Foreign direct investment (FDI) has become an integral part of national development strategies for almost all countries globally. In view of its global popularity and positive impact on productivity and employment, FDI has played an important role in India as well. Due to a surge in FDI inflows in recent years, its share in gross fixed capital formation (GFCF) increased to over 8% in 2008-09 as compared to an average of 3.6% between 1999-2000 and 2004-05 in India. The role played by FDI in the private corporate sector investment is even more significant, whose share in 2007-08 stood at over 20% as against less than 1% in the early nineties.
FDI, in many ways, has enabled India to achieve a greater degree of financial stability. As per RBI estimates, the current account deficit (CAD) is expected to touch 2.5% of GDP this fiscal as against the earlier projected 3.5%. However, financing the CAD has lately emerged as a major risk and concern for policymakers. Although capital inflows (FDI + FII) have been sufficient to finance the CAD so far, its dominant component is FIIs, which, by nature, are volatile and cannot be relied upon. Therefore, RBI in both its third quarter review of 2010-11 and in the mid-quarter policy review of March 2011 has stressed the need to alter the composition of the capital inflows towards FDI.
Foreign investment is currently permitted in virtually every sector, except those of strategic importance such as defence (opened up recently to a limited extent) and rail transport, but there are sectoral ownership restrictions. For example, in the financial services sector, foreign capital participation in local banks is limited to 74 % and in insurance companies to 26%. Similarly, with the exception of certain activities specified by law, foreign ownership in agriculture is not allowed.
Despite the opening up of its economy in 1991, India received only $5-6 billion FDI till 2004-05 due to a fairly restrictive FDI policy. But the policy regime changed in February 2006 and FDI inflow into India has accelerated since. In fact, FDI inflows remained resilient even during the global financial crisis as India received $37.8 billion in 2008-09 and $37.7 billion in 2009-10. However, FDI (April-January) in the current fiscal so far appears to have lost momentum and reached only $22 billion. Although it may be difficult to pinpoint the reason for this sudden drop in FDI inflow, there are issues with regard to current policy as also with setting up new business in India that often make FDI inflow cumbersome, notwithstanding the growth potential of the economy.
Opening the economy to FDI and allowing foreign ownership is a necessary but not sufficient condition to attract FDI. If a liberal FDI policy is all that is important then the Eastern European and Central Asian countries, which have the most open policies towards foreign investors, should be attracting huge volumes of FDI. However, East Asian countries have a better track record in attracting FDI than the Eastern European and Central Asian countries. The effectiveness of an FDI policy depends, to a large extent, on the environment within which it operates. A liberal FDI policy in a poor investment climate with high transaction costs is most likely to be ineffective. Therefore, factors like market size, infrastructure quality, respect for the law of the land, well functioning institutions, macroeconomic stability, growth potential, etc, play an equally important role in attracting FDI. Clearly, investor confidence on some of these factors with respect to India has eroded lately and may perhaps be the reason for the drop in FDI this fiscal.
However, a fundamental shortcoming of the FDI policy pursued so far in India is that it does not have a strategic focus and is open for all. By contrast, China by keeping the spotlight on a low-cost manufacturing base for exports and development of related infrastructure and facilitation followed a focussed approach to attract FDI. Not having an export focus also meant that FDI into the manufacturing sector in India has mostly not been of an export-oriented variety that leverages India?s labour cost arbitrage. Since the business rationale of FDI into India has largely been driven by the desire to profit from India?s domestic market and its rising middle class, a large proportion of FDI into manufacturing in India till lately has been of ?tariff jumping variety?, which means setting up manufacturing facilities in India mainly to avoid high Indian import tariffs. This, nevertheless, expanded the range of products available to Indian domestic consumers.
Also the FDI policy pursued so far does not appear to indicate that investment incentives given to FDI are close to what the government offers to its own residents. It has been observed that if policies are over-friendly to FDI while the transaction costs (including tax and regulatory) of investments are high for domestic firms, then it can prove to be counter-productive, leading to ?round-tripping? (i.e., where domestic investors route their investment through a foreign country to avail the policy benefits of FDI). Both India and China have witnessed sizeable FDI inflows that can be classified as round-tripping.
A significant proportion of FDI coming from Mauritius to India is of the round-tripping variety due to a treaty on avoidance of double taxation between India and Mauritius. According to the world investment report of UNCTAD, round-tripping accounts for nearly 20-30% of the total FDI in China. Some estimates put it at about 50%. Clearly, evidence of round-tripping is an indication of shortcomings in the FDI policy sphere.
A comparative analysis shows that India has a more liberal FDI regime than China. Yet, China attracts considerably more FDI than India. One of the important reasons for this anomaly is that India continues to be one of the highest transaction cost economies in the world. Here again, if one compares the ease of setting up a business by a foreign entity, then India scores over China.
According to the World Bank study
Investing Across Boarders 2010, while it takes 18 procedures and 99 days to set up a foreign-owned limited liability company in China, it takes 16 procedures and only 46 days to do the same in India. Also, the Chinese approval process is not an easy one and includes both national and regional approval quite similar to India. So where is the difference? While in China, both national and regional approval is one process, in India federal approval and state/local approval are two different processes and this often leads to projects getting bogged down in red tape and bureaucracy, leading to higher transaction costs. As a consequence, India actually receives much less FDI than what the federal government approves.
Is there a way out? After attracting a healthy FDI inflow of $35 billion and above for three consecutive years, the FDI inflow so far in the current fiscal looks out of sync with previous years. There are no readymade prescriptions to boost FDI inflow into the country. However, there are three areas that, if addressed adequately, will improve the FDI investment climate. Develop a strategic focus for FDI. Reduce the procedural delays; improve the infrastructure and trade facilitation to cut down the high transaction cost. Finally, remove the existing restriction on FDI inflows into the SME sector.
?The author is head and senior economist at Crisil Ltd. Views are personal
