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FDI issues & challenges

Conference Paper · December 2014

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 Foreign Direct Investment in India:Issues and Challenges.
YOGESH NAMDEO INGLE.
9820273565/ [email protected]

ISBN: 978-93-5097-458-2

Abstract

In this paper, we have attempted to identify the issues and problems associated with India’s
current foreign direct investment regime, and more importantly the other associated factors
responsible for India’s unattractiveness as an investment location.

Starting from a baseline of less than $1 billion in 1990, a recent UNCTAD survey projected
India as the second most important FDI destination (after China) for transnational corporations
during 2010–2012. As per the data, the sectors that attracted higher inflows were services,
telecommunication, construction activities and computer software and hardware.

Despite India offering a large domestic market, rule of law, low labor costs, and a well working
democracy, her performance in attracting FDI flows has been far from satisfactory. A restrictive
FDI regime, high import tariffs, exit barriers for firms, stringent labor laws, poor quality
infrastructure, centralized decision-making processes, and a very limited scale of export
processing zones make India an unattractive investment location.

The early nineties was a period when the Indian economy faced a severe Balance of Payment
crisis. Exports began to experience serious difficulties. The crippling external debts were putting
pressure on the economy. In view of all these developments there was a serious threat of the
economy defaulting in respect of external payments liability. It was in the light of such adverse
situations that the policy makers decided to adopt a more liberal and global approaches thereby,
opening its door to FDI inflows in order to restore the confidence of foreign investors. FDI
provides a situation wherein both the host and the home nations derive some benefit. The home
countries want to take the advantage of the vast markets opened by industrial growth. Whereas
the host countries get to acquire resources ranging from financial, capital, entrepreneurship,
technological know-how and managerial skills which assist it in supplementing its domestic
savings and foreign exchange. The contribution or impact of FDI has been well acknowledged in
various discussion papers and studies amongst these in one of the recent study done on India’s
FDI inflows trends and concepts1 it is mentioned that, “The Economic Survey 20010-11
reiterated that: FDI is considered to be the most attractive type of capital flow for emerging
economies as it is expected to bring latest technology and enhance production capabilities of the
economy. And the National Manufacturing Competitiveness Council specified that: Foreign
investments mean both foreign portfolio investments and foreign direct investments (FDI).FDI
brings better technology and management, access to marketing networks and offers competition,
the latter helping Indian companies improve, quite apart from being good for consumers. This
efficiency contribution of FDI is much more important”.

The evolution of Indian FDI can broadly be divided into three phases classified on the premises
of the initiatives taken to induce foreign investments into the Indian economy: (a) The first
phase, between 1969 and 1991, was marked by the coming into force of the Monopolies and
Restrictive Trade Practices Commission (MRTP) in 1969, which imposed restrictions on the size
of operations, pricing of products and services of foreign companies. The Foreign Exchange
Regulation Act (FERA), enacted in 1973, limited the extent of foreign equity to 40%, though this
limit could be raised to 74% for technology-intensive, export-intensive, and core-sector
industries. A selective licensing regime was instituted for technology transfer and royalty
payments and applicants were subjected to export obligations. (b) The second phase, between
1991 and 2000, witnessed the liberalization of the FDI policy, as part of the Government’s
economic reforms program. In 1991 as per the ‘Statement on Industrial Policy’, FDI was allowed
on the automatic route, up to 51%, in 35 high priority industries. Foreign technical collaboration
was also placed under the automatic route, subject to specified limits. In 1996, the automatic
approval route for FDI was expanded, from 35 to 111 industries, under four distinct categories
(Part A–up to 50%, Part B–up to 51%, Part C–up to 74%, and Part D-up to 100%). A Foreign
Investment Promotion Board (FIPB) was constituted to consider cases under the government
route. (c) The third phase, between 2000 till date, has reflected the increasing globalisation of the
Indian economy. In the year 2000, a paradigm shift occurred, wherein, except for a negative list,
all the remaining activities were placed under the automatic route. Caps were gradually raised in
a number of sectors/activities. Some of the initiatives that were taken during this period were that
the insurance and defense sectors were opened up to a cap of 26%, the cap for telecom services
was increased from 49% to 74% , FDI was allowed up to 51% in single brand retail. The year
2010 saw the continuation of the rationalization process and all existing regulations on FDI were
consolidated into a single document for ease of reference.

