Chapter

5 How Can India Attract More Foreign Direct Investment?

Author(s):
Catriona Purfield, and Jerald Schiff
Published Date:
August 2006
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Author(s)
Sonali Jain-Chandra

Foreign direct investment (FDI) is favored over other capital flows by emerging market countries. FDI is not debt creating, is less volatile than portfolio flows, and is relatively resistant during financial crises (Albuquerque, 2003). FDI has also been associated with positive spillovers through technology transfer and training to local industry (Blomström and Kokko, 2003), and may lead to enhanced export performance and growth (Borensztein and others, 1998).

FDI flows into India have risen since the 1990s but remain low, compared with other emerging market countries (Table 5.1).1 Starting at similar magnitudes (relative to GDP) of inflows in the early 1990s, FDI into China has taken off, while FDI into India has trickled in. In 2004 India received FDI inflows of around 0.5 percent of GDP, whereas China received FDI worth 3.2 percent of GDP. In dollar terms, China received 16 times the FDI than India in 2004.

Table 5.1.Foreign Direct Investment in Selected Countries, 2004
Net Foreign Direct Investment
In percent of GDPIn billions of U.S. dollars
Chile7.16.7
Vietnam5.32.3
Singapore5.05.4
China3.253.1
Argentina2.63.9
Malaysia2.22.6
Mexico2.114.1
Venezuela1.71.9
Sri Lanka1.50.3
Brazil1.48.7
Pakistan0.90.9
Bangladesh0.70.4
India0.53.4
Korea0.53.4
Nepal0.50.0
Indonesia0.41.1
Thailand0.40.7
Philippines0.10.1
Source: IMF, World Economic Outlook.

At the same time, investor surveys point to a strong interest in India as a destination for FDI. Investor surveys by the United Nations Conference on Trade and Development (UNCTAD) and A.T. Kearney in 2004 and 2005 place India as the second most attractive destination for FDI.2 This indicates that while India is on investors’ radar screens, the interest has not yet translated into actual FDI inflows. The A.T. Kearney (2005) survey finds that investors expect India’s attractiveness to increase as the government maintains focus on reforms and removes the infrastructure and regulatory barriers.

This chapter studies the reasons for the underperformance of FDI in India and examines potential measures to enhance it. Utilizing panel data for a number of emerging market countries, the chapter concludes that the most important factors affecting FDI are not FDI-specific policies but, rather, broader economic policies including corporate taxes, trade openness, and other business climate issues, such as regulatory quality and burden. This chapter also looks at differences across Indian states in attracting FDI and concludes that broad business climate issues largely determine FDI location.

Foreign Direct Investment Regime in India

India’s regulatory regime for FDI has been gradually liberalized since 1991, and, as a result, the regime is no longer particularly restrictive by international standards.3 Before 1991 all FDI proposals were considered on a case-by-case basis with FDI capped at 40 percent of total equity investment. In 1991, the policy was amended to allow automatic approval of up to 51 percent ownership in 34 sectors. This list was expanded to cover 111 sectors in 1997. In 2000, the policy was altered to one using a “negative list” approach. Since then, 100 percent FDI is permitted in most sectors via the automatic route, with the requirement that the Reserve Bank of India (RBI) be notified within 30 days. There are important exceptions to this general policy for which FDI approvals are routed through the Foreign Investment Promotion Board. These exceptions include industries subject to licensing, the acquisition of an existing Indian company under certain conditions,4 industries where the foreign investor has a presence in the same field, and industries where sectoral policies apply (Table 5.2). FDI is not permitted in retail trading, lottery business, gambling and betting, atomic energy, and agriculture and plantation.

