Foreign direct investment in India - I

By Nirupam Bajpai and Jeffrey D. Sachs

ECONOMIC POLICY reforms have played a critical role in the performance of the Indian economy since 1991. Among other things, the reforms have involved opening up the economy, making it more competitive, getting the Government out of the huge morass of regulation, empowering the States to take more responsibility for economic management and thereby creating a kind of competition among them for foreign investment. The positive trends being seen in most sectors had the capability to more than neutralise the debilitating effects of two general elections in two years, the crisis in East Asia, Kargil, the nuclear explosions, and the U.S. sanctions that followed.

In the backdrop of the East Asian crisis, growth did slow down, but India has kept growing and has avoided the worst of the crisis. From the narrow financial point of view, two things that India did were quite helpful. One, it did keep some limit on the short-term capital inflows and did not go overboard in borrowing short term from abroad. This helped India avoid the financial reverses of some of its neighbours. Second, it kept the rupee flexible and the depreciation definitely helped keep the economy more competitive and kept growth going.

In the context of the East Asian crisis, certain kinds of money fled while other kinds did not. The hottest money was short-term loans from international banks. Indeed, the reversal of short- term bank lending constituted a very large proportion of the overall $105 billion reversal in capital flows. The banks put in $56 billion in net lending in 1996, and then withdrew an estimated $21 billion in net loans in 1997, for a swing of $77 billion (or 73 per cent of the overall reversal). Portfolio equity investors (e.g. country equity funds) also reversed gear, to the extent of $24 billion. Foreign direct investors, by contrast, were very stable. Net Foreign Direct Investment (FDI) remained roughly unchanged between 1996 and 1997, at around $7 billion in net flows each year.

Significantly, India went through a near disaster in 1991 that was, among others causes, based on short-term borrowing. Of course, at that time it was short-term borrowing from non- resident Indians (NRIs), but it was the same kind of phenomenon - lots of short-term capital had come in and lots had moved out and created a severe payments crisis. In terms of foreign investment, it is the direct investment that should be actively sought. For, FDI brings huge advantages (new capital, technology, managerial expertise, and access to foreign markets) with little or no downside.

There are lots of international investors who would flock to India, especially now that they see that India has a lot of safety for them compared to China, for example. But, they are put off as they cannot get reliable power and the road system is so dreadful that even if they are producing effectively, they will not be able to get the goods to the market or back to the port for exports. Continuing fiscal difficulties that are often linked to the chronic infrastructure difficulties remain a major challenge for India. The Government has set an ambitious target of achieving $10 billion in actual FDI inflows a year. For this target to be met, it is essential to undertake some hard reform steps. Should the Government decide to implement some of the most critical reform actions necessary for making India an attractive investment destination, then India may not only be able to meet the target, but in fact do much better than that. Of course, additionally, availability of infrastructure services such as uninterrupted power, good roads, and adequate port and telecom facilities are essential.

To achieve the Government's goal, it is crucial to raise the FDI approvals to actual ratio. Actual FDI as a proportion of FDI approved was only 21.7 per cent. The same ratio is much higher in China, Indonesia, Korea, Malaysia, Philippines, and Thailand.

A few of the States have been more reform-oriented, such as Andhra Pradesh, Gujarat, Karnataka, Maharashtra, and Tamil Nadu, but Haryana, Kerala, Orissa, Madhya Pradesh, Punjab, Rajasthan and West Bengal have a lot of catching up to do. Of course, Bihar and Uttar Pradesh are even further behind. States that are ahead in the reform efforts right now are going to find that if they move against the populist policies and set up regular markets for services such as power and water they are going to move further forward.

There are rather significant differences in reform interest and economic performance between a large part of northern India and southern India where Karnataka, Tamil Nadu and Andhra Pradesh are quite dynamic now in trying to get the infrastructure, and the policy regime right to attract FDI. In Bihar and Uttar Pradesh, one does not see the same kind of reform dynamism and the results are therefore poor in terms of economic growth. These differences will be noticed politically sooner rather than later, (as inequalities will become glaring) and the States that are ahead will be rewarded with better performance and those that are behind will face a demand to catch up. That will spur a kind of competition among the States and make the reform process go much faster.

State-wise data on FDI approvals (aggregate FDI approvals between 1991-97) suggest that the relatively fast moving reformers have tended to attract higher investments, both from foreign and domestic investors. From the long-term development point of view, India has tremendous growth prospects through export-led growth which involves a broad range of sectors, both traditional and new. The most of the new sectors is software and information technology in which India is becoming one of the most important global players. It is also the fastest-growing foreign exchange earner for India. Export-led growth in services is one of the most interesting developments, and export- led growth in manufactures, the more traditional textiles and apparel, in electronics and other labour-intensive operations remains an area where India could do a lot more than in the past.

China has achieved a lot more in manufactured export production than India and for no particular reason. India has the resource base, it has the entrepreneurship, has the access to the sea, a vast labour force, it has everything that coastal China has had except the interest of the Government which even today underemphasises the role of industrial facilities, of infrastructure, of land area, of effective port facilities. But it is a place where one could find tens of millions of jobs over the next few years in real, significant foreign exchange earning private sector activity. This would require a change of attitude, a real promotion of these sectors both at the State and Central Government levels.

India's neighbours that are relying heavily on FDI, such as China, Indonesia, Malaysia, and Thailand, have been pulling far ahead in economic growth, income levels, and productivity, while also increasing their security and geopolitical influence.

India's continuing ambivalence on FDI, as a result, exacts a heavy toll on the economy. Undoubtedly, India is ceding billions of dollars of FDI to its neighbours each year. While China achieved actual FDI inflows of around $45.3 billion in 1997, India settled for a mere $3.2 billion!

Why is it that India, which provides the largest market after China in the developing world is unable to attract substantial volume of FDI? Further, when it comes to comparing China and India, why can India not match or even outpace China in attracting FDI given India's superior conditions regarding the rule of law, democracy, and the widely-spoken English language?

(The writers are respectively Director, Harvard India Program, Center for International Development, Kennedy School of Government, and Director, Center for International Development, Department of Economics, Harvard University.)

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