Revised FDI Rules: Are Fears Of Opportunistic Takeovers Of Indian Companies By Chinese Investors Real?

The above statement is the unique basis upon which recent Foreign Direct Investment curbs were enacted, with the goal of preventing opportunistic takeovers/acquisitions, in light of the sudden correction in share prices across equity markets.

There is little scope for speculation that these restrictions were put in place as a reaction to the People’s Bank of China upping its stake in what can be considered one among the most valued Non-Banking Financial Companies listed on the Indian bourses – HDFC.

These actions raise a few questions, the most principal of which is — why were we spooked by Chinese capital?

Would such a sudden change in FDI norms be implemented if it was found that investment banks domiciled in the United States had raised their stakes across companies in India?

What would our reaction be if it was discovered that foreign hedge funds had a net short position on the market, and that mutual funds and pension funds were on the losing side of these bets — what then would the basis for FDI restrictions be?

And with regard to preventing ‘takeovers’ and ‘acquisitions’, we need to evaluate if there is enough free float of equity shares in the markets that breach thresholds of significant influence or transfer of control.

Add to this an additional requirement of either a single entity having the requisite corpus of investible funds or the possibility of dispersed entities acting in a concerted manner to wrest control of Indian companies in times of economic uncertainty.

Are these happenings well within the realm of the possible?

Before we can appreciate the grand scheme of events, it would be only right to investigate the sources of this ‘fear’ of Chinese capital.

The Debt Traps

The Belt and Road Initiative (BRI) of the Chinese government is viewed as a grand geopolitical strategy to establish a new order of global influence and trade.

And no appraisal of the BRI is incomplete without discussing the debt traps that participating nations risk falling into.

There are, in spirit, only two ways to finance any venture or project — through debt or equity.

Equity investments bear the most amount of risk, all equity shares are essentially exposed to the risks of the business, and the risk of financing debt.

But by accepting a trade-off between risks and rewards, a certain distance can be maintained between owning the business and financing the business.

This happens through debt financing.

But this distance is facilitated by credit worthiness.

Since default risk stands between owning the variable rewards of a business, and the chances that an interest rate will be serviced via variable rewards.

Lesser developed economies have the twin problem of financing risky ventures in the form of infrastructure and societal overheads, whilst not ceding ownership over sovereign assets.

All this at interest rates that are not obviously unaffordable.

How is such a goal met? Debt covenants. These are terms and conditions that retain the essential form of debt, but bring the true substance of the transaction closer to equity financing.

These take the form of exclusive operating rights, royalty periods, “Build-Operate-Transfer”, convertible loans et cetera.

Loans granted by multilateral banks such as the New Development Bank, or Asian Development Bank, or the World Bank follow predetermined rules and conventions, and are not unduly swayed by the political inclinations of participating nations.

These globally agreed ways of working are quite transparent and are the bedrock of international trade and diplomacy.

But should a Sovereign-to-Sovereign loan arrangement be preferred, then the leeway is purely dependent on diplomatic relations and foreign policy.

This was the case with Sri Lanka’s Hambantota Port being leased for 99 years to China Merchant Port Holdings Limited, a subsidiary of state-backed China Merchants Group.

A borrowing state knows fully, the obligations that a long-term financing arrangement places, and it is the borrowing state that assumes all the risks and rewards of the capital lent to it.

It would not be appropriate to assume that long term debt covenants are engineered to be ‘traps’ at their inception. However, when one party that is unable to service its interest obligations is thus forced to settle on unfavourable terms — they do play out in a manner that can be quite disadvantageous from a geopolitical standpoint.

But equity is a completely different vehicle of investing.

Here the investing state assumes all the risks and rewards.

Any act that goes against ordinary business rationale can only result in economic losses to the investing state.

And in the direst of circumstances, the entities liquidate, and the investing state bears the loss.

Thus, if a foreign entity holding 1 per cent stake prospers, it conversely also means 99 per cent of domestic stakeholders prosper.

Chinese Wall

The term Chinese Wall, as it is used in the business world, describes a virtual barrier intended to block the exchange of information between departments if it might result in business activities that are ethically or legally questionable.

While there are objections to the usage of this term as being culturally insensitive, the term has held significant meaning in business parlance.

Chinese company law has long required foreign and private companies to incorporate formal party organisations.

According to a Reuters report, in the backdrop of growing US-China trade tensions, 100 government officials were being deputed to work with private companies including the likes of Alibaba.

While the argument that such officers are being deployed to ensure domestic regulatory compliance is valid, one cannot rule out the possibility of this trend ballooning into board level influences.

A 2018 ‘Special 301’ Report from Office of the United States Trade Representative highlights the burdens that are placed on companies engaging with China:

1. China uses foreign ownership restrictions, such as joint venture requirements and foreign equity limitations, and various administrative review and licensing processes, to require or pressure technology transfer from U.S. companies.
2. China’s regime of technology regulations forces U.S. companies seeking to license technologies to Chinese entities to do so on non-market-based terms that favour Chinese recipients.
3. China directs and unfairly facilitates the systematic investment in, and acquisition of, U.S. companies and assets by Chinese companies to obtain cutting-edge technologies and intellectual property and generate the transfer of technology to Chinese companies.
4. China conducts and supports unauthorised intrusions into, and theft from, the computer networks of U.S. companies to access their sensitive commercial information and trade secrets.

Reports such as these are pivotal in trade deal negotiations as it tracks the trade barriers and threats to US intellectual property.