The evolution of the FDI policy, towards more rationalization and liberalization, has narrowed
down the instruments regulating FDI policy broadly to three:
1. Equity caps: restricting foreign ownership of equity capital
2. Entry route: requiring prior Government oversight, including screening and approval
3. Conditionalities: comprising of operational restrictions/licencing conditions, such as
nationality criteria, minimum-capitalisation and lock-in period etc.

FDI INFLOWS Trends: 1991-2011

The data on FDI inflows into the country shows that foreign investors have shown a keen interest
in the Indian economy ever since it has been liberalized. An increasing trend of flows can be
observed since 1991 with the peak of FDI flows being reached in 2008-09. (Chart 1) Therefore
the trend gives support to the fact that as and when the government has taken initiatives to open
up and liberalize the economy further, the investors have welcomed the initiative and
reciprocated by infusing investments into India. There are various reasons which work in favour
of India and increase the level of interest shown in by foreign organization’s some of them being
its demographics’ with a young population there is a huge consumer base that is to be tapped, the
growing middle class, increased urbanization and awareness, rising disposable incomes.
FDI Inflow by Components:
There has been a change in the method of estimation of FDI inflows since 2000-01, prior to this
only equity inflows was taken as the FDI inflow figure however post 2000-01 the RBI has started
following the international practice and taken into account other components of FDI inflows
namely re-invested earnings and other capital. A look at the contribution of various components
of FDI reveals that the share of re-invested earnings was rising from 2000 onwards uptil 2005-06
after which it has constantly been declining. The share of equity inflows has risen sharply since
2000-01 when it stood at 59.6 per cent to 74.3 per cent in 2010-11. (Chart 2)
Ways of receiving Foreign Direct Investment by an Indian company:
Automatic Route
FDI up to 100 per cent is allowed under the automatic route in all activities/sectors except where
the provisions of the consolidated FDI Policy, paragraph on ‘Entry Routes for Investment’ issued
by the Government of India from time to time, are attracted.FDI in sectors /activities to the
extent permitted under the automatic route does not require any prior approval either of the
Government or the Reserve Bank of India.

Government Route
FDI in activities not covered under the automatic route requires prior approval of the
Government which is considered by the Foreign Investment Promotion Board (FIPB),
Department of Economic Affairs, and Ministry of Finance. Indian companies having foreign
investment approval through FIPB route do not require any further clearance from the Reserve
Bank of India for receiving inward remittance and for the issue of shares to the non-resident
investors.

As can be seen that since 2005-06 there has been a significant difference in the amount of FDI
inflows through the two routes a possible explanation for which could be that with the
investment climate in India improving and healthy competition among states to attract FDI, the
government eased foreign investment regulations leading to a spurt in FDI coming through the
RBI route, which is a positive sign. As per the data available there is an increase in share of
inflows through the RBI’s automatic route, a decrease in the shares of inflows through the
SIA/FIPB. (Chart 3)
Sectoral FDI Flow:
Changing Dynamics of Investment:

 Overall FDI into almost all the sectors had declined in the year 2010-11, a reason for
which could be the global situation that prevailed during that time frame.
 Although services sector remain the sector attracting the highest FDI inflows since 2006-
07 its share has been constantly declining.
 The FDI flows into computer hardware and software has been downward ever since
2005-06. It has drastically gone down from 24.8 per cent in 2005-06 to 4.0%in 2010-11.
 Housing & Real Estate have shown an upward trend in terms of their share in FDI
inflows.
 Investments in chemicals and metallurgical industries have been erratic as no clear trend
could be observed for the time period 2005-06 to 2010-11.
Table
Sectors Attracting Highest FDI Equity Inflows (US $ Million)
2005- 2006- 2007- 2008- 2009- 2010-
06 07 08 09 10 11
Services Sector 543 4664 6615 6138 4353 3403
-9.8 -37.3 -26.9 -22.5 -16.8 -17.5

