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Determining India’s Economic Trajectory: The Role of Foreign Direct Investment

An Interview with Pravakar Sahoo

By Sonia Luthra
January 31, 2012

India’s record GDP growth throughout the last decade has lifted millions out of poverty and made the country a favored destination for foreign direct investment. However, the sharp downturn in Europe and the United States, coupled with significant domestic challenges, has slowed this trend and stands to disrupt future growth.

In an interview with NBR, India-based economist Pravakar Sahoo (Institute of Economic Growth) discussed the outlook of India’s economy and the role that foreign investment might play in stimulating growth. Dr. Sahoo argues that the country will not realize the full potential of outside investment unless the government confronts political opposition to key policies, such as allowing FDI for multi-brand retailers like Walmart and Target, and undertakes crucial reforms to sustain investor confidence.

Growth in the Indian economy has slowed and inflation has risen in the last several months. What have been the primary triggers for this slowdown?

The Indian economy recovered well after the global financial crisis due to a fiscal stimulus package and also many social programs like the Mahatma Gandhi National Rural Employment Guarantee Act. These activities created employment and demand that resulted in 9% GDP growth in 2010. However, GDP expansion for 2011 is now expected to be 7.0%, not the forecasted 8.5%.

Several major factors are responsible for this slowdown, including the continuous rise of inflation, a tight monetary policy, a series of corruption scandals, policy paralysis on crucial reforms, and a lack of infrastructure development. Tight monetary policy for the thirteenth consecutive quarter has increased the cost of capital and affected credit flows to the commercial sector, slowing down overall investment activity. However, monetary policy has not been effective in containing India’s inflation, as this inflation is primarily a supply-side phenomenon due to a deficiency in infrastructure and bottlenecks in supply chains. Furthermore, a lack of investor confidence and positive business sentiment has led to declining FDI inflows over the last three quarters, adding pressure on new and ongoing investment.

In addition, capital outflow, triggered by lackluster investor confidence and the European debt crisis, has resulted in a huge loss in listed shares market valuation on the Bombay Stock Exchange. All of this points to slower growth in the near future.

The Indian government canceled plans to allow FDI in the country’s retail sector. What caused this recoil?

When the cabinet decided to allow 51% FDI in multi-brand retailing and 100% FDI in single-brand retailing, though subject to conditionalities, this was extremely good news and a long-awaited boon to large international retailers who had been eagerly waiting to tap into the estimated $600 billion Indian retail market and the purchasing power of India’s fast-rising middle class. This policy decision could have been one of India’s biggest in terms of having a positive impact on producers, consumers, and the overall conduct of business in India and could have attracted tremendous amounts of FDI.

Unfortunately, this politically sensitive decision incited furor from right-wing political parties such as the Bharatiya Janata Party, left-wing Communist parties, and some alliance partners for a number of reasons. The timing of the decision—made during a parliamentary session—was not appropriate, as the federal government has been challenged recently by opposition parties on issues like corruption, never-ending price increases, “black” money, policy paralysis on crucial reforms, and a mass movement led by anti-corruption crusader Anna Hazare.

What effect could the retail FDI decision have on the domestic economy and for foreign companies doing business in India?

Should it have gone into effect, the multi-brand retailing decision would have impacted different stakeholders widely. The scale economies of organized retailing would likely have offered consumers a wider variety of products at lower prices, with safeguards like quality control and checking for counterfeit products, including infringed American goods. Organized retailers would also have to buy products directly from Indian farmers and producers, paving the way for better price realization. The provision of 50% FDI from the United States and elsewhere in back-end infrastructure for storage, logistics, and better extension services would substantially reduce wastage in India’s farm produce, which is one of the highest in the world. The provision of 30% sourcing from Indian SMEs (small and medium enterprises) would have helped expand capacity, improve quality, and get exposure to international supply chains, making them internally competitive over time.

Countering these positive aspects, however, the initial impact of multi-brand retailers entering India’s market is expected to have a negative impact on the over 12 million unorganized shops and countless kirana (mom-and-pop) stores, as they lack the financial muscle to challenge major retailers in terms of variety, quality, packaging, and other offers.

If citizens and opposition parties become more receptive, might New Delhi try to further open the retail sector in the near future? Would any future deal need to be altered to incorporate the opposition’s concerns? If so, how?

