Sneha Rajan

FOREIGN DIRECT INVESTMENT IN INDIA

A STUDY OF ECONOMIC REFORMS AND RISKS

Sneha Rajan PSCI 255

Sneha Rajan

Abstract

The Sub-continent has become the prime target for foreign direct investment. India ranks 6th among the top 10 countries for Foreign direct investment1. Although not in the front line, it has become an attractive destination for foreign investment. Indias economic policies are tailored to attract substantial capital inflows and to sustain such inflows of capital. Policy initiatives taken over a period of years2 have resulted in significant capital inflows of foreign investment in all areas of economy including the public sector. This paper analysis the structure of economic reforms during the pre- independence and post independence era in the context of growth of foreign direct investment and the risks posed by the political, economic and social conditions for foreign investors. Essentially, this paper seeks to analyse and understand the economics and politics of Indias progressive integration with the global economy.

Sneha Rajan

Introduction:

Prior to understanding the economic progress of India, it is vital to first identify the current economic status of India so that it is easy to retrace the process leading to the current status. India presently enjoys the status of an attractive emerging market. However, this status has been the result of numerous economic reforms adopted over the years. India intent to open its markets to foreign investment can be traced back to the economic reforms adopted during two prime periods- pre- independence and post independence.

Pre- independence, India was the supplier of foodstuff and raw materials to the industrialised economies of the world and was the exporter of finished products- the economy lacked the skill and means to convert raw materials to finished products. Post independence with the advent of economic planning and reforms in 1951, the traditional role played changes and there was remarkable economic growth and development. International trade grew with the establishment of the WTO. India is now a part of the global economy. Every sector of the Indian economy is now linked with the world outside either through direct involvement in international trade or through direct linkages with export and import transactions of other sectors in the economy.

Development pattern during the 1950-1980 period was characterised by strong centralised planning, government ownership of basic and key industries, excessive regulation and control of private enterprise, trade protectionism through tariff and non-tariff barriers and a cautious and selective approach towards foreign capital. It was a quota, permit, licence regime which was guided and controlled by a bureaucracy trained in colonial style. This inward thinking, import substitution strategy of economic development and growth was

Sneha Rajan widely questioned in the 1980s. Indias economic policy makers started realising the drawbacks of this strategy which inhibited competitiveness and efficiency and produced a much lower growth rate that was expected.

Consequently economic reforms were introduced initially on a moderate scale and controls on industries were substantially reduced by 1985 industrial policy. This set the trend for more innovative economic reforms and they got a boost with the announcement of the landmark economic reforms in 1991. After nearly five decades of insulation from world markets, state controls and slow growth, India in 1991 embarked on an accelerated process of liberalization. The 1991 reforms ensured that the way for India to progress will be through globalization, privatisation, and liberalisation. In this new regime, the government is now assuming the role of a promoter, facilitator and catalyst agent instead of the regulator and controller of economic activities.

India has a number of advantages which make it an attractive market for foreign capital namely, political stability in democratic polity, steady and sustained economic growth and development, significantly huge domestic market, access to skilled and technical manpower at competitive rates, fairly well developed infrastructure. FDI has attained the status of being of global importance because of its beneficial use as an instrument for global economic integration.

Sneha Rajan

Pre-Independence Reforms:

Under the British colonial rule, the Indian economy suffered a major set-back. An economy with rich natural resources was left plundered and exploited to the hilt under the English regime. India is originally a agrarian economy. Indias cottage industries and trade were abused and exploited as means to pave the way for European manufactured goods. Under the British rule the economy stagnated and on the eve of independence India was left with a poor economy and the textile industry as the only life support of the industrial economy.

Sneha Rajan

Post Independence Reforms:

Indias struggle post independence has been an excruciating financial battle with a slow economic growth and development which were largely due to the political climate and impact of the economic reforms. The country began it transformation from a native agrarian to industrial to commercial and open economy in the post independence era. India in the post independence era followed what can be best called as a trial and error path. During the post independence era, the Indian Economy geared up in favour of central planning and resource allocation. The government tailored policies that focussed a great deal on achieving overall economic self-reliance in each state and at the same time exploit its natural resource. In order to augment trade and investments, the government sought to play the role of custodian and trustee by intervening in the practice of crucial sectors such as aviation, telecommunication, banking, energy mainly electricity, petrol and gas.

