.
  • Public Sector Supervision: Ensures that the private sector meets the contract’s performance standards.
  • Cost Recovery: The private sector recovers costs through service fees or direct payments from the public sector, linked to performance standards.
  • Capital Contribution: Primarily, the private sector contributes to the capital costs.

Advantages of PPP

  • Bridging Funding Gaps: Addresses the infrastructure funding gap and financial constraints.
  • Government Budget Relief: Allows government funds to be redirected towards critical sectors like education and health.
  • Access to Infrastructure Services: Shifts financial responsibility from the public sector, potentially enhancing service access.
  • Risk and Cost Management: Transfers cost escalation and project risk to the private sector, promoting efficiency.

Limitations of PPP

  • Project Viability Issues: Political, legal, and commercial challenges can deter private sector interest.
  • Crony Capitalism Risks: The potential for corruption through close ties between business and politics.
  • Tendering Costs: High costs involved in tendering and negotiation due to complex advisory and legal requirements.

Engineering Procurement and Construction (EPC) Model

  • The EPC model involves the government funding the entire project, while the private sector is responsible for the engineering and construction aspects. This model places minimal risk on the private participant, with the government handling project cost risks and additional concerns like land acquisition and security.

Process and Characteristics

  • Government-Funded: The project’s financial burden is entirely on the government.
  • Turnkey Projects: Known for their “turnkey” nature, where the government’s role is primarily to commission the project upon completion.
  • Highway Projects: Commonly applied in infrastructure projects, especially highways.

Issues with EPC

  • Cost and Margin Pressures: Delays and unrealistic estimations can escalate costs and reduce profitability.
  • Government Resource Limitations: Limited financial resources can hinder project execution.

Comparison with PPP

  • Financial Responsibility: The EPC model sees the government bearing all financial risks, while PPP involves risk-sharing.
  • Reduced Risk for Private Sector: EPC offers a more risk-averse option for private investors, with fewer responsibilities regarding clearances and land acquisition.
  • Efficiency and Timeliness: EPC can potentially offer a quicker route to project completion due to simplified procedures and reduced private sector obligations.

Sector-Specific Public-Private Partnership (PPP) Models

  • Public-Private Partnership (PPP) models represent collaborative ventures between the public sector and private entities to finance, build, and operate projects ranging from infrastructure to services. These models aim to leverage the efficiency, expertise, and capital of the private sector while retaining the public sector’s control over essential services and infrastructure.

Build-Operate-Transfer (BOT)

  • Concept: In the BOT model, a private entity is responsible for financing, constructing, operating, and eventually transferring the project back to the public sector.

Mechanism:

  • Build: Secure financing and construct the project.
  • Operate: Manage and maintain the facility, recovering investment through charges or tolls.
  • Transfer: After a set period, ownership and operation revert to the public sector.

Advantages:

  • Reduces fiscal burden on the public sector.
  • Brings private sector efficiency and quality to the project.
  • Encourages competitive bidding, lowering costs.
  • Shares financial risk with the private sector.

Design-Build-Finance-Operate-Transfer (DBFOT)

  • Concept: The private sector is contracted to design, construct, finance, and operate a project, with payment coming from the government or through user fees.
  • Key Aspect: The public sector retains project ownership.

Build-Operate-Lease-Transfer (BOLT)

  • Concept: A private entity builds and owns a facility, then leases it to the public sector, with ownership transferring back at the lease’s end.
  • Advantage: Shifts financial burden of construction away from the government.

Build-Own-Operate (BOO)

  • Concept: The private sector builds, owns, and operates a facility indefinitely, selling its output to users or the government.
  • Common Use: Often found in the power sector with or without government power purchase agreements.

Toll-Operate-Transfer (TOT)

  • Concept: The government constructs and operates a project, then leases it to a private entity for operation and maintenance.
  • Advantage: Addresses risk-sharing issues in BOT and encourages new investments.

Lease-Develop-Operate (LDO)

  • Concept: The government retains ownership of a facility, which a private entity leases, develops, and operates.
  • Application: Commonly used in airport development projects.

Government-Owned Contractor-Operated (GOCO) Model

  • Concept: A private entity operates a government-owned facility, such as a repair workshop.

