FOREIGN DIRECT INVESTMENT IN INDIA
Sent as part of monthly LEGAL UPDATE, June 2000,
K. R. CHAWLA & CO.
ADVOCATES SUPREME COURT AND HIGH COURT
A decade and a half ago most of the worlds telecommunication service providers were state owned corporations that had a monopoly position in their home market. The industry was protected from both domestic and foreign competition by government imposed regulatory barriers. Today, telecommunication service providers face a world characterised by rapidly changing technology, the growth of new telecommunication devices such as the wireless (cellular phones) and the internet, massive deregulation and the privatisation of state owned telecommunication monopolies, the emergence of aggressive new competition, and the decline of barriers to cross border investment in the industry. The combination of rapid technological change, privatisation, deregulation and the falling of barriers to cross border investment in facilities to produce and/or market a product (FDI) has fundamentally changed the nature of the entire world economy. Increasingly, cross border investment is seen as a means to rationalise the activities of a firm and increase profits resulting from a global reach.
The same has also led to a marked increase in the flow and stock of FDI in the world economy over the past two decades. FDI plays an increasing role in the global economy as firms ranging from the largest to the smallest increase their cross border investments. The average yearly outflow of FDI from larger industrialised countries increased from about $ 47 billion per annum during 1981 1985 to a whooping $ 163 billion over the next five years. 1990 saw a record of $ 222 billion in the outflow of FDI. According to UNCTAD, outward FDI from developing countries as a group grew from $ 4.8 billion to $ 108.4 billion between 1980 and 1993. In terms of the total FDI stock, these countries increased their share from 1.0% in 1980 to 5.1% in 1992 as an increasing number of developing countries started engaging in FDI.
While other sources of foreign capital investment (e.g. debt and portfolio investment) remain important, FDI by far is the most attractive source in its entirety. Unlike other forms of capital inflows, FDI almost always brings in additional package of resources capital, technology, management know how, and access to export markets which tend to be readily absorbed into the national systems of innovation. While there exists a disparate account in literature as to the effects of FDI on an economy, it is widely accepted that FDI gives rise to economies of scale and scope. It has been argued that there is a dynamic relationship between the economic structure and the extent of outward and inward foreign direct investment associated with a country. The argument is that MNEs seek to utilise their firm specific assets in conjunction with the location bound assets that are host country specific. Thus, the relationship is an interactive one, where the FDI is influential in changing the nature of these locational advantages and the kind of ownership advantages possessed by the domestic and foreign firms. It is by now axiomatic that the interaction between the location specific assets associated with countries and the firm specific assets associated with MNEs underlies the economic growth associated with foreign direct investment both outward and inward. The linkage effects created promote economic growth by creating industries, transferring technology & know how and fostering a modern perspective in the local population.
India has followed a selective policy in attracting FDI since its independence in 1947. The 1960s and 1970s experienced an effort to unbundle foreign technology and financing (e.g. the Patent Act of 1970) through a nationalisation of assets. The broad purpose of the policies was to encourage local innovative activities and create a domestic industry independent of foreign influence by reducing foreign holdings in the country. Contrary to the objective, the new laws failed to achieve the goal and India was characterised by demand conditions which were minimal because of low per capita income, inappropriate economic systems and government policies, insufficient infrastructure, little technology accumulation and hence few created assets. The lack of an adequate infrastructure was, however clearly offset to a large extent by the relatively low cost of labour. Creation of assets, where it existed was in labour intensive manufacturing and primary product sectors (such as mining and agriculture). The liberalisation of policies and a relaxation of the controls on technology licensing agreements through the 1980s and the 1990s reflected the broad realisation that the global economic forces could not be ignored. This was followed by the recognition of the importance of FDI to create, develop and maintain resources to enjoy a comparative advantage. Thus, the 1990s observed a dramatic change in the level of FDI in India.
