Industry: capital formation, foreign direct investment and MNCs

1. Capital formation

Capital formation (investment) is the addition to the stock of real capital in an economy: machinery, buildings, roads, power plants, inventories. Ragnar Nurkse described it as the process by which society does not apply all its current productive activity to immediate consumption, but directs a part to making capital goods. In national accounts it is measured as gross fixed capital formation plus change in stocks.

Stages. (1) Creation of savings by households, firms and government; (2) mobilisation of savings through banks, insurance, mutual funds and the capital market; (3) investment of those funds in real capital.

Importance for industry. Capital raises output per worker, allows new technology to be used, creates employment and infrastructure, and breaks the “vicious circle of poverty” (Nurkse): low income, low saving, low investment, low productivity, low income. Under the Harrod–Domar model, growth rate = saving rate ÷ capital-output ratio, so with a capital-output ratio of 4, a saving rate of 32 per cent gives growth of 8 per cent.

Sources of capital in India. Domestic household savings (the largest), corporate savings, public sector savings, and foreign capital: FDI, portfolio investment, external commercial borrowings, NRI deposits and aid. India’s saving and investment rates rose substantially after the 1990s.

Obstacles: low per capita income, inflation, underdeveloped financial institutions in rural areas, holding of savings in gold and land rather than financial assets, and black money.

2. Foreign direct investment: meaning

FDI is investment by a foreign entity in an Indian company that gives a lasting interest and a say in management. Under the FEMA (Non-debt Instruments) Rules, 2019, investment by a person resident outside India in an unlisted company, or of 10 per cent or more of the post-issue paid-up equity of a listed company, is FDI. Below that threshold in a listed company it is foreign portfolio investment (FPI).

Forms: greenfield investment (a new plant), brownfield investment (acquiring or expanding an existing unit), joint ventures, and wholly-owned subsidiaries.

3. FDI policy in India

• Before 1991: foreign investment was restricted under the Foreign Exchange Regulation Act, 1973, generally capped at 40 per cent.
• 1991: the New Industrial Policy allowed automatic approval up to 51 per cent in high-priority industries; the Foreign Investment Promotion Board handled other cases.
• FEMA, 1999 replaced FERA from 1 June 2000, treating foreign exchange matters as civil, not criminal.
• Two routes today. Under the automatic route no prior government approval is needed; the company only reports to the RBI. Under the government route, approval of the ministry concerned is needed (the FIPB was abolished in 2017). Policy is set by the Department for Promotion of Industry and Internal Trade (DPIIT) in a consolidated FDI policy.
• Sectoral caps. Most sectors allow 100 per cent FDI under the automatic route. Some have limits or need approval: defence, print media, broadcasting, multi-brand retail. In insurance the cap was raised to 100 per cent by the Sabka Bima Sabki Raksha (Amendment of Insurance Laws) Act, 2025. A few areas are prohibited altogether (lottery, gambling, chit funds, real estate business, tobacco products manufacture).
• Press Note 3 (2020): investment from countries sharing a land border with India needs government approval.

4. Advantages of FDI

• Supplements domestic saving and fills the investment gap;
• brings modern technology, management skills and access to world markets;
• creates jobs and raises productivity in supplier firms;
• non-debt flow: unlike loans, it carries no fixed repayment burden;
• increases competition and the quality of goods; and
• raises exports where firms use India as a manufacturing base.

5. Disadvantages of FDI

• Outflow of profits, royalties and dividends over time;
• may crowd out domestic firms, particularly small ones;
• concentration in a few sectors (services, software, telecom) and a few States;
• capital-intensive technology may create few jobs;
• transfer pricing and tax avoidance;
• loss of control over strategic sectors and data.

6. Multinational corporations (MNCs)

An MNC is a company with its headquarters in one country and production or service operations in several countries. Examples in India: Hindustan Unilever, Suzuki (Maruti Suzuki), Samsung, Hyundai, Nestlé, Google, Amazon. Indian MNCs include Tata, Infosys and Mahindra.

How they enter: wholly-owned subsidiaries, joint ventures, franchising, licensing and acquisitions. Features: huge size, central control with global operations, advanced technology, strong brands and marketing.

Merits: investment, technology, employment, exports, better products. Demerits: repatriation of profits, dominance over Indian firms, cultural influence, transfer pricing, use of outdated or polluting technology in developing countries (the Bhopal gas disaster of 1984 at Union Carbide’s plant is the standard example), and political influence. Control is through FEMA, the Competition Act, 2002, the Companies Act, 2013 (including corporate social responsibility under section 135) and tax rules on transfer pricing.

How this is examined

FDI was a compulsory short answer in the June/July 2025 100-mark paper and a 6-mark note in January/February 2025; MNCs were a short note in June/July 2025. A 6-mark answer: definition with the 10 per cent line, routes, two or three caps, four merits and four demerits. Capital formation can come as a 10-mark essay on “industry: capital formation and FDI”.