Benefits:

  • Lowers government spending.
  • Facilitates collaboration with original equipment manufacturers.
  • Requires no private investment in land, infrastructure, or machinery.
Investment Model Description Payment Mechanism Private Sector Participation
Hybrid Annuity Model (HAM) A combination of the Build-Operate-Transfer (BOT) Annuity and Engineering, Procurement, and Construction (EPC) models. The government pays 40% of the project cost in five equal installments during the construction phase. The remaining 60% is paid as variable annuity amounts over the operation period after the project’s completion. Moderate: The private sector is responsible for construction and operation but relies on the government for a significant portion of the funding.
BOT Annuity Model In this model, a private entity builds and operates the highway for a predetermined period before transferring ownership back to the government. Payments are made to the private player on a bi-annual basis after the project becomes operational, ensuring a fixed return on investment. High: The private sector takes on construction, operation, and maintenance responsibilities, with revenue coming from government annuities rather than tolls.
BOT Toll Model A road developer constructs the road and recovers the investment through toll collection from road users, with no direct payment from the government. Revenue is generated through toll collection over a concession period, typically around 30 years. Very High: The private sector bears the full cost and risk of construction and operation, with revenue dependent on traffic volumes.
EPC Model The government contracts private companies to provide engineering expertise for project construction. The government bears all construction costs and procures materials, making payments to private contractors for their services. Low: The private sector’s role is limited to providing engineering services, with no responsibility for financing or operational risks.

FOREIGN INVESTMENT MODELS

  • Foreign Investment Models play a pivotal role in the economic development of a country by facilitating the inflow of capital, technology, and expertise. Among these models, Foreign Direct Investment (FDI) stands out due to its direct impact on the economy.

Foreign Direct Investment (FDI)

  • Definition and Benefits: FDI is an investment made by an entity based in one country into a business or corporation in another country, aiming to establish a lasting interest and partnership. FDI is not just about capital; it also brings along skills, technology, and knowledge, contributing to the host country’s economic development.
  • Foreign Affiliation in India: In the Indian context, a foreign affiliate is defined as a subsidiary company or associate in which the foreign investor owns at least 10% but not more than half of the shareholder’s voting power.

Channels of FDI Approval

  • Automatic Route: This route allows Indian companies to issue shares up to 100% of their paid-up capital without prior government approval. Sectors under this route include medical devices, thermal power, insurance (up to 49%), civil aviation, and more.
  • Government Approval Route: Investments not covered under the automatic route require prior government approval. This includes sectors such as core investment companies, mining and minerals, satellite, print media, among others.

FDI in the Indian Context

  • Global Positioning: According to the World Investment Report by UNCTAD (2019), India holds the 9th position among the world’s top FDI recipients. The liberalization that began post the 1991 financial crisis has led to a steady increase in FDI.
  • Top Sources of FDI: Singapore and the USA are among the top countries investing in India. India is recognized as the world’s top destination for Greenfield FDI projects.

Impact of FDI on the Economy

  • Technology Transfer and Job Creation: FDI enables the transfer of multinational corporations’ technology to domestic firms, fostering business growth and creating employment opportunities.
  • Strengthening of Domestic Currency: An increase in exports and a surplus balance of payment, due to FDI, strengthen the domestic currency.
  • Supplementing Domestic Investment: FDI acts as a crucial supplement to domestic investment, especially in economies with low domestic savings like India.

Measures to Promote FDI

  • Government Schemes: Initiatives such as the Production Linked Incentives (PLI) for electronics manufacturing aim to attract more FDI.
  • Policy Amendments: Recent policy amendments include allowing 100% FDI under the automatic route in coal mining and increasing the FDI ceiling in the insurance sector to 74%.

Reforms in FDI Policy 2020-21

  • Strategic Disinvestment: The government has cleared strategic disinvestment in the petroleum and natural gas sector with 100% FDI under the automatic route.
  • Telecom Sector: FDI up to 100% is allowed under the automatic route in the telecom sector.

New FDI Policy

  • Aim: The new FDI policy was formulated to prevent opportunistic acquisitions of Indian companies during the COVID-19 pandemic.
  • Regulations for Bordering Countries: Investments from countries sharing a land border with India, or where the investor is based in or a citizen of such a country, must go through the government route.