Computer Software & Hardware 1375 2614 1410 1677 919 784
-24.8 -20.9 -5.7 -6.1 -3.6 -4

Telecommunications 624 478 1261 2558 2554 1665

-11.3 -3.8 -5.1 -9.4 -9.9 -5.8

Housing & Real Estate 171 467 2179 2801 2844 1127
-3.1 -3.7 -8.9 -10.2 -11 -5.8

Construction Activites 151 985 1743 2028 2862 1125

-2.7 -7.9 -7.1 -7.4 -11.1 -5.8

Automobile Industry 143 276 675 1152 1208 1331

-2.6 -2.2 -2.7 -4.2 -4.7 -6.9

Power 87 157 967 985 1437 1252

-1.6 -1.3 -3.9 -3.6 -5.6 -6.4

Metallurgical Industries 147 173 1177 961 407 1105

-2.7 -1.4 -4.8 -3.5 -1.6 -5.7

Petroleum & Natural Gas 14 89 1427 412 272 578

-0.3 -0.7 -5.8 -1.5 -1.1 -3
Chemicals 390 205 229 749 362 398
-7 -1.6 -0.9 -2.7 -1.4 -2

Total Fdi 5540 12492 24575 27330 25834 19427

The challenges facing larger FDI in India are in spite of the fact that more than 100 of Fortune
500 companies are already investing in India. These FDIs are already generating employment
opportunities, income, technology transfer and economic stability. India is focusing on
maximizing political and social stability along with a regulatory environment. In spite of the
obvious advantages of FDIs, there are quite a few challenges facing larger FDIs in India, such as:

Resource challenge: India is known to have huge amounts of resources. There is manpower and
significant availability of fixed and working capital. At the same time, there are some
underexploited or unexploited resources. The resources are well available in the rural as well as
the urban areas. The focus is to increase infrastructure 10 years down the line, for which the
requirement will be an amount of about US$ 150 billion. This is the first step to overcome
challenges facing larger FDI.

Equity challenge: India is definitely developing in a much faster pace now than before but in
spite of that it can be identified that developments have taken place unevenly. This means that
while the more urban areas have been tapped, the poorer sections are inadequately exploited. To
get the complete picture of growth, it is essential to make sure that the rural section has more or
less the same amount of development as the urbanized ones. Thus, fostering social equality and
at the same time, a balanced economic growth.

Political Challenge: The support of the political structure has to be there towards the investing
countries abroad. This can be worked out when foreign investors put forward their persuasion for
increasing FDI capital in various sectors like banking, and insurance. So, there has to be a
common ground between the Parliament and the Foreign countries investing in India. This would
increase the reforms in the FDI area of the country.

Federal Challenge: Very important among the major challenges facing larger FDI, is the need
to speed up the implementation of policies, rules, and regulations. The vital part is to keep the
implementation of policies in all the states of India at par. Thus, asking for equal speed in policy
implementation among the states in India is important. In addition to India’s poor performance in
terms of competitiveness, quality of infrastructure, and skills and productivity of labor, there are
several other issues that make India a far less attractive ground for direct investment than the
potential she has. Given that India has a huge domestic market and a fast growing one, there is
every reason to believe that with continued reforms that improve institutions and economic
policies, and thereby create an environment conducive for private investment and economic
growth that substantially large volumes of FDI will flow to India. We list some of the major
issues below:

Restrictive FDI regime

The FDI regime in India is still quite restrictive. Foreign ownership of between 51 and 100
percent of equity still requires a long procedure of governmental approval. In our view, there
does not seem to be any justification for continuing with this rule. This rule should be scrapped
in favor of automatic approval for 100-percent foreign ownership except on a small list of sectors
that may continue to require government authorization. The banking sector, for example, would
be an area where India would like to negotiate reciprocal investment rights. Besides, the
government also needs to ease the restrictions on FDI outflows by non-financial Indian
enterprises so as to allow these enterprises to enter into joint ventures and FDI arrangements in
other countries. Further deregulation of FDI in industry and simplification of FDI procedures in
infrastructure is called for.

