Private Foreign Investment in India: August 1999

Private Foreign Investment in India
August 1999
Authors:
Suma Athreye, Manchester School of Management, England

Sandeep Kapur, Birkbeck College, University of London, England
Address for correspondence
Sandeep Kapur
Department of Economics Telephone: 44 171 631 6405
Birkbeck College Fax 44 171 631 6416
Gresse Street email skapur@econ.bbk.ac.uk
London W1P 2LL
UNITED KINGDOM
Abstract
Private foreign capital, whose presence in Indian industry was long regarded with
concern and suspicion, is now touted as a panacea for India’s economic problems. This
paper compares the relative performance of domestic and foreign-controlled firms in
India, and evaluates the contribution of foreign investment over the last five decades.
We assess the impact of government policy towards foreign capital, and outline policy
implications for the future.
Keywords: India, foreign direct investment, MNCs, reform

JEL classification: F21, F23, L6
Foreign investment in India
Private Foreign Investment in India*
August 1999
Abstract
Private foreign capital, whose presence in Indian industry was long regarded with
concern and suspicion, is now touted as a panacea for India’s economic problems. This
paper compares the relative performance of domestic and foreign-controlled firms in
India, and evaluates the contribution of foreign investment over the last five decades.
We assess the impact of government policy towards foreign capital, and outline policy
implications for the future.
Keywords: India, foreign direct investment, MNCs, reform

JEL classification: F21, F23, L6
*
We thank the Company Finances Division of the Reserve Bank of India for data and guidance; John
Cantwell and Ron Smith for comments.
1
1 Introduction
The 1990s have seen a marked increase in private capital flows to India, a trend
that represents a clear break from the two decades before that. In the 1970s there
was hardly any new foreign investment in India: indeed, some firms left the
country. Inflows of private capital remained meagre in the 1980s: they averaged
less than $0.2 billion per year from 1985 to 1990. In the 1990s, as part of wide-
ranging liberalisation of the economy, fresh foreign investment was invited in a
range of industries. Inflows to India rose steadily through the 1990s, exceeding $6
billion in 1996-97. The fresh inflows were primarily as portfolio capital in the
early years (that is, diversified equity holdings not associated with managerial
control), but increasingly, they have come as foreign direct investment (equity
investment associated with managerial control). Though dampened by global
financial crises after 1997, net direct investment flows to India remain positive.
Table 1: Recent foreign investment in India, net inflows in $ billion

1990-1 1991-2 1992-3 1993-4 1994-5 1995-6 1996-7 1997-8 1998-9
Direct investment 0.10 0.13 0.32 0.59 1.31 2.13 2.70 3.20 2.06
Portfolio investment 0.01 0.00 0.24 3.57 3.82 2.75 3.31 1.83 -0.06
Total 0.10 0.13 0.56 4.15 5.13 4.88 6.01 5.03 2.00
Sources: see appendix
Table 1 highlights the growth in inflows. To put these figures in perspective, note
that the total stock of private foreign equity capital in Indian industry was about $
2 billion in 1990 (Rupees 40 billion at 1990 exchange rates). Or, comparing the
flow to broad external sector aggregates, India’s current account deficit, about $10
billion in the crisis year of 1990-91, was financed primarily through commercial
loans and external assistance: private investment flows were paltry. By 1997-98,
foreign investment inflows of $5 billion could finance a sizeable chunk of the $6.5
billion current account deficit.
India was not unique as a recipient of increased inflows in the 1990s.
International flows of private capital to most developing countries rose sharply
over this period. The historically low interest rates in the US encouraged global
investment funds to diversify their portfolios by investing in emerging markets.
International flows of direct investment, which had averaged $142 billion per year
over 1985-90, more than doubled to $350 billion in 1996, with the developing
countries receiving $130 billion. Host country policies did influence the choice of
location for this investment. China received the largest chunk: at $42bn, FDI
1
inflows accounted for as much as a quarter of its gross capital formation in 1996.
Other developing countries, most notably those in the Pacific Basin, also received
sizeable flows. Foreign direct investment flows to India were paltry in
comparison: at $2.5bn in 1996 -- less than 4% of domestic capital formation—
they remain marginal to the investment process.
The question then is not, why have inflows to India grown so much, but why
they remain low compared to other emerging markets? Some commentators
believe that if only India could attract enough foreign capital it could, as China
has, move on to a higher growth path. Official policy statements in India seems to
endorse this belief: the progress of economic reforms is measured in terms of
cumulative foreign capital inflows or, even more optimistically, in terms of
approvals granted for foreign inflows. Reality has trailed behind official
expectation—over the period 1991 to 1996, actual inflows of foreign direct
investment averaged no more than one-fifth of total approvals.
The case for foreign capital is usually made as follows. Foreign investment can
supplement domestic investible resources in a developing economy, enabling
higher rates of growth. As a source of foreign exchange, it can relax potential
balance of payments constraints on growth. Profit remittances on account of
foreign equity are related to the performance of investment projects, unlike the
inflexible repayment obligations of foreign debt: this risk-sharing feature makes
foreign equity preferable to foreign debt. Foreign firms contribute to the
technological base of the host economy, directly and through technological
spillovers to other firms in the industry. 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 long argued against this rosy picture. They
claim that multinationals monopolise resources, supplant domestic enterprise,
introduce inappropriate products and technology, and aggravate the balance of
payments problems through high remittances. They may also come to wield
considerable political influence, distort the path of development, exacerbate
income inequality, and exploit the weak environmental standards in developing
countries (recall the Union Carbide disaster at Bhopal in 1984).
Is foreign capital a pain, or is it a panacea for India’s problems? To a large
extent, the answer depends on the nature of foreign direct investment (FDI) and its
motivations. Some FDI is motivated by the high rates of return in a vibrant
economy, and aims to benefit from better international organization of production
and location. Crudely speaking, we could refer to such FDI as growth-led and
efficiency-seeking. But even a stagnant economy may attract rent-seeking
multinationals that have a comparative advantage, over domestic firms, in
extracting monopoly rent in protected markets. The relative mix of these two
2
types of FDI determines the long term benefits and costs of foreign capital.
Ideally, a country would like to attract efficiency-seeking FDI and exclude rent-
seeking FDI. Of course, from practical or regulatory points of view, it is not easy
to distinguish ex-ante between the two types of FDI. Typically, a permissive
regulatory environment may end up admitting both types, while a restrictive
environment may exclude both. In the perverse case, the regulatory environment
may create hurdles that rent-seeking FDI alone can jump over. One way to reduce
this risk is to promoting a regulatory environment that makes it hard to generate
monopoly rent, thus making investment less attractive for rent-seeking FDI.
To assess the relevance of these arguments for the Indian case, we scrutinise
the role private foreign capital has played in India over the last five decades. In
particular, we compare the conduct and performance of foreign-controlled firms
relative to domestic firms; unlike previous studies that have looked at this issue
over short periods of time, we examine long-term trends in relative performance.
Our study focuses on aggregate behaviour; this allows us to explore an issue
ignored in previous studies, namely the macroeconomic linkage between policy
towards foreign capital and its contribution to the Indian economy.
Section 2 reviews the policy framework towards foreign capital in India, and
Section 3 examines the long-term trends in foreign investment. Section 4 assesses
the importance of foreign-controlled firms in Indian manufacturing, and their
performance relative to domestic firms. Section 5 attempts to evaluate the
contribution of foreign capital to the Indian economy. Section 6 outlines the
policy implications that emerge from our analysis.
2 Five decades of policy changes

Foreign capital has a relatively long history in India. At Independence in 1947,
private foreign capital dominated the narrow industrial base in India. It was three-
quarters British-owned, concentrated mostly in extractive industries and trade, and
managed by expatriate Europeans. The continued dominance of these colonial
enterprises was an irritant to nationalist sentiments. Fledgling Indian business
houses envisioned a future in which foreign interests would be curtailed, and
Indian industry and markets reserved for swadeshi (that is, domestic) capital.1
1
The term swadeshi had its origin in the turn-of-the-century Swadeshi Movement that aimed to
boycott foreign goods. Subsequently, the term became emblematic of nearly all forms of hostility
to foreign interests. The Bombay Plan (formally, A Plan of Economic Development in India,
1944), an early articulation of hostility of Indian business houses to foreign capital. led to the
formation of the Swadeshi League. In 1953, the Federation of Indian Chambers of Commerce and
Industry adopted the Swadeshi Resolution. Nationalists were only too conscious of the record of
foreign investment in India: the East India Company, arguably the largest foreign direct
investment enterprise in Indian history, had later formed the basis for imperial rule.
3
Early statements of government policy echoed these interests. The Industrial

Policy Resolution of 1948, while conceding that ‘participation of foreign capital
and enterprise will be of value to the rapid industrialisation of the country’,
demanded that ‘the conditions under which it may participate be carefully
regulated in the national interest. As a rule, majority interest in ownership and
effective control should always be in Indian hands’, and called for a gradual
replacement of foreign personnel.
One Step Forward...

