In today’s Finshots, we explain what changed in India’s FDI policy, and why.

But here’s a quick sidenote before we dive in. We’re hiring a Content Writer at Ditto Insurance. If you like turning messy, complex topics into clear, helpful content that actually ranks (and gets read), and enjoy going beyond surface-level research, this might be for you. Check out our careers page for more or share it with someone who’d be a great fit.

Now onto today’s story.

The Story

Before we explain what changed, let’s give you a quick rundown of what FDI (Foreign Direct Investment) is and how it works. If you already know this bit, you can simply skip the italicised bits and pick up from there.

FDI is when a company or individual in another country invests money into a business in India by buying shares, setting up a subsidiary, or forming a joint venture.

And there are two ways a foreign company or individual can do this.

First is the automatic route, where the foreign investor does not need prior government approval. They can invest and then report the transaction to India’s central bank, the RBI (Reserve Bank of India). Most sectors such as IT, manufacturing, and hospitality freely allow this.

Second is the government approval route, where the foreign investor needs prior permission from the relevant ministry before investing. This applies to sensitive sectors like defence, media, banking, insurance, and spaces involving special restrictions.

Different sectors also have caps on how much of a company a foreigner can own. For example, in insurance it’s 100% and 74% in (private) banking. All of this is governed by the FEMA (Foreign Exchange Management Act) and the Department for Promotion of Industry and Internal Trade (DPIIT), which issues policy guidelines for FDI in India.

These guidelines have a special name and are called press notes, one of which was issued back in 2020. This one, called Press Note 3, said that any entity from a land-border-sharing country or any company where even one share is beneficially owned by someone from these countries, must seek government approval before investing in India. So even the automatic route was effectively locked out for companies with even a tiny Chinese investor on their cap table.

Now, there were two justified reasons why this strict press note was issued.

For starters, there was a growing concern that Chinese companies were increasing their stakes in Indian companies at cheap valuations during the pandemic. Chinese giants like Alibaba and Tencent, along with VCs, were among the biggest investors in Indian startups back then, picking up stakes in 18 of India’s 30 top unicorns.

That same year, border clashes in the Galwan Valley between Indian and Chinese troops killed soldiers on both sides. Since then, India has been on high alert in its dealings with China.

So that was that.

Now, you’d think this new policy would have helped secure Indian companies and keep them safe. But alas, that’s not exactly what happened. Instead, it created a swarm of unintended problems for other foreign investors.

For instance, if a US private equity fund or a European tech company had even a tiny Chinese investor on its cap table, it was suddenly forced to get government clearance before investing in an Indian firm, even if China had no real control over its internal decisions. This slowed things down to a snail’s pace. To give you a sense of scale, investment proposals worth ₹75,690 crore were filed under Press Note 3 in FY21 and FY22. But less than 20% of them were approved, showing how restrictive the policy was. In fact, the rejected proposals cost the country nearly 5% of its average annual FDI inflows over the past five years.

Another issue was how much it hurt startups, not just because they were robbed of investor prospects overnight, but also because there was a loophole this policy kind of failed to cover: the FPI (Foreign Portfolio Investment) route. This is simply another way foreign investors can invest in India, apart from FDI.

Here, investors buy shares only in listed companies on Indian stock exchanges. These investments are regulated by the SEBI (Securities and Exchange Board of India) and are capped at 10% of a company’s total equity shareholding per investor or investor group.

And this is the part that Press Note 3 was mum about. It only amended the FDI route and said nothing about FPI. So technically, a Chinese-linked entity registered as an FPI could keep buying shares of listed Indian companies up to 10% without needing government approval. Global investment managers could also route such investments through Singapore or Mauritius-based entities, which are considered safe havens and not considered land-border sharing countries.

Now, if you think 10% is a small portion, think again. Because even a stake like that in a mid-cap Indian bank or a defence PSU can confer meaningful economic influence even without formal control.

Besides, this gap meant that while startups couldn’t take a rupee from Chinese investors without approval, state-linked investors could quietly accumulate stakes in listed companies through stock market investments. The proof is in the pudding. The market value of FPI investments from China jumped nearly four times from December 2019 to a whopping ₹3,257 crore by March 2020 — around the same time Press Note 3 was introduced. That kind of suggests that this route was being used while startups were left stranded.

And it wasn’t just startups. Indian manufacturing took a hit too. India’s Make in India and PLI ambitions ironically required the kind of Chinese manufacturing expertise and capital that Press Note 3 blocked. Because without Chinese components and supply chains, building high-tech domestic alternatives became far more difficult.

You could look at the widening trade deficit (the difference between how much we import from China versus how much we export to it) to understand this. India’s deficit with China ballooned from $44 billion in FY21 to $112 billion in FY26. That’s a 155% increase! This suggests that India became more dependent on Chinese goods even as it blocked Chinese capital that could have boosted domestic manufacturing. So you could say this policy achieved the opposite of Atmanirbharta where it mattered most.

It also meant India was missing out on the China+1 opportunity, where companies keep manufacturing in China but add capacity in another emerging economy like India. Instead, countries like Vietnam, Thailand, and Malaysia were eating India’s lunch here, as India’s rules made Chinese firms reluctant to partner.

All of these consequences were enough to prompt global PE (Private Equity firms) and VC (Venture Capital firms) funds with Chinese limited partners (LPs), who had no real control over their operations, to ask the Indian government to ease these zero-tolerance rules. And that’s exactly what the Finance Ministry did last month, bringing the changes into effect a few days ago.

It said that if a non-Chinese company, say, a US or European firm has Chinese investors owning less than 10% in a non-controlling capacity, it no longer needs government approval and can invest in India freely through FDI, subject to sectoral conditions. However, these relaxations do not apply to entities registered in China, Hong Kong, or other land-border sharing countries.

Which makes you ask, “What will this mean for India’s economy going forward?”

Well, of course, it will help startups and manufacturing. But perhaps the most underappreciated risk is that it could increase our trade deficit with China rather than reduce it. Because if Chinese FDI flows into sectors that assemble products using Chinese-sourced components, the net effect could be that parts for things like smartphones are imported almost entirely from China. That could simply mean more demand for Chinese components, and a bigger trade deficit.

Another concern is that this relaxation could weaken India’s trade ties with countries like the US and hurt other industries. Let’s explain.

Last year, the US introduced something called the America First Investment Policy, which prioritises domestic manufacturing. This policy explicitly identifies China as a foreign adversary and tightens restrictions on FDI from them. In effect, it could exclude investors with significant ties to Chinese supply chains. So an Indian semiconductor packaging company or AI startup that accepts Chinese minority investment may find itself flagged by American regulators if it later seeks US partnerships or acquisitions. And that’s a problem, because India positions itself as a “trusted” alternative to China for US companies diversifying supply chains. If Indian firms start carrying Chinese minority stakes, that trust premium erodes, and the entire China+1 value proposition that India has been selling to American corporations starts to look hollow.

So yeah, while the new changes to India’s FDI policy make it easier to solve some of the practical problems created by Press Note 3, these relaxations could open up another can of worms — one that might need more sellotape fixes. And how the government plans to deal with that may be a story for another day.

Until then…

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