According to the IDP (Investment Development Path) framework developed by Dunning and Narula (1994), countries tend to go through five main stages of economic development which can be classified by their propensity to be outward or inward direct investors. India, as an attractive location for market and resource seeking investments resulting from the sheer size of its domestic market and an abundance in natural resources depicted the characteristics of a Stage 2 country as was observed by Narula (1996). The liberalisation of policies over the past decade has endowed the domestic industry with a virtuous circle of technology accumulation and a movement of production towards semi-skilled and moderately knowledge intensive consumer goods as it enters Stage 3 of the Investment Development Path. The country is characterised by a large domestic market both in terms of its size and purchasing power, which has made local production by foreign firms viable. Over the decade there has been a steep rise in the inflow of FDI from Rs. 5431.10 million in 1991 to Rs. 283665.34 million in 1999 with major investments coming from U.K, Korea (South), Japan, Germany, Australia, Malaysia, France, Netherlands and Mauritius [at Rs. 224811.49 million {1991 - 29/02/2000}], second only to U.S.A [Rs. 464998.31 million {1991 - 29/02/2000}]. The inflow of FDI however, is to a large extent aimed at exploiting natural asset based advantages, through resource seeking and market seeking investments and rationalising production by exploiting cost differentials between the host and the home countries. A study on US outward FDI in a select group of developing countries found US FDI in India to be most labour intensive among the select group. While capital intensity has been increasing over the years, US FDI recognises and is attracted by cheap labour in India. An exception to the rule is perhaps, the software industry, where investments are aimed at seeking complementary created assets, and aeronautics, space and nuclear research sectors, resulting from a high concentration of R&D activities in the government owned research institutes and enterprises with a relatively narrow focus on military related operations. The spillovers to the rest of the economy in terms of technology accumulation from these industries, however tends to be limited because of their niche characteristics and high degree of specialisation of knowledge.
Literature suggests that the different rates of growth across countries can be explained more by qualitative differences rather than by numbers. The government policies are responsible for these productivtiy differentials created by trade distortions and financial repression imposed on an economy. While the Statement on Industrial Policy in 1991 deregulated the economy in a substantial manner, the level of protection accorded to the domestic industry continues to be high, the tariffs though lowered were perhaps amongst the highest in the world up until 1996. It continues to be one of the least open and the most controlled economies in the world. Highly protected domestic markets tend to reduce the incentives to invest in the choice of technology appropriate for the factor endowments in the host country and in plants which would be large enough to exploit the economies of scale and at the same time reap high profit margins. The deregulation attempted to correct these structural failures in the Indian economic system. Industrial licensing was abolished with the exception of a few cases, while import restrictions and tariff levels were reduced significantly. The FERA Act was amended and restrictions placed on foreign companies by FERA were lifted. MNEs were allowed to have an equity participation in small-scale enterprises upto a limit of 24%. Majority foreign investment upto 51% was freely allowed in most sectors. Foreign equity participation upto 100% is encouraged in export oriented units. Sectors such as mining, banking, telecommunications, highway construction, insurance, e-commerce, etc. were thrown open to domestic and foreign private investors over the years. The end of 1990s was marked with further liberalisation of the Indian economy. Additional infusion of foreign equity without prior government approval was permitted in cases where original project cost was below Rs. 6 billion and where the initial approval was not granted by the Cabinet Committee for Foreign Investment. The Government substantially liberalised the foreign direct investment regulations permitting foreign investment under the automatic approval route in all barring a few exceptions. The foreign direct investment ceiling in e-commerce and petroleum refining has been raised to 100% from 49%. With India having agreed to delicence imports by 2001, cut customs duty to WTO levels and adopt a new patent regime by 2005, it is determined to reach the international levels of competitiveness.
With a pressing need to attract FDI in core areas with emphasis on infrastructure, the policy makers have accentuated sector selectivity for the inflow of FDI. The statistics indicate that while the intended investment accounted for almost half of the total investment in the infrastructure sector, much of the investment has not been realised so far. One of the main drawbacks has been that the infrastructure sector in India is highly regulated and involves complex and multilevel interface between the investor and the government agencies. For example the power sector (e.g. Enron and the Cogentrix case) is one sector which is characterised by low levels of private investment although it was opened to private investment in 1992. Given the large amount of investments and risks involved with these projects, the high tariff structures and the irregular supply of fuel create disincentives for private investors. In an attempt to attract FDI into the stagnating power sector, the Rs.1500 crore investment limit for power projects has been abolished. As the liberalisation of the policy structure continues, it is hoped that the influx of FDI would bring about the desired changes.
The liberalisation has also brought about changes in the sectoral patterns of FDI inflows. Prior to the 1990s FDI was restricted to the technology intensive sectors of the manufacturing industry. The 1995 statistics observe a slight shift away from the manufacturing towards the services sector. While manufacturing accounted for 38.4% of the total FDI stock in 1998 from 85% in 1990, investments in services had increased to 28% in 1998 from 5% in 1990. Although the exact nature of the relationship between trade and FDI is a controversial issue in international economics and business, it is axiomatic that MNE activity has a distinctive affect on the structure of trade because of their ability to internalise cross border transactions. The issue of MNEs contribution to export has been a cause for major concern in India. It was however found that the sectors with higher foreign dominance had a higher propensity to export and a more favourable trade balance as compared to other sectors of the industry. Ganesh (1997) found that the level of exports of firms in sectors where MNEs had a market share of that 67% was 11.6%. It is noteworthy to mention here the skyrocketing of Indian infotech exports to the US from $250 million in 1991 to $5.5 billion in 1999.