However, the magnitude of the industrial challenge after Independence called for
a more pragmatic approach. The government remained critical of the old foreign
investment, but new investment was considered necessary, ‘not only to
supplement savings but also because in many cases, scientific, technical and
industrial knowledge can best be secured through foreign capital’. As early as
1949, a more conciliatory statement in the Parliament promised that ‘existing
foreign interests would be accorded “national treatment”; new capital would be
encouraged on terms that are mutually advantageous; although majority
ownership by Indians was preferred, foreign control would be permitted for a
limited period if it is found to be in the national interest; repatriation of capital and
remittances of profits abroad allowed; in case of compulsory acquisition, fair
compensation would be paid’. Foreign firms were encouraged to invest in
protected industries like fertilisers and machine tools. Extensive concessions and
tax advantages were offered to attract multinational oil companies.
Despite these overtures, inflows remained modest. Kidron (1965) notes that
capital inflows to India between 1948 and 1953 were a meagre Rs 1.3 billion
($270 million), and much of that was due to the oil-majors setting up their
operations in India. The initial reticence of foreign capital was understandable.
Domestic business houses, foreign capital, and the government were locked in
what Kidron famously called ‘an uneasy triangle’. Individually, domestic
industrialists sought foreign collaboration for access to foreign technology and
brand names. At the collective level industry associations—often dominated by
the same industrialists—sought to preserve the Indian market for themselves, and
clamoured for reversal of the open-door policy. The government was not moved:
‘the wheels of industry, no matter who owns them, must be kept moving’, the
Commerce Minister declared in 1953. Government policy was non-discriminatory
in intent but still vulnerable to nationalist sentiments. The ambivalence of
domestic business interests, and uncertainty regarding future government policy,
kept foreign investors shy of the Indian market.
In the late 1950s policy and circumstance conspired to alter the situation
dramatically. The Second Economic Plan, launched in 1957, chose the path of
4
industrialisation through import-substitution. The large increase in planned

investment expenditure coincided with a severe foreign exchange crisis that
forced a drastic reduction in imports, especially of consumer goods. These events
created extremely lucrative opportunities for private investment in India. To
exploit these opportunities, Indian business had to turn abroad for technology. For
foreign capital, this was an excellent opportunity to jump the newly created tariff
barriers. This coincidence of interests overwhelmed any misgivings that Indian
industrialists might have had about foreign collaboration.
The government, keen to achieve its Plan targets, encouraged private
investment and, in particular, allowed foreign equity participation to meet the
foreign exchange needs of investment projects. At the behest of the World Bank,
the government dropped its insistence on majority Indian ownership. The Indian
Investment Centre was set up in 1961 to expedite the approval of foreign
collaborations. The government drew up a list of 26 industries where foreign
collaboration was to be encouraged. Pharmaceutical drugs, aluminium, and heavy
electricals were opened up to joint ventures.
Foreign capital poured in during the 1960s. Its form and sectoral distribution
was affected by the selectivity of government policy. Unlike the existing stock of
foreign capital, fresh inflows concentrated on manufacturing, especially the
technology-intensive industries. Collaboration was the preferred form of
investment: joint-ventures with Indian business partners provided local
intermediaries, who were better able to cope with the highly regulated industrial
regime. Indian participation made these projects more acceptable to the regulators.
... Two Steps Back?

By the end of the 1960s, the honeymoon was over. In the aftermath of two
famines and a humiliating devaluation of the Rupee, the political mood hardened
and turned towards socialist idealism. Major commercial banks were nationalised,
and the Monopolies and Restrictive Trade Practices Commission was set up in
1969. In such an environment, it no longer seemed politic to have an open-door
policy to foreign capital. If anything, there was heightened concern about the
foreign-exchange costs of repatriated profits and other remittances. The tenor of
policy towards foreign capital changed. Foreign oil-majors were nationalised in
the early 1970s. The government did not rule out new foreign capital—it had set
up the Foreign Investments Board in 1968, ostensibly to reduce average
processing time for fresh applications—but now wanted it on its own terms.
The Foreign Exchange Regulation Act (FERA) of 1973 is singled out as
evidence of the new hostility. It amended an earlier Act of 1947, and a crucial
new clause aimed to limit the extent of foreign ownership at the enterprise level. It
required that all firms dilute their foreign equity holdings to 40% if they wanted to
5
be treated as Indian companies. Most, though not all, firms chose to fall in line
with this provision rather than risk the more stringent regulations imposed on the
so-called FERA companies. However, the view that FERA was unambiguously
hostile to foreign capital and intended to protect Indian industry from foreign
dominance may be a little simplistic. The required dilution of foreign equity to
40% was not too onerous. While some multinational firms insist on majority
ownership—IBM and Coca-Cola left India in the late 1970s—for many others,
40% was sufficient to retain managerial control. Moreover, exceptions in the Act
allowed many ‘technology-intensive’, ‘export-intensive’, and ‘core-sector’ firms
to preserve majority foreign ownership, often as much as 74%. Most
multinationals found it worthwhile to continued operating in India. Indeed, as we
show later, many existing multinationals consolidated their positions in Indian
market during the 1970s. Thus, FERA proved more hostile to new foreign
investment than to existing foreign affiliates.
FERA was only a part of the new regulatory regime. Limits on foreign equity
holdings were now combined with restrictions on technology imports. Fresh lists
were drawn up of industries where foreign collaboration was still considered
necessary; others where only technical collaborations was permitted, with
curtailed rates of royalty payment; and those where the domestic technological
base was considered strong enough to obviate the need for imports of technology.
To minimise the foreign exchange costs of technology acquisition, as far as
possible technologies were to be acquired through licensing rather than financial
collaboration. Intellectual property rights were severely curtailed by a revised
Patents Act in 1970: product-patents were abolished in industries such as
pharmaceuticals and chemicals; the duration of process-patents was shortened.
Overall the technology policy, combined with selective licensing and
progressive nationalisation of some industries, served to concentrate foreign direct
investment in the manufacturing sector. Even within manufacturing, FDI was now
predominantly in technology-intensive industries such as heavy chemicals,
pharmaceuticals, and mechanical and electrical machinery. While this shift was
broadly desirable, we argue later that the policy regime restricted access to foreign
technology.
Piece-meal reform
In the 1980s, growing concern about stagnation and technological obsolescence in
Indian industry drew attention to the restrictive licensing procedures. Poor quality
and high costs in Indian manufacturing probably contributed to the poor export
performance, a particular irritant in the wake of the second oil price shock. As a
consequence, there was a softening of the regulatory regime. To encourage
exports, firms that produced primarily for exports were granted exemptions from
6
the usual FERA restrictions on foreign equity ownership. In an attempt to

modernise manufacturing industry, restrictions on technology transfers and
royalty payments were relaxed and, where attempts to acquire technology through
licensing had failed, foreign equity participation was permitted again.
This early softening did not reflect any serious change of heart. Despite the
official claims of simplified procedures and cleared bottlenecks, foreign
investment projects were still very vulnerable to bureaucratic discretion: there is
little evidence that policy was any more informed about the needs of Indian
industry or the nature of the technology market. There was only a slight increase
in foreign inflows, and the most part, Indian industry came to rely on foreign debt
capital to meet its foreign exchange needs.
Crisis and ‘winds of change’

