Foreign Direct Investment in India: Recent Trends and Prospects1

May 2005

Sandeep Kapur Birkbeck College, University of London Malet St, London, UK

This note places recent trends in FDI inflows and policy changes in a historical context, and assesses the role that foreign capital can play in continuing economic growth.

This paper draws on my ongoing research with Suma Athreye, Open University, UK.

FDI in India

1. INTRODUCTION The last fifteen years have seen a marked increase in foreign capital flows to India. Figure 1 highlights the recent growth in inflows, both of foreign direct investment and portfolio investment (the latter refers to diversified equity holdings, and thend to be relatively volatile). This trend represents a break from the previous two decades. While foreign investment flows were significant in the 1950s and 1960s, FDI inflows were meagre in the 1970s and 1980s.

Foreign Investment Flows to India (USD, millions)

20000 16000 12000 8000 4000 0
19 93 19 97 20 01 19 91 19 95 19 99 20 03

Portfolio investment FDI

Figure 1: Foreign Investment Inflows to India, 1991-2004

Source: Handbook of Statistics on the Indian Economy, R

Of course, India is not unique as a recipient of increased inflows in the recent period. At around US$ 3.2 billion in 2002, FDI in India was less than 1 per cent of its GDP in 2002. In contrast, FDI flows to China were nearly US$ 47 billion in 2002, or around 3.7 percent of its GDP. On the whole, FDI flows to India remain small in relation to its economy. Not surprisingly, host country policies do influence the size of flows. While interest in India remains high, concerns about the pace of economic reform has led to investor caution. A recent study by the IMF2 argues that capital flows to India are dampened by a variety of factors: high rates of corporate taxation, bureaucratic and regulatory bottlenecks, poor infrastructure and labour market infexibility. It suggests that further broad-based economic reform may lead to enhanced FDI flows.
2

International Monetary Fund (2005), India: Selected Issues, IMF, Washington, DC.

FDI in India

However, are greater FDI inflows desirable? The case for greater foreign capital is usually made as follows. Foreign investment can supplement domestic investible resources, especailly in large infrastructure projects, thereby removing an inportant constraint on growth. Foreign firms contribute to the technological base of the host economy through technological spillovers, and may be critical to maintaining high growth rates and exports in the software and business services outsourcing sectors. Besides, in the right circumstances, the presence of foreign firms reduces market concentration and promotes a more competitive market structure. Critics of multinational firms have often cautioned against an overly rosy picture. They claim that foreign capital flows tend to be volatile and may exacerbate volatility. Rather than create competitive market structures, in some sectors they may increase monopoly distortions. Multinational firms also tend to exploit the weak environmental standards in developing countriesL recall the Union Carbide disaster at Bhopal in 1984. In this note I argue that, on present projections, FDI flows are likely to remain only a small fraction of gross capital formation in the Indian economy. Hence, their potential contribution is not likely to be quantitative but qualitative. Foreign investment is likely to be not an engine of growth but a catalyst for growth. If so, the quality of multinational firms than enter the country matters. Some multinationals invest in India to benefit from better international organisation of production and location decisions, including the growing practices of outsourcing and off-shoring. Others are attracted by the large market and the potential rents in that. Ideally, India would like to attract efficiency-seeking FDI and exclude rentseeking FDI, though from practical or regulatory points of view, it is not easy to distinguish ex-ante between the two types of FDI. 2. A HISTORICAL PERSPECTIVE It is misleading to suggest that India is new to foreign capital. Foreign capital had a substantial presence in Indian industry prior to 1947, and was mostly concentrated in the primary sectors and services. Foreign firms, mostly British, dominated Indias mining, plantations, trade and much of the fledgling manufacturing base. Further FDI flows played an important role in the early postIndependence years, as India turned abroad for both technology and capital. By the late 1950s, the Indian government invited foreign capital in many sectors, including pharmaceutical drugs, aluminium, heavy electricals and chemicals. During the 1960s inflows concentrated on manufacturing, especially the technology-intensive industries. By the end of the 1960s, around 60 per cent of all foreign direct capital was concentrated in the manufacturing industries.