Because of the potential in FDI in expanding manufactured exports and transfer of knowledge most countries compete with each other to attract foreign investments. India has set up a large number of export processing zones in an effort to attract MNEs to invest in export oriented units by providing subsidised infrastructural facilities and a freer policy environment. Siddarthan and Kumar (1990) found the predominance of intra firm trade between US MNEs and their affiliates abroad in R&D and skill intensive industries. They concluded that export orientation and export oriented FDI would be principal means to tap into the market access of MNEs by developing countries (e.g. Indian software industry).
One of the major contributions of FDI to the Indian economy has been in terms of technology transfer, technological development and the obvious inputs to the national systems of innovation. While there has been a shift from the concentration of FDI in relatively technology intensive sectors to other sub sectors of the manufacturing industry, technology has become more important as India tries to achieve and maintain the international levels of competitiveness. While inflows of FDI indicate as well as promote the technological development, technological development has a distinctive impact on the exports of an economy. An analysis of the Indian trade statistics observes a corresponding increase in the R&D levels and the export earnings for the technology intensive sectors like chemicals, engineering goods, electronic products, etc.
Technology is a critical input in the industrialisation of a country and is sourced quite substantially from abroad as a country moves through the initial stages of its economic development. There is a growing evidence of indigenous technology capability building with in the country as is indicated by Foreign technology cases which stood at 23% of the entire stock of FDI approvals during January to May 1999. However, one major concern remains that the investment in technology development and R&D activity is low, which is adaptive at best, resulting from a triadisation (localisation of R&D within the Triad - U.S.A, Europe and Japan) of R&D activities. At the same time, the level of protection enabled to the domestic industry further distorts any incentive for the MNEs to transfer appropriate technology into the system. Often, the technology transferred to the developing countries like India is obsolete, while the first generation technology remains back at the head quarters. Reddy mentions that as global competition intensified there was an increased demand to invest in R&D activities and R&D personnel. As a corollary R&D activities started in uncommon locations such as India. The differences in technological levels were increasingly taken as an important motivation for both trade and FDI. India offers a large pool of scientifically and technically trained manpower at substantially lower wages compared to its industrialised counterparts. Hence the increase in technology inflows from the world market and the foreign and R&D activity. The same is important for complementing the local technology capability building with new technology and developing a unique created resource base. The increase in the levels of patenting and R&D expenditures indicates the level of technology accumulation in the country. One observes an increased trend to patent among firms. While the number of patent applications stood at 3.598 in 1988 89, the number of applications had risen to 10.155 in 1997 98. A CSIR analysis of patents held by 17 major countries, notes many of them substantially increased their patenting activity in India during the five-year period from 1987-88 to 1991-92 as the country started to liberalise. Correspondingly there has been an increase in the private sector expenditure in R&D activities from Rs.45646 lakhs in 1990-91 to Rs.90252.23 lakhs in 1994-95 in technology intensive sectors. At the same time one observes a concentration of the public sector R&D expenditure in defence and other activities, while its expenditure in other technology intensive sectors has remained more or less constant (Rs.41453.33 lakhs in 1990-91 to Rs.68532.76 lakhs in 1994-95).
To conclude, India took on a path towards liberalising its economy in 1991. The period from 1991 till date has observed slow but sure changes in the Indian economy as it opens up and adjusts to the global competition. However, while the increase in FDI is substantial when compared to the pre-reform period, it remains a small percentage of the GDP. Also while the FDI has observed steep jumps it does not compare very favourably to other countries in Asia (e.g. the Asian NICs). For example there is more US investment going to Shanghai than to the whole of India. In 1996, China alone attracted $ 42.3 billion in FDI, Indonesia $ 8.0 billion, Malaysia $ 5.3 billion as opposed to a mere $ 2.5 billion attracted by India. According to the world competitiveness report shows India ranked 41st in 1997 and 1998 as compared to China which moved up three notches from 27th to 24th during the same period. At the same time, while China ranked 3rd in the extent to which it participated in international trade and investment flows, India ranked low at the 42nd position in 1998. However, the emergence of the knowledge economy has offered India a chance to leapfrog into the information age. While Indias exports to the US have zoomed by 175% over an eight year period since 1991, its infotech exports alone are projected to touch $ 30 billion. A survey of experts conducted by India Today reveals that India could treble its trade with the US (from the existing $ 12 billion to $ 35 billion) and raise the inflow of investment by an equal measure (from $ 2.5 billion to $ 10 billion) in 5-10 years. As India enters the second generation of reforms, investments are expected to pour in and all is not dismal.
This is the unedited version of the article sent out in the monthly update. The list of acknowledgements and references were deleted by error while converting the document into the HTML format. Due acknowledgements and references have been made in the original version. I apologise for this error.
Copyright © 2000, Pooja Katna
Email me for list of acknowledgements and references