Role of foreign direct investment in India

Rubber Expo 2001,Mumbai,April 4th-6th 2000

1. SCOPE

1.1. Technically, foreign investment means the sum of foreign direct investment and portfolio investment. However, the scope of this paper is restricted to foreign direct investment and its impact on management in India.

2. INTRODUCTION

2.1. Foreign investment is a term that has been bandied about loosely in virtually every discussion on international business. It means different things to different interest groups. To the socialists it means the sell out of an economy to western capitalists. To nationalists it has become synonymous with cultural decadence. To liberation economists like Osvaldo Sunkel, foreign investment is the precursor to “dependencia” and the phenomenon of neo colonialism¹.

2.2. And yet, to resource starved countries, foreign investment assumes the economic equivalent of manna from heaven! East European governments for example, compete fiercely with each other to invite foreign investment into their bruised economies. The Hungarians, by all accounts, seem to have excelled in creating conditions for foreign direct investment : they accounted for some 45 % of all foreign direct investment flow into the Middle and East European bloc as a whole from the EU region during the period 1992-94.²

2.3. In an increasingly globalized world foreign investment has assumed a crucial role. It is becoming as common to invest in a foreign country as it is to invest in another city or state. Technological and policy alignment around the world has truly globalized investment.. The avenues open to investors are global and therefore any project or government for that matter, now has to offer a competitive return on investment if it has to attract adequate capital. Similarly, on the supply side, any government or project now can tap into global capital markets for local needs.

2.4. This is not without its dangers. As George Soros comments in the aftermath of the East Asian economic meltdown, “ It would be regrettable if we remained complacent just because most of the trouble is occurring beyond our borders. We are all part of the global capitalist system which is characterized not only by free trade but more specifically by the free movement of capital. The system is very favorable to financial capital which is free to pick and choose where to go and it has led to the rapid growth of global financial markets. It can be visualized as a gigantic circulatory system, sucking up capital into the financial markets and institutions at the center and then pumping it out to the periphery either in the form of credits and portfolio investments, or indirectly through multinational corporations”.³ Soros goes on to add that markets need to be managed because of what he calls their reflexive nature ( i.e. the impact of thought and perceptions on feeding back into the market and thereby affecting its behavior); markets will not autonomously revert to equilibrium as is commonly believed (as evinced by the East Asian experience).

3. DEFINITION

3.1. Foreign direct investment can broadly be defined as a long term capital inflow into a country other than aid, portfolio investment or a repayable debt. In other words, it is usually a long term investment in equity by an entity that is outside the host country. This investment is deployed to earn a return over a long period of time by way of dividend. An additional objective of the investment is often to obtain a significant or controlling interest in the management of the firm or company in which such an investment is made.

3.2. Foreign direct investment is financed in many ways. It can be via a transfer of funds from the parent company abroad or by borrowing in local markets by the parent company. It can also be through part transfer and part borrowing in local markets. In countries where foreign exchange scarcity is endemic, any foreign direct investment is characterized by an inward remittance of hard currency.

3.3. However, definitions of foreign direct investment vary across countries. For example, in Denmark foreign direct investment is defined as an investment conducted with a view to establishing a permanent financial relationship between the investor and the company concerned. The investor must also through the investment obtain, maintain or expand access to the exertion of significant influence on the management of the company. In practice a direct invest takes place if the investor holds at least 10 percent of the net capital in the company.⁴

1. MACROECONOMIC COMPULSION

1.1. India’s public borrowing is unsustainable ; debt service is approximately Rs.101,000 crores for the year 2001-02⁵. This means that the lion’s share of government resources is gobbled up by debt service thereby crowding out expenditure and investment in development, infrastructure or other productive areas. India is therefore teetering on the precipice of a debt trap.