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 India’s credit rating. The government
turned to the International Monetary Fund for help.
As part of the reforms agreed with the IMF, the Rupee was devalued by 20%.
The trade regime and the regulatory framework were liberalised. Industrial
licensing was abolished in all but a handful of industries. Foreign direct
investment was invited in a wide range of industries, including consumer goods.
The government dropped its insistence that foreign equity participation provide
specific benefits in terms of technology transfer or export earnings. The limit on
foreign equity participation was raised to 51% for most industries, and even 100%
in some cases. Foreign investment was especially sought in the infrastructure
sectors previously monopolised by state enterprises: power generation, highway
and port construction, telecommunications, oil and natural gas exploration, etc.
The services sector, where foreign capital had been gradually eliminated as a
matter of deliberate policy, was reopened to foreign investors: they were invited
to invest in financial services, retail banking, and recently, in life and general
insurance. Restrictions on the use of international brand names were removed.
Reforms in the technology policy have provided greater recognition of intellectual
property rights.
This liberalisation coincided with growing interest in emerging markets,
especially among the global pension funds. In a major break from the past, foreign
institutional investors (FIIs) were allowed to make portfolio investments in Indian
companies, subject to overall limits on ownership within each firm. Foreign funds
7
surged in, initially in the form of portfolio capital, but increasingly in direct
investment projects. In 1997-98, foreign direct investment inflows exceeded
$3.2bn. Despite the exceptional political instability after 1995, successive
governments have continued to court foreign capital even though the liberal
stance has not always been consistent. In a sense, the attitude towards foreign
capital seems to have turned a full circle. In a pattern reminiscent of the early
1950s, domestic business interests have increasingly lobbied the government for
continued protection against foreign capital.
In the last five decades, policy towards private foreign capital has moved
closely with exigencies of India’s external payments position, and with changing
official perceptions of the role of foreign capital in alleviating or exacerbating that
position. The early liberalisation of the late 1950s was in part motivated by a
balance of payments crisis. The restrictive regime of the 1970s, and FERA in
particular, was influenced by the belief that excessive remittances of foreign
enterprises were worsening a precarious balance of payments position. The
gradual liberalisation of the 1980s and the major reforms of the 1990s were, to
different degrees, responses to external payments difficulties. Even when the
private capital inflow was not large by itself, it was expected that a more liberal
regime towards foreign investment would enable other flows, including those
from the multilateral lending agencies. The changing policy environment affected
the extent of foreign capital in Indian industry and its contribution to the
economy. We discuss these in turn.
3 Private foreign capital in India: long-term trends
At Independence, the total stock of private foreign capital in India was valued at
Rs 5.8 billion ($1.2 billion at 1948 exchange rates). By 1995, the most recent year
for which comparable data is available, the stock had grown to Rs 989 billion
($31 billion). Table 2 profiles the long-term foreign liabilities of Indian firms over
this period.
Table 2: Stock of private foreign capital in the Indian corporate sector

1948 1960 1970 1980 1987 1992 1995
Long-term investment
(Rs billion), of which 5.8 5.7 16.4 22.19 133.6 536.5 988.9
1 Direct investment 2.6 5.0 7.4 9.3 17.4 38.4 94.2
(% share in total) (89) (44.8) (42.1) (13.0) (7.2) (9.5)
2 Portfolio investment na 0.5 0.9 1.2 4.6 14.8 226.2
(% share in total) (9.0) (5.7) (5.5) (3.4) (2.8) (22.9)
3 Foreign debt na 0.1 8.1 111.0 483.3
(49.5) (52.4) (90) (67.6)
This is private long-term capital in firms, excluding banks. The procedure for classifying equity capital as
direct investment and portfolio investment changed in 1992, hence relative shares are not comparable after
that year. For a discussion of this and all data sources, see the appendix.
8
The growth rate of foreign liabilities varied across time and investment categories.
Foreign direct investment (i.e., foreign equity holdings associated with foreign
control of enterprises) grew steadily at first, its stock rising from Rs 2.6 billion in
1948 to Rs 7.4 billion by 1970. Its rate of growth fell in the 1970s, picked up in
the 1980s, but the surge came after 1992: the stock of direct investment rose from
Rs 38 billion in 1992 to Rs 94 billion by 1995. In contrast, foreign portfolio
investment was restricted a matter of deliberate policy for most of this period. The
total stock of portfolio capital was less than Rs 15 billion in 1992. With
liberalization these portfolio holdings rose to Rs. 200 billion by 1995, though
recent financial crises have seen net outflows on this account. But, most
strikingly, the largest single component of private foreign capital after 1980 has
been long-term corporate debt: when foreign equity inflows were restrained
during the 1980s, Indian firms made up by borrowing abroad. Even in 1995,
foreign corporate debt was more than twice as large as foreign equity capital. (Of
course, the rupee value of debt is slightly exaggerated by currency devaluation in
1991-92.) Thus the commonly held view that the Indian economy was cut off
from foreign capital is not quite true—more accurately, the corporate sector was
deprived of foreign equity participation.
Foreign Direct Investment

Table 3 summarises the changing industrial distribution of foreign direct
investment. In 1948, a third of all foreign direct capital was in the primary sector
(plantations, mining, and oil), a quarter in manufacturing, and the rest in services
(mostly trading, construction, transportation and utilities). By the mid-1990s,
manufacturing accounted for about 85% of all foreign direct investment. In
absolute terms, the stock of foreign direct capital in manufacturing rose from Rs
0.7 billion in 1948 to over Rs. 79 billion by 1995. Within manufacturing, the
capital goods sector was the predominant recipient of FDI: engineering and heavy
chemicals account for two-thirds of all foreign direct capital.
The primary and services sectors now account for less than 10% each of all
foreign direct capital. Foreign holdings in plantations and mining fell steadily
after Independence. The share of oil-refining rose as the oil-multinationals entered
in the early 1950s, but then fell when they were nationalised in the 1970s. The
energy sector has seen renewed interest among foreign investors in recent years.
The share of the services sector fell as many firms were nationalised in the 1970s,
but once again there is renewed foreign interest in these sectors.
The changed industrial distribution of foreign capital in India reflects the
success of a selective regime. To a large extent, the government managed to direct
foreign capital to technology-intensive, manufacturing sectors: this was consistent
with the needs of an industrializing economy.
9
Table 3: Changing distribution of foreign direct capital stock in India, percentages
Industry/Sector 1948 1960 1970 1980 1987 1992 1995

Plantations 20.4 19.0 16.5 4.1 8.8 8.5 4.8
Mining 4.5 2.4 0.8 0.9 0.3 0.6 0.3
Petroleum 8.7 29.7 16.7 4.0 0.1 2.0 2.9
Total primary sector 33.6 51 34 9 9.2 11.1 8.0
Food & beverages , tobacco 14.2 6.4 5.6 4.2 6.5 4.9 7.3
Textiles 39.4 2.7 3.0 3.4 4.6 2.9 3.9
Transport equipment 1.4 1.2 3.7 5.6 9.9 12.4 10.5
Machinery & machine tools 1.7 0.8 3.8 7.6 12.1 12.6 11.3
Metals and metal products 11.3 2.8 8.8 12.7 4.9 5.1 4.6
Electrical goods 6.8 2.3 6.5 10.5 11.9 11.0 10.8
Chemicals & pharmaceuticals 3.1 6.4 18.8 32.4 29.6 28.0 22.2
Miscellaneous 9.9 6.2 12.0 10.7 6.1 6.4 12.8
Total manufacturing 27.8 30 60 87 85.6 83.2 83.4
Trading 16.3 5.4 2.6 2.3 0.4 1.1 1.3
Construction, utilities, transport 11.9 7.6 1.6 0.6 2.2 1.1 0.7
Total services 38.7 19.5 16.0 4.0 5.1 5.7 8.9
Total FDI (current Rs. Million) 2558 5017 7354 9330 17420 38400 94160
1992 and 1995 figures use the modified definition of FDI. See appendix.
The historical dominance of British firms has shown remarkable persistence in

post-imperial India. Three-quarters of all foreign capital was British in 1948. This
share declined to 40% by 1992, but since then has been eroded to 25% by
disproportionately large inflows from other countries. The share of US firms has
risen; Germany, Japan, and Switzerland have a significant presence, too. The
industrial distribution of foreign capital differs according to the nationality of
investors. Multinationals from the US, Germany, and Japan have gravitated to
technology-intensive manufacturing. Traditional investments, such as plantations,
are predominantly monopolised by British firms.
Table 4: Countries of origin: stock of foreign direct investment in India