The policy of central planning adopted by the government sought to ensure that the government laid down marked goals to be achieved by the economy thereby establishing a regime of checks and balances. The government also encouraged self sufficiency with the intent to encourage the domestic industries and enterprises, thereby reducing the dependence on foreign trade. Although, initially these policies were extremely successful as the economy did have a steady economic growth and development, they werent sustained. In the early 1970s, India had achieved self sufficiency in food production. During the 1970s, the government still continued to retain and wield a significant spectre of control over key industries such as power, mining, transportation and communications. 3

Sneha Rajan In the Early 1980s-Macro-Economic Policies were conservative. Government control of industries continued. There was marginal economic growth & development courtesy of the development projects funded by foreign loans. The financial crisis of 1991 compelled drafting and implementation of economic reforms. The government approached the World Bank and the IMF for funding. In keeping with their policies there was expectation of devaluation of the rupee. This lead to a lack of confidence in the investors and foreign exchange reserves declined. There was a withdrawal of loans by Non Resident Indians (NRIS).

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Economic reforms of 1991:

India has been having a robust economic growth since 1991 when the government of India decided to reverse its socially inspired policy of a retaining a larger public sector with comprehensive controls on the private sector and eventually treaded on the path of liberalization, privatisation and globalisation.4

During early 1991, the government realised that the sole path to India enjoying any status on the global map was by only reducing the intensity of government control and progressively retreating from any sort of intervention in the economy thereby promoting free market and a capitalist regime which will ensure the entry of foreign players in the market leading to progressive encouragement of competition and efficiency in the private sector. In this process, the government reduced its control and stake in nationalized and state owned industries and enterprises, while simultaneously lowered and deescalated the import tariffs. All of the reforms addressed macroeconomic policies and affected balance of payments. There was fiscal consolidation of the central and state governments which lead to the country viewing its finances as a whole. There were limited tax reforms which favored industrial growth. There was a removal of controls on industrial investments and imports, reduction in import tariffs. All of this created a favorable environment for foreign capital investment.

As a result of economic reforms of 1991, trade increased by leaps and bounds. India has become an attractive destination for foreign direct and portfolio investment.

Sneha Rajan

Foreign Direct Investment and Indian Policy:

FDI is investment of foreign assets into domestic structures, equipment, and organizations. It does not include foreign investment into the stock markets. FDI is thought to be more useful to a country than investments in the equity of its companies because equity investments are potentially "hot money" which can leave at the first sign of trouble, whereas FDI is durable and generally useful whether things go well or badly.

Emerging markets pose a significant potential for foreign investment both direct and portfolio. Foreign direct investment (FDI) is defined as the investment of foreign assets into domestic structures, equipment and organizations. However, it doesnt include foreign investment in the stock markets. FDI is thought to be more beneficial to a country than its investment in equity of its corporations because equity is considered to be potential hot money, which can leave at the first sign of trouble. On the other hand FDI is durable and generally useful whether things go well or badly.

China currently ranks first among the top ten countries for foreign direct investment among developing countries in 2001.5 Mexico, Singapore, Brazil are also among the top ten. India although is also an attractive destination for foreign investment, it is not in the front line. This is a stark reality despite the fact that the Indian economic, political and social conditions stable.

India is one of the largest economies of the world. Its strategic location in the subcontinent provides it with continued access to SouthAsian markets and middle-east markets.

Sneha Rajan The country also enjoys a huge consumer markets. Fast moving consumer goods find a significant market share in India, providing a market conducive to trade and finance.

Foreign investment is open in India and there arent cumbersome procedures in force for approval of inflows of foreign capital.6 India is also an attractive destination for foreign investment because of its access to skilled labor at competitive costs. Being the one of the largest manufacturing sectors of the world, it has a market conducive to trade and production.

India also has in place well established legal and accounting system to ensure proper administration of foreign capital to key sectors. Also, the stability of the political environment is another factor which makes India an attractive destination for foreign capital.

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Mechanics of FDI:

Foreign investment in India is permitted through the following modes:7 a. Through the route of foreign collaborations b. Through Joint ventures and technical collaborations c. Through capital markets via euro issues8 d. Through private placement or preferential allotment Although, the Government of India has permitted FDI in crucial sectors such as power, aviations, telecommunications etc., the following sectors cannot benefit from inflows of FDI: a. Arms and Ammunition:- National defence and security is solely within the control, regulation and supervision of the Central Government b. Atomic Energy: Due to its impact on national security, this subject is under the sole control of the Central Government. The Constitution of India stipulates 3 lists for legislation of numerous subjects namely the Central list, State list and the Concurrent List. Atomic Energy finds a mark on the Central List and the Central Government has so sole control on legislation.9 c. Railway Transport d. Coal and Ignite e. Mining of Iron, Manganese, Chrome, Gypsum, Sulphur, Gold, Diamonds, Copper and Zinc. While the government has opened most sectors for FDI, there are certain sectoral caps10 that are imposed to ensure that domestic corporations are not left out of the greater participation in the privatisation schemes. Industry wide break up in FDI ensures that inflows of FDI are concentrated only on priority sectors. In order to ensure sustained and accelerated growth in each sector, to increase the inflows of foreign capital and to introduce

Sneha Rajan appropriate institutional arrangements and transparent procedures, the Government of India has structured a Committee that shall implement policies and shall grant approval for foreign investment in domestic corporations and State- owned Enterprises. This committee is called the Foreign Investment Promotion Board. 11 The Board is the sole authority to consider investment proposals.