The government should have discussed the retail FDI matter with opposition parties and its alliance partners before getting approval from the cabinet. It eventually succumbed to outside pressure and suspended FDI in multi-brand retailing, and is unlikely to reopen the issue until after the 2012 state elections in Uttar Pradesh, Punjab, Uttarakhand, Manipur, and Goa. The Singh government would like to weigh its political position in these states after the elections before it makes tough decisions on issues such as FDI in multi-brand retailing. The flip-flop in retail FDI has created more uncertainty among investors and created doubts about further big-ticket market reforms in the near future.

To move forward, it is time that the Singh government talks to opposition and alliance partners about the benefits of multi-brand retail FDI. However, the political climate will be much clearer after parties position themselves leading to the state elections early this year. In addition, the government also needs to educate stakeholders like producers and consumers about the beneficial effects of FDI in multi-brand retailing, as not enough has been done on this front.

Is there anything else New Delhi can do to assuage outside fears of a slowdown in India?

The Indian economy’s biggest strength is that India is still the second-fastest growing nation next to China, with an annual growth rate of over 7%, and its growth is mostly led by domestic demand. Therefore, the government needs to do everything possible to sustain investors’ confidence and a positive market sentiment. To indicate that India is serious about market reform, the government should put on the fast track some of the other big-ticket reforms such as retail FDI, banking, pension, insurance, civil aviation, labor reforms, land acquisition, and clarity over environmental issues. Movement toward reform and good governance are necessary to bring back investor confidence in the Indian economy.

The industrial sector has slowed down due to increasing costs of production, increases in policy rates over the last few quarters, numerous scams and damage to corporate credibility, renewed debate over land acquisition, and environmental clearances. Unfortunately, governance and corruption issues are delaying reforms, leading to a loss of faith in the Indian economy.

What kind of impact has India’s slower economic growth had on trade and economic relations with the United States and other partners like China and Europe? If this trend continues over the next year, what can outside observers expect?

India’s economic slowdown may certainly affect the country’s external sectors, including the country’s bilateral trade with the United States. China’s cost of domestic production is rising, and many investors, including some from the United States, are looking to India as an alternative destination. As many foreign investors look to tap into India’s domestic market, capital inflows could decrease. In fact, if the downturn continues, there may be more outflows of capital from India than inflows to India.

India is a major buyer of American products, particularly high-value and technology-intensive products in sectors such as defense, and a slowdown in the Indian economy would likely affect trade between the two countries.

What are the political implications of India’s economic slowdown?

If the slowdown continues and reduces resource mobilization, it would jeopardize the effective implementation of the Indian government’s grand social programs such as the right to education and the new food security bill. Regarding the latter, in December 2011, India’s cabinet cleared a bill to provide food at highly subsidized rates to 60% of the population, amounting to roughly $6 billion per year. These mandatory programs require a tremendous amount of resources at a growing rate and are only possible if economic growth continues. If not, the government’s fiscal deficit will breach its limits and, along with increasing the current account deficit, will create undesirable effects for the Indian economy. India’s twin deficits will use up both domestic savings and foreign savings to manage the economy and will lead to high inflation, the crowding out of private investment, high interest rates, and difficulties in managing monetary policy. India has experience with deficits leading to a balance-of-payment crisis, as occurred in 1991.

Growth is necessary for the government to meet the socioeconomic infrastructure requirements for a majority of the population. Lagging investor confidence and an economic slowdown in manufacturing and industry would disappoint the aspirations of millions of young people searching for jobs. With a median age of 25 years, India has a young population compared to other Asian countries like Japan and China, which need to deal with an aging population. Now India must sustain its growth and create jobs to reap the rewards of its population dividend.

What else can the Indian government do to attract foreign investors?

The post-liberalization period has been remarkable for FDI in India. It has created a conducive environment for foreign investment by abolishing industrial licensing, establishing institutions, lifting FDI equity ceilings, shifting more sectors to the automatic route, providing incentives, and liberalizing foreign exchange regulations. Consequently, FDI inflows, negligible before 1991, have increased substantially.

FDI in India is still concentrated in a few sectors and states. Factors that hinder FDI inflows include infrastructure bottlenecks, rigid and complicated labor laws, lack of coordination between the states and the central government, lack of reforms at the state level, FDI equity caps in many potential sectors, and delays in getting multiple clearances and approvals.

Future reforms and policies need to address these issues and set up appropriate institutions. Some necessary reforms include: creating a better environment for infrastructure development with an appropriate institutional framework such as a dispute-resolution mechanism, independent regulatory authority, and special investment law; establishing a uniform labor code after an independent review and proper consultation with stakeholders; ensuring proper design and planning of special economic zones (SEZ), including local-level solutions for land acquisition and sector-specific policies with incentives to attract FDI into SEZs; revisiting outdated laws, controls, regulatory systems, and government monopolies affecting the investment environment; and last, encouraging nongovernmental facilitation services for foreign investors.