Percent share of 1960 1971 1980 1987 1992 1995
UK 76.6 64.5 53.9 51.7 40.2 28.0
USA 14.5 18.4 21.1 12.9 18.6 24.1
Germany 1.1 3.1 7.0 16.7 12.4 8.9
Japan 0.2 0.4 0.4 3.7 5.5 7.6
Switzerland 2.4 5.0 5.9 3.7 4.8 5.6
Others 5.2 8.6 11.7 11.3 18.5 26.8
4 Foreign-controlled firms in Indian Industry
To what extent have foreign-controlled firms dominated Indian manufacturing?

The relative share of foreign firms in Indian industry has been a matter of some
controversy. Existing estimates—see Kumar (1994) for an excellent survey—are
10
based on a variety of methods, data, and working assumptions, so provide a poor

guide to the long-term trends.
We estimate the foreign share in Indian industry for the period 1970 to 1994,
using unpublished data from the Reserve Bank of India (RBI). The data is
constructed from a sequence of surveys of Finances of Medium and Large Public
Limited Companies.2 The use of this data has some limitations for our purpose.
The surveys exclude public sector (i.e., state-owned) enterprises, private limited
(i.e., ‘unlisted’) companies, and small companies. The excluded sectors are
predominantly domestically-owned so our estimates probably exaggerate the
foreign presence. Moreover, if excluded sectors grow faster (or slower) than the
firms in our data set, changes in foreign presence over time are over- (or under-)
estimated. Variations in the coverage of surveys, and in the identification of
foreign firms also affect our estimates. Despite these limitations, the data has the
merit of being internally consistent and covers a reasonable period of time. Earlier
versions of this data have been used for point estimates by Chandra (1977, 1991),
and Kumar (1994), among others.
Conceptually, the relative foreign presence can be measured either as the share
of assets that are foreign-owned, or as the asset- or market-shares of foreign-
controlled firms. The identification of foreign-controlled firms is not free from
ambiguity. Managerial control of listed companies is exercised through ownership
of sufficiently large blocks of voting stock. Majority ownership enables control in
most circumstances, but minority ownership may be sufficient if other share-
holdings are fragmented, i.e. dispersed among a large number of small share-
holders. Many studies, Kumar (1994) for instance, classify a firm as foreign-
controlled if at least 25% of its shares are held abroad. The International Monetary
Fund uses a lower threshold: its Balance of Payments guidelines treat a firm as a
foreign direct investment enterprise if 10% of its voting stock is held abroad by a
single investor. The choice of the right threshold is largely a matter of convention:
Graham and Krugman (1995) discuss the merits of the 10% criterion.
We rely on the classification scheme used by the RBI. The RBI identifies each
firm by its country of controlling interest. For much of the period under study,
Indian regulations treated a firm as foreign-controlled if 25% of the equity was
held by a single foreign investor, or if 40% of the equity was held in any one
foreign country. Effective 1992, the RBI adopted the IMF guidelines for
identifying foreign direct investment enterprises. Thus, over time, changes in the
identified country of control may just reflect changes in the classification rules for
foreign investment. Our results must be interpreted with this caveat.
2
These surveys are described in the Appendix.
11
We estimate foreign shares in Indian manufacturing as the share of foreign-

controlled firms in gross sales; one could equally well measure their share in
assets or, indeed, any size-related variable, but this does not seem to affect the
overall pattern. Figure 1 shows that foreign-controlled firms accounted for
between a third and a quarter of gross sales in Indian manufacturing over period
1970 to 1990. The foreign share rose slightly from 1970 to 1976 and since then
has declined. We believe that the sharper decline after 1991 is an artefact of the
data: foreign firms seem under-identified or under-represented in recent surveys.
More detailed results reported in Athreye and Kapur (1999) show that foreign
shares are high in electricals (especially dry cells and lamps), chemicals
(especially pharmaceuticals, plastics, paints, and toiletries), tyres and tubes,
cigarettes, aluminium, automotive components. British-controlled firms have the
largest share: in 1990-91, they controlled 15% of all sales --domestic or foreign --
in Indian manufacturing; the share of US firms was a little below 5%.
Our estimates are broadly consistent with others’ who have earlier versions of
this data (see, for instance, Kumar’s (1994) estimates for 1980-81). Others, with
alternative assumptions, produce different estimates. Ganesh (1997) identifies
foreign-control with majority foreign ownership (i.e., foreign ownership in excess
of 50%). Among the largest 1000 listed firms in 1995, he found that only 72 firms
are foreign-controlled by this (tighter) criterion, and together control only 9% of
total sales. Ganesh concludes, on this evidence, that foreign presence in Indian
manufacturing has been exaggerated.
Identifying foreign control by the criterion of majority ownership is probably
inappropriate in the Indian context. Under the Foreign Exchange Regulation Act
(1973), many multinationals operating in India were forced to dilute foreign
shareholdings to 40%. In most cases, the foreign parent could maintain complete
control over their Indian affiliates even with this minority shareholding. Typically,
the required dilution was achieved through fresh equity issues. Control of share
allocations ensured that domestic shareholdings were fragmented. For instance, 89
thousand individuals together made up the 47% domestic shareholding in
Hindustan Lever, while its parent, Unilever, retained 51% (figures for 1980).
State-controlled financial institutions, which often had significant equity holdings
in Indian business houses, did not invest in foreign affiliates -- this removed a
possible channel of countervailing power. Even when the government enforced
the complete Indianization of managerial cadres in India, many minority foreign-
owned affiliates found non-equity forms of control over their local management.
When foreign exchange was a scarce commodity, control over loans from the
foreign parents to the Indian subsidiaries became a indirect channel of control.
Our findings do not support the common-place belief that FERA (1973)
curtailed foreign control in Indian industry. As Encarnation (1989) notes, many
12
multinationals ‘continued to turn adversity into opportunity’: in exchange for

expanded exports or increased production in priority industries, the government
allowed more than a hundred foreign enterprises to retain majority-holdings in
their Indian affiliates. The required equity dilutions allowed them to raise fresh
capital at a time when access to capital markets was severely restrained by the
government. Even though a few multinationals—notably Coca-Cola and IBM—
left India in the late 1970s, most chose to stay. Indeed, many foreign-controlled
firms managed to consolidate their position in the Indian market. Overall, FERA
allowed incumbent foreign firms to preserve their market shares in India, and
sometimes to thrive too, even as it deterred new foreign investment.
The gradual decline in foreign market shares, especially in the 1980s, is better
explained by the restrictions placed on foreign firms by the overall regulatory
framework. Greater selectivity in industrial licensing restrained the growth of
many multinationals. Many multinationals were unable to compete against well-
organised domestic industrial lobbies. Restrictions on monopoly power (the
Monopolies and Restrictive Trade Practices Act) and a diminution of intellectual
property rights (the Patents Act) eroded many of the rent-seeking advantages that
foreign firms had enjoyed in India. Encarnation (1989) argues that India acquired
financial autonomy from foreign enterprises at an early stage by mobilising
domestic and foreign capital, and then managed to unbundle technology
acquisition from equity participation. As a result, domestic enterprises gradually
acquired control over product markets that were previously dominated by
multinationals. Foreign multinationals were also displaced by the growth of state-
owned enterprises in some sectors (steel, engineering, chemicals, pharmaceuticals,
mining, transport, power), and progressive nationalisation in others (textiles).
Despite this gradual erosion in some sectors, multinationals were not quite
dislodged from India. Many preserved their foothold in India, and were well
placed to recover their position in the 1990s.
Foreign-controlled firms: conduct and performance