Foreign Portfolio Investment (FPI)

  • Foreign Portfolio Investment (FPI) involves the holding of foreign financial assets, including stocks, bonds, and other investment vehicles, by investors from another country. Unlike Foreign Direct Investment (FDI), FPI does not grant the investor direct control over a company’s assets or operations. FPI is characterized by its liquidity and the ease with which investments can be bought and sold in the market. However, this liquidity also means FPI is more susceptible to market volatility.

FPI vs. FDI

  • FPI and FDI are both crucial means through which economies attract foreign investment, yet they serve different investor goals and have distinct impacts on the economy. FDI involves investing in a foreign country with the intent of obtaining a lasting interest and significant influence over the management of a company. This typically means owning 10% or more of the business’s shares. On the other hand, FPI is generally more passive and involves investments that do not confer control over a business. Investors in FPI are often more interested in quick, short-term gains rather than long-term growth and operational control.

FPI in the Indian Context

  • Short-term Perspective: FPI investors usually look for short-term gains, moving in and out of investments quickly. This contrasts with FDI investors, who typically seek long-term growth and possibly a say in a company’s management.
  • Ownership Stakes: FPI is characterized by smaller ownership stakes in companies, often less than 10%. This level of investment does not provide significant influence or control over a company’s operations.
  • Regulatory Framework: In India, FPIs include FIIs, their sub-accounts, and Qualified Foreign Investors (QFIs). These entities are permitted to own up to 10% of a company, aligning with the global definition of FPI.

Significance of FPI for Economies

  • FPI plays a vital role in providing economies with the necessary capital for growth and development. For emerging markets like India, FPI represents a significant source of investment, contributing to the overall health of the stock market and providing companies with the capital they need to expand and innovate. However, due to its volatile nature, FPI can also lead to increased market instability. Sudden influxes or withdrawals of FPI can affect currency values, stock prices, and even the broader economy.

FII Vs. QFI

Feature/Regulation Foreign Institutional Investors (FII) Qualified Foreign Investors (QFI)
Definition FIIs are companies headquartered outside of India that propose investments within the country. They can significantly influence a nation’s economy and include hedge funds, mutual funds, pension funds, insurance companies, investment banks, etc. QFIs are individual investors, groups, or associations from countries that are members of the Financial Action Task Force (FATF) or have ratified the IOSCO’s MMoU. They are considered as a subcategory of FPI and regarded as potentially longer-term investors than FIIs.
Regulatory Body Registered and regulated by the Securities and Exchange Board of India (SEBI). Also regulated by SEBI in collaboration with the Reserve Bank of India (RBI).
Investment Cap FIIs, NRIs, and OCBs combined have an investment cap of 24% in a company’s stock, with individual FIIs allowed to invest up to 10%. Not specifically mentioned, but QFIs also operate under SEBI guidelines which may include similar caps depending on the sector and specific rules governing foreign investments.
Eligibility Organizations with a 5-year track record and registered with a regulatory authority in their home country. This may include endowments, university funds, foundations, charitable trusts, and organizations. Individuals, groups, or associations from FATF member countries or those who have ratified the IOSCO’s MMoU.
Market Influence FIIs have a significant impact on market trends. The market tends to swing positively when FIIs invest in equities and assets, and the opposite can occur when they withdraw their investments. They control a substantial portion of the market. The introduction of QFIs aims to infuse more foreign funds into the Indian capital market and is thought to reduce market volatility, given that individuals are seen as longer-term investors compared to institutional investors.
Policy Amendments Amendments to the SEBI Regulations in 1996-1997 allowed FIIs to allocate 100% of their portfolios to debt securities with SEBI approval and set investment caps to encourage the inflow of FPI. The QFI initiative was unveiled in the 2011 Union Budget to allow individual foreign investors to participate more directly in the Indian capital market, aiming to deepen the market and encourage long-term investment stability.
Number Registered with SEBI Around 1450 FIIs are registered with SEBI. The specific number of QFIs registered is not provided, as it’s a relatively newer category compared to FIIs and focuses on individual rather than institutional investors.
Focus Generally have a short-term investment perspective, leading to faster trading rates in and out of stocks. This often results in reduced company stakes. Seen as potentially having a longer-term investment perspective compared to FIIs, which can help in providing more stability to the market.