1.2. Globalization has put a premium on competitiveness and that is exactly what the current pattern of government expenditure does not allow. Government has no resources to upgrade infrastructure and capacity. Similarly, the Indian private sector too has resource constraints in ratcheting up to global scale. The only way this resource gap can be overcome is to take recourse to foreign direct investment. It is therefore not surprising that the government has over the last 10 years or so liberalized the policy towards foreign direct investment ( overview provided in Appendix 2).

1.3. In order to cut the debt service burden, the quantum of debt has to be reduced. This can happen in two ways: one, swap the debt for equity and two, invite foreign direct investment on a massive scale to create productive, global scale capacity in infrastructure and industry. This is vital if the hitherto high cost Indian economy is to churn out quality competitive goods and services at globally competitive prices. The alternative is to miss the bus of globalization and sit on the sidelines of the new international economy.

2. FOREIGN DIRECT INVESTMENT FLOWS IN INDIA

2.1. World trade has grown substantially over the last decade as a result of an increasing awareness that protectionism is a relic of the past. Dismantling of trade barriers has contributed to this explosion in trade. “ During the period from 1985 to 1995, the volume of world merchandise exports consistently grew more rapidly than world output, with average annual rates of 6 percent and 1.5 percent respectively in 1990 to 1995. Consequently, trade came to have a much greater influence on the economies of most countries.⁶

2.2. Accompanying this growth is a highly significant structural alteration in the pattern of trade flows ;“between 1985 and 1995, developing countries raised their share of trade from 23 to 29 percent, increased their share of trade among themselves from 31 to 37 percent, and increased the share of manufactures in their exports from 47 percent to a staggering 83 percent”.⁷

2.3. The combination of both these trends meant that the developing world had assumed the role of manufacturer while the developed world had moved on to production of services. This in turn meant that productive capacity had expanded dramatically in the developing economies; since capital scarcity is a definitive feature of developing economies, this could only mean that the capital for such a capacity expansion could only come from outside. Foreign Direct Investment had therefore played a crucial role in increasing the economic growth of the developing countries.

2.4. The general experience has been that exports are the precursor to foreign direct investment ; that is, a firm first pursues a low risk approach to a foreign market by exporting to it. Then, after learning to operate in that market and assessing its profitability, decides to invest in either acquiring or setting up a local company to produce and sell in that market. Considering the fact that the Internet has now eliminated the problem of information scarcity, many companies are now leapfrogging the process: they can now invest directly without having to go through the learning curve of exporting first.

2.5. In India, too these trends are visible. During the decade of the 1990s, the foreign trade component of the economy grew substantially. Exports accounted for 6.7% of GDP in 1990-91 ; by 1997-98 they had increased to 8.3% ( in some earlier years the share was even higher).⁸ Following the increase in exports, foreign direct investment in India has also increased substantially. Foreign direct investment approvals increased from $325 million in 1991 to $6.13 billion, a growth of around 20 times⁹. This is conclusive evidence of the increasing openness of the policy makers towards foreign direct investment.

2.6. While approvals are a cause for celebration, the actual foreign direct investment inflow is a matter of concern. While approvals for the period 1991 to 1998 stood at a cumulative total of $54.2 billion, the actual inflow of foreign direct investment was a paltry $11.8 billion. In other words, the conversion rate was a meager 21.7 % over this period¹⁰. If indeed the entire approved foreign direct investment had been converted into actual inflows, economic growth would perhaps have been higher by about 1% per annum during this period.

2.7. Apparently, there has been a huge slip between the cup and the lip as far as foreign direct investment is concerned. If this gulf has to be bridged and the quantum of foreign direct investment flowing into the economy has to be increased substantially, several factors need to be considered. An overall environment that is conducive to foreign direct investment needs to be fostered. It is interesting to note that already $54 billion worth of investment is in the pipeline ; if the blocks are removed, very quickly a substantial portion of this could be converted into actual foreign direct investment flow. It could well result in over $20 billion worth of investment flowing in over 12 or 18 months. If that happens, a lot of macroeconomic miracles can happen; for example, the rupee could rapidly appreciate against the dollar and interest rates could come even more sharply down.