Did the foreign-controlled firms in India differ from domestic firms in terms of
their conduct and performance? Kumar (1994) examines the discriminating
characteristics of domestic and foreign-controlled firms, using data for 1980-81,
and with careful attention to the underlying statistical issues. He found that as a
proportion of sales, foreign-controlled firms spent less on R&D (presumably
because they rely on technology imports) than domestic firms, but expenditure on
advertising was broadly similar for the two groups of firms. However, foreign-
controlled firms were significantly more profitable in their operations, a result
corroborated by other studies. Kumar (1990) concluded that the profitability of
foreign-controlled firms was protected by entry-barriers: in knowledge- and skill-
intensive industries, their technological strength, access to global marketing
13
networks and brand names gave them a clear edge over domestic firms. He found
that degree of seller concentration did not seem to affect profitability but there
was market segmentation: foreign-controlled firms competed on the high value
end of the market while domestic firms concentrated on the low-value end.
We use the RBI data to compare the conduct and performance of foreign-
controlled and domestic firms over the period 1970 to 1994. For each variable
under scrutiny, we compare the (weighted) average for foreign-controlled firms
with that for domestic firms. Figure 2 confirms earlier findings that foreign-
controlled firms have persistently higher profit margins, whether measured as
share of net sales or net fixed assets.
How did the multinationals defend these profit margins? Advertising intensity,
measured as the ratio of advertising expenditure to net sales, was greater for
foreign-controlled firms (see figure 3), but domestic firms relied more heavily on
selling commissions (figure 4). Of course, different industrial sectors differ in the
advertising intensity: the overall difference in marketing strategies might reflect
the differences in industrial concentration of foreign-controlled and domestic
firms. Figure 5 shows that domestic firms have increased their expenditure on
technology imports, especially in recent years, and have overtaken foreign firms
in this respect. Unfortunately, we do not have comparable data for R&D
expenditure, but these were typically quite small for all manufacturing firms in
India. On the whole, the observable differences in conduct were not that large.
5 The contribution of private foreign capital
What has been the impact of private foreign capital on the Indian economy? Has
the presence of multinational corporations helped or hampered growth in Indian
industry? There is no easy consensus on these issues. 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 crumbling
infrastructure, and allow India to modernise its technological base. Moreover,
greater competition in Indian manufacturing will benefit the Indian consumer. On
the other hand, critics of foreign capital point to the poor record of multinational
corporations in India, their excessive profitability, the adverse impact of profit
remittances on India’s balance of payments, and limited technology transfer, and
their domination of the Indian manufacturing sector. We scrutinise the available
evidence to assess the validity of the rival claims, but it helps to begin on a
conceptual note.
Does foreign investment 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
14
levels of foreign capital. Many Latin American countries have periods of slow
growth despite openness to foreign capital, while much of sub-Saharan Africa has
experienced low growth and poor investment flows. 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? Anecdotal evidence apart, cross-country
econometric evidence does not offer stronger conclusions: de Mello (1997),
surveying the evidence, concludes that the relationship between FDI and growth
depends on country-specific factors.
In theory, foreign direct investment inflows affect economic growth through
increased investment in the economy. The relation between the FDI and domestic
investment is best explained through the following macroeconomic identity. Total
investment in an economy must be financed somehow within each period:
investment = domestic savings + foreign savings
where foreign savings refer to resources received from foreign citizens invest, as
foreign equity and foreign debt inflows. Other things being the same, an increase
in FDI increases foreign savings, and so increases investment in the economy.
However, quite plausibly, increases in FDI inflows may coincide with a reduction
in debt inflows (so that total foreign savings remain constant) or be accompanied
by a fall in domestic savings (if there is a consumption boom): in each case
domestic investment does not rise.
The effect on balance of payments can be analysed by rewriting the above
identity as
foreign savings = imports - exports
In general, if an increase in FDI increases available foreign savings, it allows the
host country to import more or to accommodate a decline in exports. Thus, at least
in the short run, inflows of foreign capital allow the current account to worsen.3
This is not surprising: indeed, the purpose of foreign savings is to import more in
the short run. Note that the effect on the balance of payments is the flip side of the
effect on domestic savings and investment: FDI can conceivably increase
domestic investment, or provide additional balance of payments financing for an
existing current account deficit, but cannot do both at the same time.
In general, an FDI-financed, short-run, ability to import more could equally
well support a consumption boom or an investment boom. If it is the latter, it
would typically result in faster growth and, possibly, increased exports. After
3
This is not always true: the monetary authority may choose to accumulate inflows as foreign
exchange reserves. Large, rapid inflows then present problems for the management of money
supply: sterlization of flows is not always effective.
15
allowing for some profit repatriation on account of successful investment, the host
economy would still benefit. However, the long-term outcome is not always so
favourable. Singh and Weisse (1998) note that rapid inflows to Mexico in the
early 1990s fueled a consumption boom, accompanied by large current account
deficits. Arguably, if inflows are in the form of portfolio capital (rather than, say,
FDI in greenfield ventures), they are more likely to result in consumption rather
than investment booms. Patnaik (1997) notes that a significant fraction of recent
inflows to India have been short-term flows of portfolio capital, whose direction is
easily reversed with changes in market perceptions. A sudden reversal of flows
has catastrophic effects on investment, output, and the balance of payments, as
evident from the experience of Mexico, and more recently, East Asia. Instability
in capital flows would then result in increased volatility in economy-wide growth
rates.
In view of this, it may be over-optimistic to rely on FDI to increase investment
and growth in India, especially in the short-run. India has had a relatively high
savings rate, and it is quite possible that FDI may merely substitute for domestic
savings.
Savings and Investment

Theoretical possibilities apart, does FDI increase aggregate investment in an
economy? Fry’s (1995) econometric analysis of FDI flows over 1966-88 to 16
large developing countries, including India, cautions against any simple
generalizations. Correcting for a host of country-specific factors, he finds that FDI
inflows seem to have a negative effect on domestic investment. Other studies, for
instance Dhar and Roy (1996), confirm this finding. It could well be that FDI
crowds out domestically-financed investment. Alternatively, it could be that FDI
inflows rise in recessionary environments -- note the ‘fire-sale FDI’ in wake of the
recent South Korean crisis. Fry’s related finding, that FDI flows do not have any
significant positive impact on contemperaneous growth rates, is hardly surprising.
FDI inflows may have a more positive contribution in the long-run, and more
so for some countries than others. Fry finds that domestic investment and growth
are positively related to FDI flows lagged by 5 years. A sub-sample of Pacific-
Basin countries does better than the countries outside that region. For the Pacific
Basin countries, domestic investment rises by the full extent of the FDI inflow,
with generally beneficial effects on growth. Outside the Pacific Basin, FDI
appears to substitute for other kinds of foreign flows: FDI inflows were
accompanied by lower investment, lower savings and slower growth. In other
words, FDI could even be immiserising.
It is argued that these diverse experiences are related to the overall economic
regime of the host country, and that countries with a ‘favourable environment for
16
investment’ do better with FDI than countries with distorted financial or trading
systems. Of course, the ingredients of a favourable environment are not easy to
specify, ex-ante. Balasubramanyam, et al (1996) claim that countries with a
liberalised trade environment grow better with FDI than countries with distorted
trading systems.
Balance of payments
Fry (1995) finds that foreign direct investment inflows tend to worsen the current
account in the short run, a tendency consistent with the theoretical expectation.
The long-term effects on the balance of payments depends, among other things,
on the operating characteristics of FDI enterprises, notably their export
propensity, the extent to which they rely on imported inputs, including technology
imports, and on the volume of profit-repatriation. Of course, there are indirect
effects too. Multinationals can conceivably increase the export-propensity of
domestic firms through spillover effects. Further, if domestic production by
multinationals substitutes for previously imported goods, FDI can reduce the total
import bill. Unfortunately, these indirect effects are harder to measure in firm-
level data.
The relative export propensity of foreign and domestic firms has been a
controversial issue. Figure 6, based on the RBI data, reveals that exports as share
of net sales were broadly similar for foreign-controlled and domestic firms,
though foreign-controlled firms have performed slightly better in recent years.
Our estimates are in keeping with Kumar’s (1994) finding that the export
behaviour of foreign-controlled and domestic firms for 1980-81 did not differ
significantly.
Some studies, typically not as robust as Kumar’s, conclude that multinationals
export more. Lall and Mohammad (1985) found that industries with high foreign
shares (as measured by the share of dividend paid abroad) tended to be more
export-intensive. Majumdar and Chhiber (1998) find that, among foreign-
controlled firms, there is positive correlation between the level of foreign equity
ownership and export performance, but only when foreign affiliates have majority
control. They conclude that majority ownership is essential for effective foreign
control, and the latter essential for export performance. Such findings, even when
true, have to be interpreted cautiously. In the post-FERA regime, firms that
exported a ‘significant part of their output’ were allowed foreign shareholdings
above the usual 40%. In other words, greater foreign shareholdings could be a
reward for good export-performance, rather than its cause. Besides, anecdotal
17
evidence that foreign-controlled firms often used ‘third-party exports’ to meet