It would be worth noting that India and China, feature prominently on the Priority Watchlist of the Special 301 Report.

The larger argument being that US and Europe based companies lead primarily by being champions of innovation and disruption; assets that result in tremendously valuable intellectual property.

Furthermore, the ownership of the intellectual property and the protection of rights is very secure.

This is demonstrable from cases like the one where Apple Inc refused to build a ‘master key’ or even revamp its software to allow the FBI to break into a phone to prevent and prosecute terrorists.

Then, there is the case with Australia banning Huawei from rolling out key 5G infrastructure in the nation, citing the possibility of the company being subject to extra judicial directions from a foreign government.

“... capability takes a long time to put in place. Intent can change in a heartbeat, so, you have got to hedge and take into account the risk that intent can change in the years ahead,” the then Prime Minister of Australia, Malcolm Turnbull, had said regarding the matter.

There indeed is wide governmental cognisance of China’s ability to direct companies operating in its jurisdictions.

A statement titled “Who we are” on Huawei’s website explicitly states that the government of China does not influence its decision making and that the company would sooner shut down than compromise the security of its customer networks and products.

Developments such as these lead us to another source of ‘fear’.

How Private is Private?

Private capital must be separated from private businesses, for the former holds up to simple tests of commercial substance — investments seeking rational returns commensurate with the risks undertaken, while the latter can mean the simple placement of capital in private corporate/non corporate forms.

A relevant example being Temasek — a sovereign wealth fund owned by the Government of Singapore, having a stake in HDFC Bank.

This fund has a clear mandate of seeking sustainable returns, and so acts quite like a private equity fund.

Sovereign wealth funds seek to bolster the sponsoring nation’s wealth, as an alternative to usual taxation.

It is highly unlikely that such a fund structure can be used to further Singapore’s foreign policy.

But even sovereign wealth funds with clear profit-making intentions, cannot escape the political overhang that comes with global events.

Take the example of Saudi Arabia’s Public Investment Fund.

The PIF has been an investor in Softbank’s Vision Fund.

Placing its capital alongside Apple, Foxconn, and others, Vision Fund’s portfolio includes Paytm, OYO, and Policy Bazaar.

Despite its goals being congruous with private companies, the political ramifications that followed the death of Jamal Kashoggi raised many questions regarding its participation in the fund.

Softbank COO Marcelo Claure, and CEO Masayashi Son had to withdraw their participation from a Saudi Arabian investment conference in 2018.

One could conclude that Saudi Arabia’s alleged involvement in the killing of the Washington Post columnist had ‘tainted’ the capital it was bringing.

Contrasting is the investment vehicle China Overseas Ports Holding Company — the holding company for Pakistan’s Gwadar Port.

According to a Business Recorder Report, this company has highly suspect origins with no clarity about its ownership details, while also sharing its registered address with a company finding mention in the Panama Papers.

The corporate form of business gives rise to regulatory chicanery, wherein the substance of transactions is divorced from the form those transactions take.

According to a CNBC report, in order to prevent a conflict with Saudi Arabia’s extant investment in Uber, Softbank invested in Didi Chuxing via another fund that carved out Saudi Arabia’s PIF participation.

In a situation where prominent founder-investors on whose instructions and guidance Boards of companies are accustomed to act, rise to ranks within political parties, we need to push the envelope of what counts as ‘private’ even further and evaluate if corporate forms of businesses are not used as an extension of foreign policy.

These fears are but natural as in the case of Alibaba’s founder Jack Ma, whose membership with the Communist Party of China was confirmed in 2018, while a 2015 Forbes column had suggested that the Chinese government conducted business on Alibaba’s platforms to ensure its high growth rates.

The Indian Context

Taking stock of the sources of ‘fear’ about Chinese capital, we have reviewed the Debt Traps, protection of Intellectual Property and the blurred lines between state and private entity.

However, do these surmised concerns that are quoted from a macro perspective — operate within the Indian context?

India’s total external debt as of December 2019 stood at $563.9 billion, of which a mere $26.3 billion was bilateral.

With an external debt service ratio of 6.4 times, and foreign exchange reserves to debt ratio of 81.5, the signs of an emerging debt trap is remote.

On the intellectual property and innovation front, India has to seriously introspect, if Chinese venture capital comes with an adversarial attitude or rather acts as a strategic springboard for India’s blooming startup ecosystem.

Until such time that India can boast of its own powerhouses like Sequoia, Tiger Global, Temasek, Vision Fund, and Y Combinator, foreign capital will remain the driving force.

In all fairness, established Indian startup founders are branching out to create their own investment and incubation houses.

With Sachin Bansal’s BAC Acquisitions and discount broker Zerodha’s Rainmatter, the first generation of startup success is giving back to the blooming ecosystem.

India is still seen as a market — a billion people offering up their wallets and eyeballs to sell, stream or advertise to.

And with today’s technology and internet enabled marketplace, companies will be domiciled where there is the best of talent and capital.

If India is to own its growth story and not be exposed to political risks emanating from China, it must create an exceptionally conducive venture capital environment and host the titans of the Fourth Industrial Revolution.

Seeing how India runs a substantial trade deficit with China, any sanctions inviting posturing only hurts the Chinese economy.

The ‘threats’ if any from China, still remain quite traditional — our unresolved land border, and the race for political clout in the region.

With an increasingly active diplomatic corps, and the call for ‘Atmanirbharta’ in India’s post Covid-19 reconstruction, India is doubling down on the only long-term play that can secure the economic prosperity of the region.