Lack of clear cut and transparent sectoral policies for FDI

Expeditious translation of approved FDI into actual investment would require more transparent
sectoral policies, and a drastic reduction in time-consuming red-tapism.

High tariff rates by international standards

India’s tariff rates are still among the highest in the world, and continue to block India’s
attractiveness as an export platform for labor-intensive manufacturing production. Much greater
openness is required which among other things would include further reductions of tariff rates to
averages in East Asia (between zero and 20 percent). Most importantly, tariff rates on imported
capital goods used for export, and on imported inputs into export production, should be duty free,
as has been true for decades in the successful exporting countries of East Asia.

Lack of decision-making authority with the state governments

The reform process so far has mainly concentrated at the central level. India has yet to free up its
state governments sufficiently so that they can add much greater dynamism to the reforms. In
most key infrastructure areas, the central government remains in control or at least with veto over
state actions. Greater freedom to the states will help foster greater competition among
themselves. The state governments in India need to be viewed as potential agents of rapid and
salutary change. Brazil, China, and Russia are examples where regional governments take the
lead in pushing reforms and prompting further actions by the central government. In Brazil, it is
São Paulo and Minais Gerais which are the reform leaders at the regional level; in China, it is the
coastal provinces, and the provinces farthest from Beijing, in the lead; in Russia, reform leaders
in Nizhny Novgorod and in the Russian Far East have been major spurs to reforms at the central
level.

Limited scale of export processing zones

The very modest contributions of India’s export processing zones to attracting FDI and overall
export development call for a revision of policy. India’s export processing zones have lacked
dynamism because of several reasons, such as their relatively limited scale; HIID Development
Discussion Paper No. 759 the Government’s general ambivalence about attracting FDI; the
unclear and changing incentive packages attached to the zones; and the power of the central
government in the regulation of the zones, in comparison with the major responsibility of local
and provincial government in China. Ironically, while India established her first EPZ in 19654
compared with China’s initial efforts in 1980, the Indian EPZs never seemed to take off -- either
in attracting investment or in promoting exports.

No liberalization in exit barriers

While the reforms implemented so far have helped remove the entry barriers, the liberalization of
exit barriers has yet to take place. In our view, this is a major deterrent to large volumes of FDI
flowing to India. An exit policy needs to be formulated such that firms can enter and exit freely
from the market. While it would be incorrect to ignore the need and potential merit of certain
safeguards, it is also important to recognize that safeguards if wrongly designed and/or poorly
enforced would turn into barriers that may adversely affect the health of the firm. The regulatory
framework, which is in place, does not allow the firms to undertake restructuring.
Stringent labor laws
Large firms in India are not allowed to retrench or layoff any workers, or close down the unit
without the permission of the state government. While the law was enacted with a view to
monitor unfair retrenchment and layoff, in effect it has turned out to be a provision for job
security in privately owned large firms. This is very much in line with the job security provided
to public sector employees. Most importantly, the continuing barrier to the dismissal of
unwanted workers in Indian establishments with 100 or more employees paralyzes firms in
hiring new workers. Labor-intensive manufacturing exports require competitive and flexible
enterprises that can vary their employment according to changes in market demand and changes
in technology, so India remains an unattractive base for such production in part because of the
continuing obstacles to flexible management of the labor force.