Investment Models Followed by India

Investment Model Description Key Features
Viability Gap Funding (VGF) Aims to support infrastructure projects that are economically viable but fall short of profitability. Financial support is limited to private-sponsored infrastructure projects chosen through competitive bidding.

Funding cannot exceed 20% of the total project cost, with an option for additional grants up to 20% by the government.

Both state and federal governments can contribute.
India Infrastructure Finance Company Ltd. (IIFCL) A government organization established to provide long-term financing to viable infrastructure projects. Supports infrastructure related to transportation, energy, water, sanitation, communications, social and commercial services.

PPP Projects are prioritized.
Infrastructure Debt Fund (IDF) Financial entities designed to finance the infrastructure sector through long-term debt. Aims to attract a significant portion of the outstanding commercial bank debts.

IDFs can be established by NBFCs, Trusts, or Mutual Funds.

Maintains a debt-to-equity ratio of 70:30.
3P India Expected to address issues related to regulation, financing, contract management, and execution of Public-Private Partnership (PPP) projects. Focus on enhancing the framework for PPP projects such as Jal Marg on Ganga, highways, and solar plants.
Infrastructure Investment Trust Fund (InvITs) Investment vehicles similar to mutual funds, designed to facilitate investment in infrastructure projects. Raises funds from investors to invest in infrastructure projects directly or through special purpose vehicles (SPVs).

There are two types: those investing in revenue-generating completed projects and those with the flexibility to invest in ongoing projects.

Units are sold through public offerings or private placements to be listed on stock markets.

Must distribute at least 90% of the net available cash to investors every six months.

The minimum application size for InvIT units is Rs. 10 lakhs.

 

UPSC PREVIOUS YEAR QUESTIONS

 

1.  Why is Public Private Partnership (PPP) required in infrastructure projects? Examine the role of the PPP model in the redevelopment of Railway Stations in India. (2022)

2.  Examine the developments of Airports in India through Joint Ventures under the Public-Private Partnership (PPP) model. What are the challenges faced by the authorities in this regard? (2017)

3.  Explain how private-public partnership agreements, in longer gestation infrastructure projects, can transfer unsuitable liabilities to the future. What arrangements need to be put in place to ensure that successive generations’ capacities are not compromised? (2014)

4.  Adaptation of the PPP model for infrastructure development of the country has not been free from criticism. Critically discuss the pros and cons of the model. (2013)

5.  Justify the need for FDI for the development of the Indian economy. Why there is gap between MOUs signed and actual FDIs? Suggest remedial steps to be taken for increasing actual FDIs in India. (2016)

6.  Consider the following statements: (2023)

1.  Statement-I: Interest income from the deposits in Infrastructure Investment Trusts (InvITs) distributed to their investors is exempted from tax, but the dividend is taxable.

2.  Statement-II: InviTs are recognized as borrowers under the ‘Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002’.

Which one of the following is correct in respect of the above statements?

(a)  Both Statement-I and Statement-II are correct and Statement-II is the correct explanation for Statement-1
(b)  Both Statement-I and Statement-II are correct and Statement-II is not the correct explanation for Statement-1
(c) Statement-1 is correct but Statement-II is incorrect
(d)  Statement-I is incorrect Statement-II is correct

7.  With reference to Foreign Direct Investment in India, which one of the following is considered its major characteristic? (2020)

(a)  It is the investment through capital instruments essentially in a listed company.
(b)  It is a largely non-debt creating capital flow.
(c)  It is the investment which involves debt-servicing.
(d)  It is the investment made by foreign institutional investors in the Government securities.

8.  Which of the following would include Foreign Direct Investment in India? (2012)

1.  Subsidiaries of companies in India
2.  Majority foreign equity holding in Indian companies
3.  Companies exclusively financed by foreign companies
4.  Portfolio investment

Select the correct answer using the codes given below:

(a)  1, 2, 3 and 4
(b)  2 and 4 only
(c)  1 and 3 only
(d)  1, 2 and 3 onlyBottom of Form