3. FACTORS AFFECTING FOREIGN DIRECT INVESTMENT

3.1. The factors that can narrow the gap between foreign direct investment approvals and actual foreign direct investment inflows and indeed make India a preferred destination for global capital are, among others:

3.1.1. Availability of infrastructure in all areas (transport, hospitality, telecom, power)

3.1.2. Transparency of processes, policies and decision making and reduction of government decision making lead time

3.1.3. Stability of policies (entry, exit , labour etc) over a definite time horizon so that definite plans can be made

3.1.4. Acceptance of International Standards including accounting standards

3.1.5. Capital account convertibility so that all capital and payments can flow easily in and out of the economy

3.1.6. Simplification of the regulatory framework in general and tax laws in particular

3.1.7. Improvement in the enforcement of intellectual property rights ( since Indian laws in this area are already among the best in the world)

3.1.8. Improvement in bandwith for Internet and data communication

3.1.9. Implementation of the WTO Agreement in full

4. CONNECTION BETWEEN GLOBALIZTION AND FOREIGN DIRECT INVESTMENT

4.1. Everyone is today concerned about globalization. Love it or hate it, globalization is here to stay! Even political parties that are left behind are willy, nilly forced to admit that it is a phenomenon that is well and truly out of the bottle ! Technology has done what ideology could not : unite us all into a fraternity of interconnected and interdependent economies and communities.

4.2. How do traditionalists deal with such a new world order ? The short answer is that they cannot because their analytical frameworks are incompatible with current realities. Moore’s law for example, has ensured that the frontiers of knowledge are constantly expanding. The law postulates that the density of information that can be packed into a computer chip doubles every 18 months or so. This means that computing power is doubling every 18 months thereby enabling undreamed of advances in science, technology and knowledge in general. Perhaps the best is yet to come because the pundits expect Moore’s law to be valid till the year 2017 when the limits of computing as we know it would be reached. That is when sub-atomic computing is expected to take over and keep computational power growing.

4.3. All this inevitably means that human beings are getting even more connected every day. Some observers are convinced that the greatest technological marvel of the last century was not the computer chip but the Internet. This is in turn means a networked and therefore globalized world.

4.4. The impact of such a networked world is that classical trade theory will stand vindicated to the ultimate extent. Producers now have the capability to pursue the optimal production function globally. They are able to manage lowest cost manufacturing at each stage of the production process by using web-based manufacturing, inventory, customer relationship and supply chain management technologies.

4.5. Investment therefore flows into all these parts of the global supply and manufacturing system. Increasingly therefore, we are witnessing decentralized manufacturing and logistics operations spread over many countries by the same firm. In fact, according to a study completed by the Massachusetts Institute of Technology, one scenario for the new millennium is the increased power of “virtual countries”¹¹. The scenario envisages the total domination of the global economy by a few corporations that control virtually every industry. In fact, people are likely to be distinguished not by the country they belong to but by the company they are part of; corporate loyalty supplants national pride!

Foreign direct investment is one of the 2 main channels through which globalization flows (the other is technology, especially internet and information technology). It is important to understand that over 50 % of world trade is conducted between companies and their foreign subsidiaries and affiliates. Therefore, the growth of trade signifies first an increase in exports and then an attendant increase in foreign direct investment. An increase in foreign direct investment in a country integrates it further into the global trading system. Therefore, the quantum of foreign direct investment in an economy is an important determinant of that economy’s participation in globalization. The relationship between foreign direct investment and globalization of an economy can be visualized as follows:

8. IMPACT ON MANAGEMENT

8.1. Firstly, foreign direct investment will usher in a convergence of standards. Therefore, parameters for quality and performance are now not related to our local conditions but to the global norms. This is simply because the foreign investors demand globally comparable quality and returns. Therefore, success demands delivery of global standards, nothing less. There is no hope for any product or service or indeed any organization that does not adhere to global standards even if they are being produced for Indian markets. After all, even the Indian markets have gone global because the barriers to entry have been cleared in virtually every industry. The lesson is clear: local customer and foreign investor are both demanding global standards in all aspects of business.