FDI in India

However, in the aftermath of two famines and the devaluation of the Rupee in the 1960s, there was a hardening of policy. Foreign oil majors were nationalised in the early 1970s. The government did not rule out new foreign investment but now wanted it on restrictive terms. The Foreign Exchange Regulation Act (FERA) of 1973 introduced a clause that required firms to dilute their foreign equity holdings to 40 per cent if they wanted to be treated as Indian companies. There were new restrictions on technology imports, with a preference for licensing over financial collaboration, and restricted rates of royalty payment. Intellectual property rights were severely curtailed by a revised Patents Act in 1970: productpatents were abolished in industries such as pharmaceuticals and chemicals. By the mid-1980s, growing concern about stagnation and technological obsolescence in Indian industry led to a push for economic reform and deregulation. To encourage exports, export-intensive firms were granted exemptions from the usual FERA limits on foreign equity ownership. In an attempt to modernise manufacturing industry, restrictions on technology transfers and royalty payments were relaxed. However, despite official claims, foreign investment projects were still very vulnerable to bureaucratic discretion. Foreign equity inflows remained paltry and, to a large extent, Indian industry came to rely on foreign debt capital to meet its foreign exchange needs. The 1990s began with a major crisis. In the wake of the Gulf War, and the consequent expulsion of Indian expatriate labour from the Middle-East, foreign exchange remittances fell. As the balance of payments position deteriorated, a panicked withdrawal of funds deposited in India by Non Resident Indians exacerbated the problem. The real possibility that India might default on its external obligations led to a downgrading of Indias credit rating. As part of the reforms agreed with the IMF, the Rupee was devalued, and fresh attempts were made to liberalise the trade regime and the regulatory framework. Industrial licensing was abolished in all but a handful of industries. Foreign direct investment was now permitted in many sectors from which foreign capital had been excluded in the past. These included the infrastructure sectors previously monopolised by state enterprises: power generation, highway and port construction, telecommunications, oil and natural gas exploration. The services sector, where foreign capital had been eliminated as a matter of deliberate policy, was reopened: fresh investment was approved in financial services, retail banking, insurance, and recently in the media and retailing. The cap on foreign equity participation was raised to 51 per cent for most industries, and even 100 per cent in some cases. Restrictions on the use of international brand names were removed. Reforms in the technology policy provided greater recognition of intellectual property rights.

FDI in India

On the whole, in the nearly six decades since Independence, policy towards private foreign capital has moved closely with exigencies of Indias external payments position. Nevertheless the changing policy environment had a direct effect on the extent of foreign capital in Indian industry and its contribution to the economy. Athreye and Kapur (2001)3 studied the long-term relative performance of multi-national and domestic firms in India, using company-level data collected by the Reserve Bank of India. They found that multinationals were dominant in many sectors (electricals, chemicals, rubber, cigarettes, aluminium, automotive components) even during the restrictive phase. They found that foreign-controlled firms had higher profit margins than domestic firms throughout the period, possibly due to their technological strength, access to global marketing networks and brand names that gave them a clear edge over domestic firms.

3. ROLE OF FOREIGN DIRECT INVESTMENT What is the role of FDI in India? Those who advocate a more liberal regime claim that FDI will provide the much-needed investible resources and foreign exchange for reviving Indian industry, improve the poor infrastructure, modernise the technological base, and foster greater competition in Indian manufacturing. On the other hand, critics of foreign capital point to the poor record of multinational corporations in India, their excessive profitability, and their limited technology transfer. Does FDI contribute to growth? Casual empiricism does not offer any simple lessons. Countries like China have experienced large FDI inflows and high growth in recent years, while Korea grew rapidly without significant levels of foreign capital. Many Latin American countries have had periods of slow growth despite openness to foreign capital, while much of sub-Saharan Africa has experienced low growth and poor investment flows. In general, the relationship between FDI and growth seems to depend on country-specific factors. Moreover, even if we did find some positive correlation between FDI and growth, the issue of causality remains unresolved. Does foreign capital increase the growth rate, or does the prospect of higher growth attract investment flows? In general, foreign capital flows can equally support a consumption boom or an investment boom. Rapid capital inflows to Mexico in the early 1990s fuelled a consumption boom, accompanied by large current account deficits, and eventual
3

Athreye, S and S. Kapur (2001), Private Foreign Investment in India: Pain or Panacea?, World Economy, 24, 399-424.

