India’s weakening FDI fulcrum: Act before it’s too late

An emerging economy short of savings must make good use of FDI as a strategic pivot to prosperity

is a director at Arrjavv. Her X (formerly Twitter) handle is @DivaJain2

Many shall be restored that now are fallen and many shall fall that now are in honour— Horace

After having fallen during covid, the Indian economy now finds itself among the most honoured globally. Most high-frequency indicators are firing vigorously and recent headline GDP numbers have been buoyant beyond expectations. A fiscally restrained budget in an election year and sensible policy interventions have ensured that confidence in the economy and the government’s ability to manage it is high, and the stock market is undergoing one of its periodic bouts of exuberance.

But behind the clinking of champagne glasses on Dalal Street and self-congratulatory chatter on social media lies a structural story of India’s economy that’s relatively sombre. Gross capital formation has been stagnant below its past peak for a decade and private capex is still anaemic. With an economic multiplier that is orders of magnitude higher than other forms of spending, capex is critical for India to convert the economy’s upward momentum into a structural trend. The government, cognizant of this, has been spending furiously on capex in the hope of crowding in the private sector, which has so far been circumspect.

Historically, investment has been the fuel that has boosted developing economies to attain the escape velocity required to leave poverty behind and join the middle-income orbit. Unfortunately, India has seen its net household savings rate fall to multi-year lows. This begs the question: Where will low-cost capital to fund India’s massive investment needs come from?

Poor economies with similarly low capital stock have typically solved this problem by accessing sticky foreign direct investment (FDI). Sadly, India has been a laggard on this count. Net FDI as a percentage of GDP now stands at about 1.2%, its lowest since 2005. In comparison, Vietnam has absorbed net FDI inflows at an average rate of above 5% of GDP since 2007. Similarly, while it was industrializing, China absorbed net FDI at an average rate of above 4% of GDP from 1993 till 2011. Even America’s industrialization from 1800 to 1870 was driven by copious British capital. The only exceptions to

FDI-driven growth have been Japan and South Korea. But in lieu of FDI, both were funded by massive reconstruction aid from America, free access to US technology and easy access to American markets, which allowed them to run export surpluses that fulfilled their investment needs.

Neo-classical purists might argue that India receives foreign portfolio investment (FPI), which is equivalent to FDI, but practically speaking, they are as different as chalk and cheese. One, FDI flows are sticky and thus provide patient capital required for industrialization. Second, academics have long proven that FDI is highly correlated with increases in total factor productivity, as foreign capital brings with it global skills and expertise. Third, FDI has massive spillover effects for local firms as foreign technology slowly gets absorbed and disseminated across the wider economy. In the 1990s, China had a lower tax on FDI projects than on local firms, especially if these investments were in areas that were export, technology, or manufacturing intensive.

India’s substantial underperformance in attracting FDI remains a large structural chink its economic armour, requiring quick redressal. India has many strengths that make it an attractive destination for FDI, including a large domestic market and depth of human capital, but factor market frictions and bureaucracy remain a significant dampener of FDI flows. While factor market reforms will take major political will, there are several easy policy levers that the government can use to crank up FDI flows.

Primarily, India first needs a national framework to identify and target industries where FDI is likely to have the largest impact in terms of job creation, productivity, technology and exports. Next, the government should roll out a comprehensive set of national tax incentives/ holidays on FDI investments in those areas. Simultaneously, the DESH bill or an amended version of the SEZ Act, which seems stuck in bureaucratic wrangling, needs to be activated at the earliest with explicit provisions targeting FDI.

Most importantly, we must recognize that state governments play a significant role in attracting and retaining FDI. In most countries, especially China, regional governments compete vigorously to attract FDI with incentives over and above those offered by the central government. In China in the 1990s, regional governments were offering incentives worth as much as $1,000 (a princely sum there) per job to foreign firms. In India, barring a few exceptions, most states are indifferent towards foreign investment. These also tend to be the states that need it the most. The Centre could encourage competition among states by linking its fiscal support to them with their performance on attracting FDI.

In sum, there is no escaping the economic reality of FDI in driving investment in an emerging economy that is savings deficient. Addled by the warm embrace of hot portfolio flows, we have ignored this reality for many years. Unless we make a vigorous attempt to attract FDI and use it to convert our current economic momentum into a long-term trend, we might find ourselves staring helplessly at Horace’s ominous warning to those who were once in honour.