8.2. Convergence of standards is undoubtedly an effect of technology and competition but it is also equally being driven very proactively by several high power global institutions. For example, the WTO is fostering a transparent rule-based global trading system. The Bretton Woods twins, World Bank and the IMF, are ardent advocates of prudent economic development, trade, fiscal, monetary and other macroeconomic policies; while their prescriptions do not always find ready acceptance or relevance in every country, they are respected sources of research-based advice on sustainable development. The Bank for International Settlements is actively crafting the standards for the global banking industry while the International Standards Organization contributed norms for globally accepted standards for quality (ISO 9000 series) and environment management (ISO 14000 series).

8.3. Secondly, foreign direct investment drives productivity growth. This will ensure that the laid back approach to work is over, the number of holidays will be slashed and the proliferation of computers across India will accelerate. This is turn will fuel all aspects of the knowledge economy: education, training and services. Though it is fashionable to talk about the global market for software, I am convinced that a significant part of that market is right here in India. The need to increase productivity in every segment of the economy will spur a huge growth in the Indian software industry. Foreign capital and Indian technological know-how is likely to create an explosive growth of the domestic IT industry; a rapid, economy-wide growth in productivity will be the result.

1.3.1. Productivity growth spurred by foreign direct investment will in turn create undreamed off opportunities for poverty alleviation. For instance, fiscal deficits can turn into surpluses and large allocations are possible for the creation of social safety nets. Adequate resources will become available for creating a better quality of life for the poorest of the poor. Poverty elimination ( at least on the scale it now exists ) is a distinct possibility.

8.4. Thirdly, foreign direct investment increases competition in the domestic market. Therefore, profit margins will narrow to global levels. It is now futile to expect that the usurious margins of the past (20 to 50 %) to continue. Competition from global players in the now opened Indian market has eaten into the traditionally high margins. Soon, companies will have to learn to operate at net margins of around 5 %. Already, interest rates have fallen and the benefits have passed through to customers in the form of stable or lower prices. Profitability will now have to come from lower costs from higher volumes and productivity gains. The possibility of raising prices frequently is now more or less like a mirage in the desert. This global reality however does not appear to have sunk in among the ownership and top echelons of management in many companies in India. Foreign direct investment will increase the pressure on managements to vastly improve operational effectiveness.

8.5. Fourthly, foreign direct investment and globalization ensure easy information availability and thereby, transparency. Leaders in politics, corporate boardrooms and markets can no longer hide behind opaque shields. Internet, email, data archiving and convergence have ensured that everybody has access to almost everything. For India, the hope of decreasing corruption is now brighter; all the shenanigans will be displayed in the public domain and neither the power of the state nor the power of money can prevent it. Open societies and the Internet combine synergistically to guarantee transparency. Therefore, corporate governance, effective governance by government and compliance of all regulations and laws , all become de facto standards.

9. CONCLUSION

9.1. In the ensuing years, we can expect “an even larger increase in the volume, speed and complexity of financial and direct investment flows and a multiplication of financial markets, again involving greater integration of developing countries; private capital inflows to developing countries rose from an average of one-half of one percent of their GDP in the period from 1983 to 1989, to between 2 and 4 percent from 1994 to 1996, with the share of bank lending falling and that of direct investment rising”.

9.2. Foreign direct investment will therefore assume a very important role in financing the knowledge economy of the 21^st century. It is therefore a national priority to remove the gaps between approvals and actual flows vis-à-vis foreign direct investment. At the same time, attention to all the factors affecting foreign direct investment is necessary. In short, this means accelerating India’s integration with the global economy. When that happens, foreign direct investment will play the same role in India that it has played in the USA: a productivity multiplier that also finances the long term current account deficit.

continued...

*****

print this article