FDI in India

default. A sudden reversal of flows has catastrophic effects on investment, output, and the balance of payments, as evident from the experience of Mexico and East Asian countries in the 1990s. In such circumstances, volatility in capital flows leads to economic instability. Indeed many commentators have made a case for dampening international capital flows, especially flows of portfolio capital. Notably, some of the recent surge in capital flows to India has been in the form of portfolio capital rather than FDI in greenfield ventures. Does FDI increase aggregate investment in an economy? For one, FDI flows to India are likely to remain small relative to the size of the economy. Two, econometric analysis of FDI flows to large developing countries suggests that found that FDI inflows seem to have a negative effect on domestic investment.4 In view of this evidence, it may be over-optimistic to believe that growth in FDI alone can increase the rate of growth. However, FDI could serve as a catalyst for growth. There is some evidence of positive technological spillovers from R&D expenditure of multinational firms in India,5 and it is likely that business practices introduced by multinational firms can improve the international competitiveness of domestic firms. Of course, there is the legitimate concern that foreign direct investment could make sectors more concentrated in the long run. Historically, there is evidence that industrial concentration and foreign presence were positively correlated across industrial sectors in India. In the post-liberalisation period, there is a tendency towards increasing concentration in some sectors. Multinational companies have been remarkably active in acquisitions, accounting for nearly a third of all corporate acquisitions over the period 1991-1997. Hindustan Lever, a 51 per cent foreign-owned subsidiary of Unilever, is one of the largest multinationals in India, with interests in soap, detergents, tea, processed food, cosmetics, edible oil, etc. In a series of mergers and acquisitions after 1992, Hindustan Lever acquired Tata Oils (its principal rival in oil), Brooke Bond Lipton (previously an associate company), Ponds India (cosmetics), Kwality and Milkfood (both processed foods).

4 Fry, Maxwell (1995), Money, Interest, and Banking in Economic Development, Second edition (Baltimore: The Johns Hopkins University Press)

See Basant, R. and B. Fikkert (1996), The Effects of R&D, Foreign Technology Purchase, and Domestic and International Spillovers on Productivity in Indian Firms, The Review of Economics and Statistics and Kathuria, V. (1998), Foreign Firms and Technology Transfer Spillovers to Indian Manufacturing Firms, INTECH Discussion Paper No. 9804 (United Nations University).

FDI in India

4. CONCLUSIONS
The recent surge in FDI flows has revived the question of the role foreign capital can play in maintaining Indias growth rate. Should India continue to open up new sectors like retailing and media to multinationals? Some commentators believe that foreign investment can play a crucial role in removing infrastructural bottlenecks, and thereby increase productivity of existing capital. Infrastructure has largely been a state monopoly in India. Given the poor performance of public sector enterprises, and the reluctance or inability of the domestic private sector to invest in these sectors, the hope is that foreign investment will improve power generation, the highways, ports and roads. However, the principal reason that makes these sectors unattractive for domestic investors, namely the low rate of return in the short run, holds for foreign investors too. Is there a case for using direct incentives to attract private foreign investment in infrastructure, say, as in the provision of profit guarantees that were given to attract Enron Corporation in power generation? Evidence suggests that the net pay-off to such sweeteners is negative in the long run. It is hard to deny that Indian industry needs fresh investment but the hope that openness to FDI alone can achieve this is misplaced. With FDI accounting for only a small fracttion of gross capital formation in India, its direct contribution to the growth rate be marginal in the near future. In the Indian context, growth-led FDI is more likely than FDI-led growth. To that extent, foreign capital is neither necessary nor sufficient for growth in India. Greater openness to foreign capital may be desirable but is not a substitute for policies that improve the incentives for investment, be it foreign or domestic.