How to deal with the national security risk from FDI and trade

In the absence of a specific law addressing the national security risks posed by FDI, India relies on FEMA, a foreign exchange control law, to screen foreign investments for national security concerns, highlighting a legal gap.

• Trade and FDI Pose Threat to National Security: Let’s assume there is a bank used by many Indians, and China buys shares of that bank, becoming the largest stakeholder. This would mean all the data would be accessible to China.
  • Now, consider another situation: if China became a major stakeholder in IT companies and a war-like situation arose, China could withdraw all its money. It would already be in possession of sensitive information. This would lead to the collapse of those businesses.
  • This shows that if an enemy state has a significant investment in a country, it could pose a major security risk. That State could use such power of trade for arm twisting as well. China is already known to use such measures.
• What is FDI?: The term foreign direct investment (FDI) refers to an ownership stake in a foreign company or project made by an investor, company, or government from another country.
• FDI Routes in India: FDI in India is permitted either through the Automatic route or Government route.
  • Automatic Route: Under the Automatic Route, the non-resident or Indian company does not require any approval from the Government of India.
  • Government route: Under the Government route, approval from the Government of India is required prior to investment. Proposals for foreign investment under the Government route are considered by the respective Administrative Ministry/Department.
• FDI Laws in India: India does not have a comprehensive legislative framework to deal with FDI and international trade on grounds of national security.
  • FEMA: In India there is only Foreign Exchange Management Act (FEMA) — a law that provides the architecture for the orderly development and maintenance of the foreign exchange market in India. FEMA does not contain explicit provisions to deal with FDI on national security grounds.
  • PN3: In April 2020 (at the time of Pandemic), India adopted a new FDI regulation called Press Note 3 (PN3). PN3 is enforced through the FEMA.

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• What is Press Note 3 (PN3)?: To prevent opportunistic takeovers and acquisitions of Indian companies weakened by the pandemic, PN3 requires prior approval from the central government for inward investments from countries sharing land borders with India (the so-called government route). 
  • Although several countries (China, Bhutan, Bangladesh, Nepal, Pakistan, Myanmar) share land borders with India, this regulation primarily targets Chinese FDI. Essentially, India imposed stricter controls on Chinese FDI for national security reasons, even though PN3 does not explicitly mention “national security.”
• Other Steps Taken by India: In the 2015 Model Bilateral Investment Treaty (BIT) two things were added
  • Article 6 deals with foreign investment-related exchange control issues
  • Article 33 empowers the state to take measures for the protection of national security even if such measures violate the treaty’s substantive provisions.
• Need for Such Steps: India already has an FTA (Free Trade Agreement) with some countries which do not put any restrictions on trade. 
  • Case of Mauritius: Mauritius is a small island nation and a huge investment has come to India. A large number of foreign portfolio investors (FPI) and foreign entities route their investments in India through Mauritius. 
  • Tax Evasion: Tax evasion through a practice known as investment round-tripping — where capital is channelled through a low tax jurisdiction (here Mauritius) before being reimported into the economy of origin as FDI — remains a problem.
  • This can easily be used by China (or other countries) against India.
  • Also, significant investments by China could pose a risk to India’s economy. Such investments might give China leverage to exert pressure and manipulate India. If China were to withdraw its investments from various sectors, it could potentially destabilise the Indian economy.

• Countries Restricting Chinese FDI: While India was not the only country restricting Chinese FDI, several liberal democracies like Canada, and Australia too limited Chinese FDI during the pandemic.
  • For instance, Section 25 of Canada’s Investment Act empowers the government not just to screen inward FDI but also to act against FDI in operation if it is “injurious to national security”.
• Way Forward: There is a need for a separate provision or a dedicated watchdog organisation to oversee investments from blacklisted companies, especially in critical sectors like the military, to mitigate national security risks.
  • • For instance, US based Lockheed Martin is an aerospace and defence manufacturer and Boeing is an American aerospace company. The US would never allow countries like China or Russia to have a high stake in such companies. As this would give China or Russia high control over their economy.
  • India can learn from international trade agreements such as the General Agreement on Tariffs and Trade which contain separate provisions to deal with trade restrictions arising out of foreign exchange difficulties and national security. 

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Conclusion

While foreign direct investment (FDI) can drive economic growth, it also poses potential national security risks. India must develop a comprehensive legal framework to effectively manage these risks, ensuring that economic benefits do not come at the expense of national security

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