their export obligations makes it hard to formulate simple policy conclusions.4
Of course, export behaviour is only a part of the picture when considering the
overall impact on balance of payments. Comparing earnings and expenditures in
foreign exchange – the latter includes imports of raw materials, royalty payments,
technical fees, and dividend remittances -- Chandra (1977, 1993) estimated that
the net foreign exchange contribution of foreign-controlled firms was negative
through the 1960s and 1970s. While this is a reasonable (and frequent) criticism
of multinationals, we find both domestic and foreign-controlled firms in India did
badly by this criterion. Figure 7 suggests that the net foreign exchange
contribution of foreign-controlled firms and domestic firms was broadly similar
and, indeed foreign firms may have done better in recent years. Even the RBI’s
(1985) fourth survey of foreign collaborations found that, in the post-FERA
period, majority foreign-owned subsidiaries exported more than they imported.
Besides, it helps to get a sense of the absolute sums involved. Our calculations
based on RBI (1993) show that total outgoings of foreign-owned firms (technical
fees, royalties, and dividends) averaged $120 million per year through the 1980s.
While this was not insubstantial, even moderately successful export performance
could have financed these flows.
The real issue, then, is the poor export performance of all manufacturing firms,
foreign or domestic. The average export propensity in manufacturing remained
low, at around 5%, for most of this period. Nayyar (1978) had arrived at similar
estimates for an earlier period. The high profitability in the sheltered domestic
markets probably blunted the incentive to export, both for domestic and foreign-
controlled firms. As a high-cost economy, India was an unlikely export base for
multinationals: regardless of the government’s motives, the major motivation of
foreign investors was to jump the quota- and tariff-barriers to the Indian market.
in that sense, much of the foreign capital in India was of the rent-seeking variety.
There are exceptions: more recently, India has emerged as an export base for US
firms in the computer software industry, a sector in which India has substantial
skills at low cost.
Technology: policy and reality

Host country governments often encourage foreign investment in the hope of
improving the productivity of domestic firms. Foreign direct investment
potentially brings new technologies to the host economy. Technology inflows can
also improve the productivity of domestic firms through ‘spillovers’, as better
4
For instance, there is evidence that Peico Electricals, the Indian subsidiary of the electronics giant
Phillips, met its export obligations by exporting ‘marine products’ (mostly shrimp).
18
production and management techniques diffuse in the host economy. Markusen

and Venables (1998) believe that foreign investment can be a catalyst for growth.
Wang and Blomstrom (1992) isolate two channels for this spillover process.
The more disembodied aspects of superior technologies used by foreign firms can
spread to domestic firms through the mobility of trained workers and managers,
and through technical guidance provided to vertically-linked domestic suppliers.
Thus, the mere presence of foreign firms exposes domestic firms to superior
technologies: this is the demonstration effect. Two, competitive pressure exerted
by foreign firms (in the form of lower prices or higher product quality) forces
domestic firms to improve their technologies. Productivity gains materialise only
if competition is effective – that is, it encourages domestic firms to catch up, and
if domestic firms have the ability to innovate or imitate successfully. The latter
requires that the technological gap should be small enough relative to learning
capabilities of domestic firms. If it is not, isolated instances of foreign entry can
degenerate into foreign monopoly. At the same time, the extent of spillovers may
be limited by the tendency of multinational firms to concentrate their R&D
activity in their developed country headquarters – the so called ‘headquarters
effect’. The relative importance of these effects may explain why spillover effects
have been stronger in some countries and for some sectors.
Empirical evidence on the nature and extent of spillovers from foreign to
domestic firms is mixed. For developing countries in general, de Mello (1997)
finds a negative relationship between FDI and total factor productivity at the
economy-wide level. Kokko (1994, 1996) finds that large foreign shares and large
technology gaps may produce negative spillover effects on productivity. On the
basis of firm-level data for Morocco, Haddad and Harrison (1993) find that the
spillover from foreign firms to domestic firms varies across sectors. In industrial
sectors that were protected, foreign investment had a significantly negative
influence on productivity growth of domestic firms. In sectors without protection,
they found no statistically significant effect of foreign presence. Conceivably,
protected sectors attract rent-seeking FDI, and perhaps inappropriate technology.
Indeed, Haddad and Harrison found that liberalisation weakened the negative
influence of foreign presence on domestic productivity growth.
For the Indian case, Basant and Fikkert (1996) find some evidence of positive
spillovers in R&D expenditure. Even here, Srivastava (1991) notes that
productivity growth in Indian manufacturing rose was liberalisation in the early
1980s. Kathuria (1998), in a study of firm level data concludes that there was a
positive productivity spillover from foreign to domestic firms.
Undoubtedly, in the Indian case the policy environment had a role to play in
the nature and extent of technology transfer. The regulation of private foreign
capital was accompanied by restrictions that sought to minimise the total cost of
19
technology acquisition, and to unbundle technology acquisition from foreign

equity participation. Manufacturing was divided into three categories. Where
indigenous technological capability was deemed to be sufficient, no technology
imports were permitted. Where the technology was considered simple or stable,
licensing was the preferred mode of technology acquisition. Foreign equity
participation was permitted only if the technology was sophisticated and unlikely
to be available through licensing. Foreign technology collaborations were
permitted more readily in sectors with large technology gap, but the imperative to
avoid duplication in technology-acquisition through ‘repeat licensing’ remained
strong. Taken to its regulatory extreme, this imperative was bound to create
monopolists.
Restraints were placed on the royalty payments: standardised rates of royalty
were specified for many industries. The duration of collaboration agreements was
often restricted to five years in the belief that long-term agreements might be
‘exploitative’. Intellectual property rights were severely curtailed when the
Patents Act was modified in 1970. At one stage, government regulations even
required that Indian partners in technical collaboration agreements be permitted to
sub-license acquired technology freely to other domestic firms.
To a large extent, the technology policy succeeded in its self-defined
objectives. The average duration of collaboration agreements fell and royalty
payments were kept in check. Domestic R&D was afforded limited protection in
some sectors. Taking advantage of increased competition in international
technology markets, Indian firms managed to unbundle technology from foreign
equity, especially after the 1970s. Of course, the policy was not always successful.
In some cases where royalty payments fell, the less-regulated lump-sum payments
rose. Sometimes success was achieved at a cost. Where FERA managed to reduce
foreign ownership and control, it induced multinationals to tighten contractual
provisions of technology agreements. Restraints on equity participation clearly
affected the quality and quantity of technology transferred. The requirement that
Indian subsidiaries be free to sub-license technologies made foreign partners wary
of transferring valuable technologies. In some sectors, notably electrical and
mechanical engineering, domestic R&D filled the gap admirably, and at much
lower cost. In others the exclusion of foreign technology and capital contributed
to growing technological obsolescence.
Lee and Mansfield (1996) find that foreign investment by US multinationals,
and the magnitude of associated technology transfers, depends significantly on
investors’ perceptions about the security of intellectual property (IP) rights in host
countries. In their 1991 survey of 100 US multinationals, India was perceived to
be a country with poor IP rights regime. About 44% of the multinationals
considered IP protection in India too weak to permit them to transfer their newest
20
or most effective technology to Indian subsidiaries or joint-venture partners, or to