Overall, India needs to address its lack of adequate infrastructure, rigid labor laws, and bureaucratic delays and make state-level reforms to realize its FDI potential.

What are the primary issues for the Indian economy at this moment? What are the major hurdles to making India’s growth more inclusive and sustainable?

The most pressing issue for the Indian economy now is to improve competitiveness across all sectors. If India desires to be an economic power, it needs to reduce trade and transaction costs, improve governance, and carry out institutional reforms for effective law enforcement.

A serious problem that might halt the Indian economy’s growth is the country’s infrastructure bottleneck. Lack of high-quality physical and social infrastructures have led to high costs in trade and transaction costs, thereby lowering India’s economic competitiveness. The planning commission has estimated that the infrastructure sector requires investment of up to $1 trillion in the 12th Five Year Plan (2012–17), but it may be difficult to raise such funds.

The service sector, which was the driver of growth for the last two decades, has also showed signs of a slowdown in the last few quarters. Decreased output in the industrial sector, along with low demand for India’s services in the United States and Europe, has resulted in a slowdown for services exports as well. Given the current situation, particularly the European debt crisis and the overall slowdown in developed countries, a moderation in exports in general, and trade in services in particular, is expected.

India also faces internal problems, such as widespread poverty, corruption, and poor governance. Market reforms over the last two decades have created opportunities for the private sector to grow, resulting in a high growth rate, but they have also produced high inequality in India. Growing inequality and a high poverty rate (more than 30% of the population) are the biggest challenges to sustained economic growth, and if not addressed properly, will create disharmony.

A primary step that the Indian government must take to reduce inequality and poverty is to improve productivity growth in agriculture. More than 56% of the total labor force depends on agriculture, although this sector contributes only 16% to India’s total GDP. The government should institute policies that provide education and vocational training in order to move people out of agriculture and make use of opportunities in the market economy.

What is the impact of the sudden decrease in the value of the rupee on both trade and the Indian economy?

The fall of the rupee by more than 15% since August 2011 is a blow to India’s economy. Costlier imports of petroleum products, steel, and rubber will add pressure to the price of production in manufacturing and inflation in general, which has been around 9% for the last couple of years. In fact, India’s top exports are in the same industry as India’s top imports, showing high and increasing intra-industry trade. In some industries, like automobiles, electronics, and computer hardware, India primarily imports intermediate inputs, and an increase in price for these inputs will be passed onto consumers, which contributes further to price increases. More importantly, rising production costs would reduce profit margins and overall investment activities. The favorable impact on exports would be modest and confined to a few sectors, especially with consumer demand slowing in the United States and Europe.

The present scenario also does not augur well for India’s external sector and fiscal deficits. Given the sticky components of imports such as petroleum and expected lower favorable impact on exports, the trade deficit is likely to go up. In addition, a decline in capital inflows would contribute to the current account deficit. The prospect of a higher current account deficit and trade deficit will make investors in general, and foreign investors in particular, more skeptical about the Indian economy.

What are some indicators or benchmarks to look at in order to assess if India’s economy is experiencing a turnaround?

There is no one indicator to detect a turnaround. India’s economy faces multiple challenges, including a slowdown across many sectors and high inflation. However, the first thing one should look for is a turnaround in investment trends, particularly in private investment, which has slowed substantially due to a lack of a conducive business environment and policy paralysis. An increase in private investment and inflows of foreign capital, both FDI and institutional investment, would reflect a revival of the Indian economy.

The reduced production of capital goods and intermediate goods in the manufacturing sectors over the last few quarters reflects a decrease in overall economic activity. Improvement in manufacturing and an increase in net sales and corporate profits would demonstrate a reversal of trends in these sectors and would be good indicators of a broader economic turnaround. Finally, strong performance in agriculture and the service sector, along with moderate inflation, would likely eliminate existing structural imbalances in the Indian economy.

For all this to happen, however, India needs to fast-track major policy decisions on issues ranging from land acquisition and fiscal consolidation to banking and insurance reform, along with implementing policies to improve the country’s overall governance.

Sonia Luthra is Assistant Director for the National Asia Research Program (NARP) and Outreach.

This is part of a series of Q&As produced by NBR for the Senate India Caucus.

Pravakar Sahoo is an Associate Professor at the Institute of Economic Growth (IEG). The views expressed here are his own and do not reflect the position of the Institute of Economic Growth.