How to boost FDI inflows into India
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Last fortnight’s move to do away with the statutory taxation clauses imposed in 2012 on overseas business transactions between foreign entities has been hailed by foreign investors and governments alike. Though ab initio bad in law, it needed to be revoked much earlier. Unsurprisingly then, the Indian apex court had explicitly found it legally untenable and the Permanent Council of Arbitration, Hague sided with an arbitration award in favour of the appellant Vodafone, UK. The company had challenged the Indian government’s demand for capital gains and a withholding tax liability of Rs 11,000 crore, plus as much interest there on. During the nine years that the provisions for retrospective taxation were on the statute book, justifiable doubts were cast on the country, with adverse international perceptions on it being law abiding and fair to business.
Attaching due significance in India to foreign direct investment (FDI) as a way of supplementing domestic capital availability and access to modern technology is merely two decades old. After the initial burst of growth in the first decade, net inflows have grown moderately, with a CAGR of 6% between 2015 and 2020. Though ranked fourth in terms of inflows, India positions at a lowly 61st in the Global FDI Country Attractiveness Index 2020; just ahead of Philippines, Indonesia and Egypt, and behind virtually all European countries, the two Americas and the Gulf countries. In 2019-20, $74.39 bn, or about 0.5% of the country’s GDP of $1.7 trn flowed in, while in 2020-21 the estimate was $81.8 bn, largely on the back of the $15 bn raised by Reliance Jio.
Over the years, Indian FDI inflows have been primarily in ICT (information and communications technology), construction (infrastructure) and services. A significant portion has been in brownfield ventures, rather than in new ventures or in the expansion of existing entities. Much needed investment in manufacturing, which has been struggling at just 14% of GDP, has not materialised except in automobiles and its vast component industry. This dynamic has understandably caused the benefits of FDI not fully accruing.
Beginning 1999, the extant FDI regulations were perceptibly relaxed with a new Foreign Exchange Management Act (FEMA). By 2004, almost the entire gamut of manufacturing had been opened to 100% FDI on the automatic route, i.e. no permission was required from any authority to bring in foreign equity, be it a greenfield or existing manufacturing unit (except in defence, alcohol and tobacco which remained prohibited). Several tertiary activities were also opened. However, in other economic activities, specific ceilings were imposed on the extent of FDI permitted, with further permissions needed in some cases from the Central government.
In the years since, there have been further, albeit gradual, relaxations in both the ceilings and the FDI permission routes. The foreign investors, however, continue to find these industry specific ceilings and routes unique to India. Securing the requisite permissions are also perceived to be sometimes discriminatory and subjective, requiring a cumbersome and time-consuming process.
While it no-doubt recognizes India’s efforts in implementing a few reforms to improve the investment environment, the recent US State Department Climate India Report 2020 does call India a difficult place to do business. It highlights how in late 2018 just before the last general elections, the Union Government rewrote the regulations for FDI supported e-commerce players virtually overnight—requiring those with more than 25% foreign equity to choose within just three months to either operate only as an e-commerce platform or be an inventory holding entity (that could not offer discounts on sale of other firms’ products or sell more than 25% sourced from a single vendor). These sudden restrictions had evoked strong criticism from foreign governments including the US.
In 2018, a similar adverse reaction was seen when without any prior stakeholder consultation, an obligation was cast upon all system holders to store their data on transactions in India within the country. This imposition was extended by the RBI the following year to foreign banks as well. Another example of potentially unfriendly business regulations was the introduction in the insurance industry of the insistence that management and control remain with the Indian minority partner, despite permitting an increase in the FDI limit from 49% to 74% on the automatic route. As one can imagine, foreign investors understandably prefer a more consultative process with a much longer time horizon to comply. More importantly, there is widespread demand for greater stability and predictability in regulations, including more equitable treatment with domestic businesses.
An additional oft-repeated deficiency is the inadequacy of effective mechanisms for the enforcement of contracts. Fast-track arrangements for resolving commercial disputes are not in place. Most arbitration and specialized tribunal awards are routinely questioned in judicial courts, and very often, governments, both central and provincial, go on appealing till the very last available forum. Despite an agreement with the Permanent Council of Arbitration, Hague to open a regional office in India, no ground level action has yet been initiated. The Indian government’s intended move to require foreign investors to first exhaust all local administrative and judicial reviews before resorting to international arbitration as provided in the 50-odd Bilateral Investment Treaties to which India is a signatory has also been met with understandable resistance.
While cognizant of what India does have going in its favour—namely a large domestic market, functioning democracy, English as the common lingua franca and a fairly well functioning IPR regime—businesses are not getting carried away by just these intangible advantages. Hard-nosed investors funnel money into the most advantageous locations; characteristics such as high productivity of factors of production, pronounced pro-business regulations, and a benign attitude of the public at large towards foreign capital, weigh heavily on investors’ minds. Until recently, little had been emulated by India from the roaring success seen in neighbouring China, where the lion’s share of global capital has flowed in for the last three decades.
What China did right in attracting a huge quantum of foreign capital, both equity and debt needs to be recalled. Though their one-party authoritarian rule across the nation gave it a clear execution advantage not available to others, valuable lessons still remain. Convinced that it needed both western capital and their technology to move away from decades of widespread poverty and abysmally low productivity in almost all spheres of the economy, China unequivocally opened its doors widely to foreign capital and technology. They leveraged their huge and inexpensive workforce to quickly become the foremost low-cost manufacturer. Thereafter, with planned foresight and unprecedented determination, they moved up the value chain—from low technology deployment and a focus on consumer goods production to intermediates and assemblies first and then sophisticated capital equipment and machinery.
Building world class physical infrastructure, including modern modes of rapid transportation, elaborate logistics networks, huge industrial cities, and plug and play manufacturing estates, well ahead of demand was a calculated risk. Adding massive housing capacity for workers, making cheap energy available, and tuning its vast political bureaucracy to go past the red tape, became the driving mantra in all the industrial townships and special economic zones (SEZS). Government machinery on the ground with which foreign investors had to deal with were trained to demonstrate a business-friendly attitude, rather than introduce roadblocks to private initiatives. Early on, Chinese authorities also took a call to opt for flexible labour laws rather than persist with rigid guaranteed employment. They extended heavy financial, fiscal, and other incentives to units exporting their produce. The overseas Chinese diaspora was attracted to return with their capital and skills through a variety of meaningful concessions, including in taxation.
The end result of these moves is evident for all to see. Many high-end US technology companies deployed manufacturing capabilities (with or without their R&D set ups) into China, with some altogether relocating their entire facilities to that country. Reportedly, the Shangai SEZ now houses 430 of the top 500 MNCS and has close to 40,000 foreign companies located in it. As a result, the Chinese now dominate global supply chains for a variety of products, both advanced and less complex. Their vendors control the international availability of a host of critical inputs including solar cells, semiconductors and key ingredients for drugs. That a significant portion of the Chinese end products now also have a vast local market is an additional advantage that enables it to reap sizeable economies of scale. The Chinese dominance in global exports is based on such comparative endowments.
Clarity of vision and relentless execution have allowed China to use FDI as a key tool in its arsenal for development, and serves as a worthy roadmap to study for Indian authorities.
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