licence technology to Indian firms. In chemicals and pharmaceuticals, this
reluctance was reported by 80% of the firms. The perception of India was worse
than the 13 other large developing countries in their study. Lee and Mansfield find
that the volume of FDI flows was directly related to perceived levels of IP
protection, correcting for other variables, such as openness to trade, degree of
industrialisation, etc. Further, they find that in countries where IP protection was
perceived to be poor, a greater proportion of the US firms’ direct investments was
associated with pure sales and distribution or rudimentary production.
At the same time FERA, by reducing the likelihood of new foreign investing in
India, eliminated the potential technological threat from international competitors.
Together these policies allowed existing foreign firms to operate technologies that
were internationally obsolete, but nevertheless superior to those used by domestic
firms. In many sectors the elimination of effective competition, domestic or
foreign, resulted in a more concentrated market structure.
Market Structure
Generally speaking, the relationship between openness to foreign investment and
market structure is complex. Caves (1996) notes the positive relationship between
the extent of foreign investment and the degree of market concentration found in
empirical studies. In theory this could be due to rent-seeking foreign investment
being especially attracted to sectors or countries with high concentration (and high
profitability). Even so, the short-run effect of foreign entry, especially when it is
greenfield investment, is to increase the number of firms and reduce
concentration. The long-run effects depend on the nature of competition between
entrants and incumbents. If incumbent firms are moderately competent, there may
well be virtuous cycles of technological competition. On the other hand,
inefficient domestic firms with poor learning capabilities would lose market share
to foreign firms. Insurmountable technological barriers and economies of scale
may drive incumbent firms to the fringes. Foreign entry might thus increase
market concentration through mergers and acquisitions, and occasionally, through
predatory-pricing.
In the Indian context, there is evidence that industrial concentration and foreign
presence was positively correlated across industrial sectors. Figure 8 shows that,
at the level of 3-digit industry sector classification, there is positive correlation
between foreign shares and the Herfindahl index of industrial concentration. Once
again, correlation does not imply causation. For most of this period, both foreign
shares and the pattern of industrial concentration in India were influenced
primarily by industrial policy, and its attendant control of production capacities.
21
There is a marked tendency towards increasing concentration, especially after

the 1991 liberalization. Basant (1999) points out that multinational companies
have been remarkably active in mergers and acquisitions, and have probably
increased their control of the Indian corporate sector. Typically MNCs have used
their controlling block of shares to increase their equity shares: there have been
very few greenfield investments. For example, British American Tobacco has
tried to consolidate its position in its Indian affiliate, ITC, by buying shares at a
discount. Anecdotal evidence confirms the tendency towards agglomeration.
Hindustan Lever, a 51% foreign-owned subsidiary of the Anglo-Dutch 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 has acquired Tata Oils (its principal rival in oil),
Brooke Bond Lipton (previously an associate company, India’s largest in food and
beverages), Pond’s India (cosmetics), Kwality, and Milkfood (both processed
foods). It has also formed joint ventures with many US firms keen to invest in
India, and has acquired a pre-eminent position in its sectors of operation.
There are many sectors in which the absence of competition -- foreign or
domestic -- has contributed to poor performance. Protecting Indian industry from
foreign multinationals was an exercise in the best traditions of infant-industry
argument but often produced home-grown brats. In many sectors monopoly power
engendered supply scarcity, poor product-quality, and technological obsolescence.
All this makes a case for allowing new entrants and, if necessary, a more open
stance towards foreign capital. Whether this alone will create a more competitive
environment depends on the form in which foreign capital arrives. Foreign
inflows that amount to increased shareholding in existing multinationals are
unlikely to have any impact on market concentration. Greater openness to foreign
investment may not be a substitute for an active competition policy.
6 An evaluation of the policy regime
Control of foreign capital took various forms in India. Hostility to foreign capital
did not quite reach the level that multinationals most dread—confiscation or
outright nationalisation of foreign assets—but FERA (1973) forced the
multinationals to ‘Indianise’ themselves by diluting their foreign ownership.
Many multinationals, especially those operating in high technology or priority
sectors, managed to retain majority share holdings through special exemptions.
Multinationals not granted such exemptions diluted their holdings to 40%, and
through a wider distribution of Indian shares, control remained in the hands of the
foreign parent. Thus dilution of equity holdings did not quite diminish the level of
foreign control. On the whole, multinationals that chose to remain in India largely
22
retained managerial control and valuable access to protected Indian markets.

Indeed, even as new foreign investment fell, many existing multinationals
expanded and diversified their Indian operations. The profitability of their Indian
operations was typically higher than that in other parts of the world.
Restraints on foreign ownership were supplemented by restrictions on the
operational freedom of foreign-controlled firms. To conserve foreign exchange,
foreign remittances were curbed by direct and indirect means. Preference was
given to projects that were at least neutral in terms of their balance of trade, that
is, whose foreign exchange requirements could be met through equity inflows and
future export earnings. To encourage exports, foreign firms were allowed higher
foreign equity thresholds if they exported a significant proportion of their output.
The obsession with foreign exchange costs was combined with what is best
described as technological fundamentalism. After the 1970s there was a stated
preference for technology acquisition with no or low foreign equity participation.
The underlying assumption was that bundled technology had more hidden charges
and higher remittances. The imperative to reduce the overall cost of technology
acquisition resulted in a policy regime that did not quite appreciate the market for
technology. Poor protection of intellectual property reduced the incentives to
transfer technology to India, and deterred FDI inflows in some technology-
intensive areas. The price of technology acquisition was distorted by various
restrictions, which did not always work to domestic advantage. Even when the
policies succeeded in their immediate objectives, the long run costs, in terms of
technological obsolescence, were probably high.
The regulation of private foreign capital had its rationale. The aim was to tilt
the balance of incentives away from old foreign capital of the rent-seeking
variety, and in favour of new growth-oriented foreign investment. The imposition
of export obligations and the outright regulation of the technological
characteristics of foreign-collaboration agreements aimed to create entry barriers
that would deter rent-seeking FDI, without shutting the door to growth-oriented
foreign investment. In theory, this was a valid intervention. In practice, the
regulation did not work according to the intention. The recurrent concern with
foreign exchange outflows created a regime with a whole range of ancillary
regulations. Restrictions on operational freedom of firms, combined with poor
protection of intellectual property rights, choked-off fresh inflows of technology-
intensive FDI. Of course, much of the existing foreign capital, predominantly of
the rent-seeking variety did not leave. Apart from the standard hysteresis effects
that accompany investment decisions, various restrictions (say, on ‘repetitive
technology imports’) preserved pockets of monopoly rent in the economy, making
it worthwhile for incumbent multinationals to thrive. For them, even small
advantages, in terms of technology and marketing networks, translated in to
23
substantial profit differentials over domestic firms. Thus, for multinationals that
hung on, the ability to operate in protected markets constituted an indirect subsidy
that more than compensated for the costs of operating in a regulated regime.
Overall, this perverse outcome proved costly. India wanted foreign capital to
boost exports; the kind of FDI that survived was attracted primarily by access to
the Indian market. India wanted foreign capital to improve its technological base;
the absence of sufficient safeguards to intellectual property rights was a
substantial impediment to the transfer of technology. The absence of foreign
competition exacerbated monopoly power in many industries.
Policy implications
The current euphoria surrounding international capital flows has generated a new
enthusiasm for foreign investment in India. Proponents of openness argue for
further liberalisation of the economy, and for altering the economic regime to
attract foreign capital. Large inflows of foreign capital, they claim, are necessary
for transforming India’s stagnant economy. Critics of liberalisation point to the
dangers of excessive openness. They point out that openness only encourages the
inflow of ‘hot money’, whose volatile flows expose the economy to destabilising
influences, and that large-scale foreign investment will undo the carefully
achieved self-reliance in Indian industry.
Should India adopt a more open stance to private capital flows? Rodrik (1999)
argues that the benefits of openness to foreign capital are generally exaggerated. It
is hard to deny that Indian industry needs fresh investment but the hope that
openness to FDI alone can achieve this is misplaced. The contribution of foreign
capital to overall investment is likely to be marginal in India. FDI inflows in 1996
were only 4% of gross domestic capital formation. In the Indian context, growth-
led FDI is more likely outcome than FDI-led growth. Foreign capital is neither
necessary nor sufficient for growth in India. What is needed is a sound investment
policy to improve the incentives for long-term investment. Openness is arguably
an element of a sound investment policy, but it is not a substitute for it. The
nationality of investors is a secondary issue.
What are the elements of a sound investment policy? By international
standards, the investment environment in India is still highly regulated. In
hindsight, the performance of all firms -- foreign-controlled or domestic -- was
influenced directly by the regulatory environment. Investment decisions are still
subject to discretionary control, and that control is used to protect entrenched
public sector and private sector companies. Tatas, a domestic business house, has
repeatedly been denied entry to the partially-privatised airline sector. Even when
the government resorts to market-friendly methods of allocating investment rights,
it does not quite get it right: the auction of telecommunication licenses was
24
followed by ex-post changes in the allocation rules. In the absence of political

