Foreign direct investment(FDI) seems to be new buzzword of the Congress led United Progressive Alliance (UPA) government. Earlier this week the government relaxed foreign direct investment norms in twelve sectors including telecom, insurance, asset reconstruction, petroleum refining, stock exchanges and so on.
This sudden love of the government for FDI after nearly nine years of sitting on their bums, can be attributed to the rupee losing value rapidly against the dollar and creating huge economic problems. The hope is that with FDI reform foreign investors will bring in dollars into India to set up new businesses, increase their investment in existing businesses or buy up businesses.
When these dollars come into the country they will have to be converted into rupees. This will increase the demand for rupees and ensure that the rupee will gain value against the dollar. That is how things are supposed to work, at least in theory.
But this is easier said than done. A foreign investor looking to get money into India through the FDI route is committing to stay invested for the long term. In comparison, a foreign investor investing money in the stock market or the bond market, can sell the stocks or bonds, take his money and leave, the moment he sees things going wrong.
An investor who has got in money through the FDI route cannot exit like an investor who has invested money in stocks or bonds. Selling a business or a factory is not as easy as selling stocks or bonds for that matter. And more than that setting up a profitable business to justify the investment being made in a foreign country is not so easy. It is worth remembering that the Western world in general and the United States in particular is currently dealing with the aftermath of the financial crisis. There is great pressure on companies to set up new businesses or expand current ones in their home countries. In this scenario if they do decide to go abroad and set up new businesses, it needs to be a very good proposition for them.
Given this, any investor getting in money through the FDI route is likely to look at many factors than get in money simply because FDI is the flavour of the week with the government.
Take the case of the South Korean steel company POSCO which has pulled out of setting up a steel plant in Karnataka. The company had signed an agreement to set up a steel plant with a capacity of 6 million tonnes in the state in June 2010. The project would have got in $6 billion worth of FDI in the state. Along similar lines ArcelorMittal, the global steel giant, has decided to opt out of a $12 billion steel plant in Odisha. So the country lost out on FDI worth $18 billion within two days of the Congress led UPA government discovering FDI.
The reasons for pulling out cited by both the companies were similar. They couldn’t get the land required to set up the steel plant and at the same time iron ore linkages weren’t in place. Iron ore is used to produced steel.
What this tells us is that it is not very easy for a foreign investor to set up shop in India. The process of acquisition of land for the Posco plant in Karnatka had been on for around two and a half years. ArcelorMittal also had been trying to acquire land for its plant in Odisha for more than three years now.
Every year the World Bank puts out a ranking which measures the Ease of Doing Business across countries. In the 2013 ranking, India came in 132nd on the list. India’s ranking was the same in 2012 as well. When it comes to enforcing a contract, India came in 184th on the list. When it comes to starting a business India is 173rd on the list. What this means is that foreign investors have an option of starting their business in a much easier way in 172 countries other than India. Given this, why should they be hurrying to India?
In fact ArcelorMittal had announced last year that India was no longer a priority for them when it came to making major investments. Of course these withdrawals would have had much more impact on prospective investors than the announcements made by the government welcoming FDI.
Then there is issue of corruption. Over the last few years a spate of scams from coalgate to the telecom scam have come to light. This also has an impact on the foreign investor looking to get in money into India through the FDI route.
As Ali Al-Sadig writes in a research paper titled The Effects of Corruption on FDI inflows written for the CATO insitute “From a theoretical viewpoint, corruption—that is, paying bribes to corrupt government bureaucrats to get “favours” such as permits, investment licenses, tax assessments, and police protection—is generally viewed as an additional cost of doing business or a tax on profits. As a result, corruption can be expected to decrease the expected profitability of investment projects. Investors will therefore take the level of corruption in a host country into account in making decisions to invest abroad.”
And empirical research shows that there is a negative relationship between corruption and FDI inflows. As Al-Sadig writes “That is, ceteris paribus, a one-point increase in the corruption index causes a reduction in per capita FDI inflows by 11 percent.”
In another research paper titled Foreign direct investment, corruption and democracy Aparna Mathura and Kartikeya Singh reported a similar result. As they write “We find quite convincingly that corruption perception does play a big role in investors’ decision of where to invest. The more corrupt a country is perceived to be, the less the flows of FDI to that country.”
So corruption is another factor which will continue to have an impact on FDI into India in the days to come, given that its not going to go away any time soon.
Then there is the perpetual problem of India’s infrastructure. Businesses need roads, ports, power, rails etc to function. There is a clear lack of supply on this front. And this also has an impact on the amount of money coming in through the FDI route. As Rajesh Chakrabarti, Krishnamurthy Subramanian, Sesha Meka and Kuntluru Sudershan write in a research paper titled Infrastructure and FDI: Evidence from district-level data in India published in March 2012 “We find that while there is indeed a positive relationship between physical infrastructure and FDI inflows, the relationship is essentially non-linear with a “threshold level” of infrastructure after which the positive effect becomes significant.”
What this means is that districts in India which have a better physical infrastructure attract more FDI. What it also means is that significant FDI inflows happen once physical infrastructure is of a certain ‘threshold’ level. So there is a clear link between physical infrastructure and the total amount of FDI that comes in. And India loses out on this front.
All these factors have led to a situation where FDI into India has fallen in the last three out of the four years. For 2012-2013(i.e. the period between April 1, 2012 and March 31,2013), FDI fell by 21% to $36.9 billion, as per government data. The United Nations Conference on Trade and Development (UNCTAD) in a recent release said that FDI inflows to India declined by 29 per cent to $26 billion in 2012.
To conclude, while the Congress led UPA government might have fallen in love with FDI, it is unlikely to lead to a flood of dollars in the months to come. For that to happen the country first needs better governance which will lead to better infrastructure, lower corruption and a greater ease of doing business. But governance is something that has gone missing from this country. And given this, the rupee will continue to have a tough time. It is currently quoting 40 paisa lower at Rs 59.74 to a dollar against yesterday’s close of Rs 59.35 to a dollar.
The article originally appeared on www.firstpost.com on July 20, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)