Financial sector reforms

Reform of India’s financial sector is crucial for large FDI flows into India. However, only some
partial steps have been undertaken and these are by no means going to make any meaningful
changes to the existing system. India’s banking and insurance companies were nationalized more
than two decades ago. While a number of countries had undertaken such actions in the 1970s and
early 1980s, for instance Mexico, France, and Chile, however, they have almost completely
reversed this policy by now. Be that as it may, India still continues to rely on a state-owned,
state-run banking system and the insurance sector till very recently remained a government
monopoly. This as one would According to UNCTAD (1982), the first two EPZs were
established in Mayagaez, Puerto Rico (1962) and Kandla, India (1965). According to the
Industrial Disputes Act (IDA), 1947 if a firm employs 100 or more workers, then workers cannot
be laid-off without the prior permission of the concerned state government. Besides, the Act
prohibits closure unless of course the state government has granted approval to do so.HIID
Development Discussion Paper No. 7598 expect has had highly adverse results, both in terms of
availability of funds for investment and a negligible presence of foreign banks and no presence
of foreign insurance companies in the country.

High corporate tax rates

Corporate tax rates in East Asia are generally in the range of 15 to 30 percent, compared with a
rate of 48 percent for foreign companies in India. High corporate tax rate is definitely a major
disincentive to foreign corporate investment in India. India must also focus on areas of poverty
reduction, trade liberalization, and banking and insurance liberalization. Challenges facing larger
FDI are not just restricted to the ones mentioned above, because trade relations with foreign
investors will always bring in new challenges in investments.
The need for larger FDI exists because India is at a stage where it needs not only US
investments, but also technology, and management policies to sustain and enhance its economic
growth. . In 2006, Foreign Direct Investment (FDI) in India amounted to US$37 billion, out of
which only $5 billion was from the US.This was not a very encouraging figure in view of the
goal of increasing the GDP by 34-36%. Therefore, there is a need for larger FDI. India still
requires an FDI component equal to 4% of the GDP. The US needs to invest more in various
sectors of the Indian economy. There is a potential to attract more FDIs in areas like
infrastructure, IT hardware, automobiles, leather, textiles, gems, jewellery, and the financial
sector. As such, India is rated as the 2nd best economy to invest in, after China. Surprisingly, the
US is rated 3rd in this domain! Focus is on the insurance and banking sector, in context with
Foreign Direct Investments. Only 10% of the insurance sector has been tapped for foreign
investment. Foreign companies need to persuade the parliament for increasing Foreign Direct
Investment capital.
Conclusion:

FDI since 1991 has proved to be game changer for wide segments of Indian industry.FDI has
change quality, productivity, and production in areas where it has been allowed. FDI has led to
the creation of new activities such as IT-BPO, which was initiated by select foreign companies.
India needs huge investment in the 12th Plan period, it is calling for investments to the tune of $1
trillion in the infrastructure sector alone.

We need among many other infrastructure facilities infrastructure in retail as well as those for
food & perishable products. Opening of FDI in retail would have led to the creation of such farm
infrastructure. This apart mining and manufacturing sectors also require huge investments and
FDI can supplement domestic efforts significantly. There is also an urgent need for India to
augment the investment absorption capacity. Moreover it has to be understood that India is
competing for foreign investments with other emerging economies and so far a comparative
analysis suggest that India has not been a large recipient of FDI.

I feel that FDI liberalization should be pursued we also recommend some immediate ground
level reforms for increasing the ease of doing business in India. Therefore we would like to
propose a few suggestions to the policymakers for their consideration:

 Bureaucratic delays and various governmental approvals and clearances involving

different ministries need to be fastened so as to increase the absorption rate of FDI into
the country.
 Restrictions on sector caps and entry route to sectors other than those of national
importance need to be liberalized further and constant reviewing of policies must be
done.
 Government must ensure consistency of policy so as to improve the business and investor
confidence.
 It is in the interest of the industry at large if a mechanism could be developed which
facilitates a consultation between Centre and State governments before a policy rollout so
that once the decision is taken its implementation does not get affected.
 Government must recognise that good regulations and efficient processes are key
catalysts for FDI. Accessible and reliable information and efficient and predictable
 actions by public institutions help create a business environment conducive to
investment.
 Time bound, non-discretionary, simplified and less number of procedures and approvals
would also help in uplifting the international investor’s confidence and help foster more
investment into India.
 Reference:

 www.assocham.org
 www.madhyam.org.in

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