Sneha Rajan

Implications of Foreign Direct Investment:

Foreign direct investment affects economic growth through increased investment in the country. An increase in the inflows of FDI would essentially increase foreign savings and consequently would result in increased investment in the country. Another direct consequence of enhanced inflows of FDI is the positive impact on improvement in technology and infrastructure. FDI potentially brings new and emerging technologies to emerging and developing markets, and this can contribute to economic growth and development in the long run. Improved Technology also enhances the productivity of domestic enterprises and industries, thereby leading to efficiency and creation of competitive and open markets in sectors originally within the folds of state and central control.

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Policy Regime:

Control and restraints on foreign investment has long been the subject of controversy and major political debate in India. India drafted two major legislations which directly address the issue of foreign capital namely the Foreign Exchange Regulation Act ( FERA) and the Foreign Exchange Management Act ( FEMA). The policy framework for FDI is as follows: a. FDI in priority sectors like power and telecommunications enjoy automatic approval from the FIPB b. All other proposals for foreign investment have to go through the FIPB approval route. c. To provide enhanced and sustained access to foreign capital and to encourage modernisation of traditional and small scale industries, FDI up to the sectoral cap of 24% is permitted in traditional and small scale industries. d. The Reserve Bank of India (RBI) the apex central bank of India, grants automatic approval for all industries with respect foreign technology agreements and collaborations. e. The licensing requirement which required industrial enterprises to apply for and obtain industrial licences was abolished to enhance competition and promote efficiency. f. Majority investment by foreign parties is permitted. The FERA imposed equity participation limits on foreign corporations. The new FEMA has retrospectively altered this policy. As a result equity participation up to 51 % is permitted by foreign corporations.

Sneha Rajan The above policy design portrays that the government of India is making every endeavour to project India as global markets by diminishing and eliminating restrictions and restraints on the flow of foreign capital. The procedural framework for inflow of foreign capital has also been structured in a manner to ensure that foreign players are not dissuaded from investing because of cumbersome and tedious procedures. The policy also sought to ensure that the granting of approval for foreign investment was transparent and was not subject to whims, caprice and arbitrary decisions of the political; parties in power by formulating the formation of the FIPB..

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Conclusion:

Present day India enjoys the status of an emerging market. Skilled and managerial labor and technical man-power are such as that they match the best available in the world. A combination of these factors contributes to India having a distinct and a cutting edge in the globe. India has been termed as the stealth miracle economy of the new millennium. 12 It is among the largest economies in the world. GDP shoots up to 10.4%. There has been the entry of many multinational corporations (MNCS). There has been the advent of outsourcing which has put India on the global map.

Sneha Rajan

References

1 2

World Investment Report, 2003. 1947- till date ( 2004) 3 http://india.punjabilit.com/economy.htm 4 Privatization has been defined as the economic process of transferring the ownership of public sector enterprises to the private sector. This process facilitates the establishment of a free market and fosters competition and efficiency. 5 World Investment report. ***** 6 Approval is required from the Foreign Investment Promotion Board, There are 60 industry categories where approval is automatic. 7 http://finance.indiamart.com/investment_in_india/fdi.html 8 Indian Companies are allowed to raise capital through the issue of Global Depository Receipts. It would be pertinent to note that GDR are denominated in dollars and there are no ceiling imposed on investments in GDRs. http://finance.indiamart.com/investment_in_india/fdi.html 9 The structure of the Constitution stipulates that as far as subjects in the Central List is concerned the Central Government has the sole legislative and regulatory power, subjects in State List are within the legislative power of the state legislative assemblies, and subjects in the Concurrent List are shared in the legislative power of both Central and State Government, however, the Central Government has priority. 10 Sectoral Caps stipulate the maximum amount of FDI that can invested in a particular sector. 11 The Board is chaired by the Secretary of the Department of Industrial Policy and Promotion. The two main functions of the Board are: a. Undertake investment promotion activities and b. Facilitate investment in the country by Multi0national Corporations, Non-resident Indians and Foreign investors. 12 India to the Be the Next Economic Miracle http://www.meadev.nic.in/news/clippings/19991124/bs.htm