stability, policy changes carry little credibility amongst investors. Surveys of
international business investors refer repeatedly to the ‘difficulty of doing
business in India’, a portmanteau term that refers to anything from lack of
transparency to poor infrastructure facilities that lower the economy-wide return
on capital. (As evidence of procedural complexity, consider the phraseology of
reformed policy requirements: even in sectors where foreign investment is readily
allowed, firms must secure ‘automatic approval’.)
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. In view of 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 take care of power generation, highways, ports, roads, etc.
However, the principal reasons that makes these sectors unattractive for domestic
investors, namely the low levels of anticipated return on investments, hold for
foreign investors too. Does it make sense to use direct incentives to attract foreign
investment in infrastructure, say, as in the provision of profit guarantees to attract
Enron Corporation in power generation? Evidence suggests that the net pay-off to
such sweeteners is negative in the long run; they often encourage ‘roundtrip’
capital flows and may even prove counter-productive if they generate hostility
towards foreign capital. The frequent calls for a ‘level-playing field’ between
Indian and foreign-controlled firms are indicative of this hostility. The creation of
a broad political consensus is a crucial to maintaining inflows.
How should technology policy be reformed? In general, there is a case for
allowing firms greater freedom in their technology acquisition decisions, and
greater recognition of their intellectual property rights. To some extent, such
reforms are likely to be forced upon India as part of the WTO reforms (note their
emphasis on TRIPs and TRIMs). For most sectors, this is not necessarily to
India’s disadvantage. However, in some sectors the allocation of intellectual
property rights may have stark implications. For instance, patent rights conferred
upon biotechnology firms may have drastic consequences for agriculture; patent
rights of pharmaceutical firms may have implications for the availability of low-
cost drugs in India. Indeed, if the new WTO regime makes it harder to deny
intellectual property rights, it may even make sense to inhibit foreign investment
in these high-risk sectors. However, for most of the manufacturing sectors, the
gains from greater recognition of intellectual property probably exceed the
downside risks.
Within manufacturing, is there a case for selectivity or preference among
industries? Critics of foreign capital complain that an open door policy towards
25
foreign capital has encouraged investment in ‘inessential’ consumer goods and

other non-priority sectors. Foreign entry in the more visible consumer goods
industries—Pepsi, Coca-Cola, Kentucky Fried Chicken, etc.—provide ready
ammunition for these critics. While there may be a case for influencing the
industrial composition of FDI, it is sobering to note that discretionary control
failed miserably in the past. Policy-makers in India were usually poor judges of
India’s needs, and there is little reason to believe that they will do better in the
future. Once we discard the model of unitary state, there is the risk substantial
divergence between the policy-intent and the bureaucratic implementation of it.
Besides, a discretionary environment also creates the possibility of lobbying and
rent-seeking behaviour, especially in industries that have concentrated domestic
interests. Cross-country experience suggests that multinationals have a
comparative advantage in rent-seeking, and may be able to use a discretionary
regime to their advantage: Enron did negotiate itself out of all political
obstructions. A non-discriminatory system would be safer. For the same reason, it
is best to avoid discretionary environments that favour foreign capital in export-
oriented sectors or in technology-intensive sectors: once entry has occurred, it is
hard to monitor fulfilment of export obligations or to penalise the failure to do so.
Should multinationals be regulated at all, and if so, how? The anti-competitive
behaviour of some multinationals is a legitimate cause for concern. Multinationals
that entered India through joint-ventures have sometimes tried to oust their Indian
partners. Hindustan Lever’s mergers and acquisitions after 1992 have been a
subject of monopoly enquiry, and correctly so. On the strength of anecdotal
evidence, the aims of greater competition seem far from being the reality. In the
past monopoly regulation has concentrated on identifying monopolies and
restricting their growth through licensing. An altered regulatory environment is
now needed to check anti-competitive conduct: to focus on the abuse of monopoly
power and to promote competition.
26
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28
Figure 1: Market share of foreign-controlled firms in manufacturing

gross sales, percentages
35
30
25
20
15
10
0
1970 1975 1980 1985 1990 Year
Note: Manufacturing covers medium and large public limited firms that are classified under
SIC codes 310-590: this excludes plantations, mining and services. Data after 1991 is not
strictly comparable with that for earlier years.
29

Private Foreign Investment in India: August 1999

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Private Foreign Investment in India

Suma Athreye, Manchester School of Management, England

Address for correspondence

Keywords: India, foreign direct investment, MNCs, reform

Private Foreign Investment in India*

Keywords: India, foreign direct investment, MNCs, reform

Table 1: Recent foreign investment in India, net inflows in $ billion

2 Five decades of policy changes

Early statements of government policy echoed these interests. The Industrial

One Step Forward...

industrialisation through import-substitution. The large increase in planned

... Two Steps Back?

the usual FERA restrictions on foreign equity ownership. In an attempt to

Crisis and ‘winds of change’

3 Private foreign capital in India: long-term trends

Table 2: Stock of private foreign capital in the Indian corporate sector

Foreign Direct Investment

Table 3: Changing distribution of foreign direct capital stock in India, percentages

Industry/Sector 1948 1960 1970 1980 1987 1992 1995

The historical dominance of British firms has shown remarkable persistence in

Table 4: Countries of origin: stock of foreign direct investment in India

4 Foreign-controlled firms in Indian Industry

To what extent have foreign-controlled firms dominated Indian manufacturing?

based on a variety of methods, data, and working assumptions, so provide a poor

We estimate foreign shares in Indian manufacturing as the share of foreign-

multinationals ‘continued to turn adversity into opportunity’: in exchange for

Foreign-controlled firms: conduct and performance

5 The contribution of private foreign capital

Savings and Investment

evidence that foreign-controlled firms often used ‘third-party exports’ to meet

Technology: policy and reality

production and management techniques diffuse in the host economy. Markusen

technology acquisition, and to unbundle technology acquisition from foreign

or most effective technology to Indian subsidiaries or joint-venture partners, or to

There is a marked tendency towards increasing concentration, especially after

6 An evaluation of the policy regime

retained managerial control and valuable access to protected Indian markets.

followed by ex-post changes in the allocation rules. In the absence of political

foreign capital has encouraged investment in ‘inessential’ consumer goods and

Kidron, Michel (1965), Foreign Investments in India, Oxford University Press.

Figure 1: Market share of foreign-controlled firms in manufacturing

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