Table 5.2.Sectoral Caps and Controls on Foreign Direct Investment in India, 2004
SectorCapControls
Private sector banking74Subject to Reserve Bank of India (RBI) guidelines. The cap is applicable only to private sector banks that are identified by RBI for restructuring.
Nonbanking financial companies (NBFCs)100Various minimum capitalization norms for fund-based NBFCs.
Insurance26Automatic route available, subject to obtaining license from the regulatory body. 2004/05 budget proposed raising it to 49 percent; however, this is not yet operational.
Airports74/10074 percent foreign direct investment (FDI) under automatic route. Government approval required for FDI beyond it.
Domestic airlines49Automatic route available. Foreign equity participation up to 49 percent and investment by expatriate Indians up to 100 percent. Subject to no direct or indirect equity participation by foreign airlines.
TelecommunicationsRestrictions include licensing, FDI beyond 49 percent needs approval from Foreign Investment Promotion Board (FIPB), and divestiture of 26 percent in five years.
74For basic, cellular, value-added services, and global mobile personal communications by satellite, subject to licensing and security requirements, and a lock in period for transfer of equity.
100For e-mail, voice mail, Internet service providers (ISPs) not providing gateways.
74For ISPs with gateways, radio-paging and end-to-end bandwidth. FDI beyond 49 percent requires government approval.
Petroleum (refining)26Cap applies to public sector units. Automatic route not available.
100Cap applies to private Indian companies. Automatic route available.
Petroleum (other than refining)100Automatic route available. FDI of 100 percent is possible in oil exploration in small and medium-sized fields, petroleum product marketing, and natural gas/liquefied petroleum gas (approval required).
Housing and real estate100Automatic route available. Applies to townships, housing, built up infrastructure, and construction-based development projects.
Coal and lignite100For most activities in this sector.
74For coal exploration or mining. Other restrictions apply.
Venture capitalRequires RBI approval. Subject to regulations under the Foreign Exchange Management Act.
Trading51Automatic route available. Meant for export activities.
Atomic minerals74For subsectors, mining, separation, value addition, and integrated activities.
Defense and strategic industries26Automatic route not available. Subject to licensing and security requirements.
Agriculture0No FDI is permitted.
100Tea, including tea plantations. Restrictions apply, including approval from government, divestiture of 26 percent in five years, and approval in case of change in land use.
Print media100FDI allowed in publishing and printing scientific and technical magazines, periodicals, and journals.
26In newspapers and periodicals dealing with current events, subject to editorial control by Indian residents.
Broadcasting100In television software production.
49In cable networks, direct to home (including both FDI and foreign institutional investors).
Mining74Automatic route available in the exploration and mining of diamonds and precious stones.
100Automatic route available in the exploration and mining of gold, silver, and other metals.
Postal services100FDI of 100 percent in courier services, with prior approval. No FDI allowed in the distribution of letters.
Establishment and operation of satellites74Automatic route not available.
Source: Ministry of Commerce and Industry, Department of Industrial Policy and Promotion.

FDI Inflows: Is India an Outlier?

As India’s FDI regime is relatively unrestrictive, the key question is what other factors could explain the underperformance of FDI. Some papers emphasize macroeconomic stability and openness, while others the quality of institutions.5 The standard determinants of FDI include labor market conditions, the quality of infrastructure, corporate taxation, inflation, trade openness, market size, corruption and administrative procedures, and bottlenecks. Existing qualitative work on India emphasizes factors limiting FDI, such as relatively high tariffs and limited scale of export processing zones, stringent labor laws, high corporate tax rates, exit barriers, a restrictive FDI regime, and the lack of transparent sectoral policies for FDI.6 The Global Competitiveness Report 2005–06, based on investor surveys, lists key constraints to doing business in India (Figure 5.1). A.T. Kearney (2004) notes that investors favor China over India, citing as factors market size, access to export markets, government incentives, favorable cost structures, infrastructure, political stability, and the macroeconomic climate. India’s potential attractiveness stems from its highly educated work force, management talent, rule of law, and transparency.7

Figure 5.1.India: The Most Problematic Factors for Doing Business1

(In percent of responses)

Source: World Economic Forum (2005).

1 From a list of 14 factors, respondants were asked to select the 5 most problematic for doing business and rank them between 1 (most problematic) and 5. The bars in the figure show the responses weighted according to their rankings.

Despite being one of the fastest growing economies, the investment climate in other emerging markets in Asia appears to be more conducive to attracting FDI inflows (Table 5.3). Compared to selected Asian countries, India’s overall infrastructure quality ranks low (World Economic Forum, 2005). The significant burden of bureaucratic red tape and regulation in India further worsens the investment climate. For instance, it takes 89 days to start a business in India, more than double the time required to start up in China. The enforcement of contracts takes longer in India (425 days) than the average in the sample. Also, once in business, firms find it difficult to exit.8 Labor market rigidities are especially onerous in India.

Table 5.3.Snapshot of the Investment Climate in Selected Emerging Market Countries
IndiaChinaIndonesiaKoreaMalaysiaThailand
Macroeconomic environment
GDP per capita (constant 2000 U.S. dollar, 2004)538.41,161.5906.212,742.54,220.62,399.4
GDP growth (2005 proj.)7.49.06.03.85.53.5
Gross capital formation
(current U.S. dollar, 2003)138.3627.042.0177.922.235.8
Inflation (2005 proj.)3.93.08.12.93.04.2
Openness (trade in goods as a percent of GDP, 2004)32.679.457.766.1221.0124.6
Current account (percent of GDP, 2005 proj.)−2.56.11.21.913.5−2.5
International reserves (billion U.S. dollar, 2004)131.2618.636.3199.066.749.8
Governance indicators (2004)1
Voice and accountability0.3−1.5−0.40.7−0.40.2
Political stability−0.8−0.1−1.40.50.4−0.1
Government effectiveness0.00.1−0.40.91.00.4
Regulatory quality−0.6−0.5−0.40.70.40.0
Rule of law−0.1−0.5−0.90.70.5−0.1
Control of corruption−0.1−0.5−1.20.20.3−0.3
Infrastructure
Overall infrastructure quality
(rank out of 117 countries)278.069.066.023.014.033.0
Electric power consumption
(kwh per capita, 2002)379.8987.1411.06,171.12,831.81,625.8
Internet users (per 1,000 people, 2003)17.563.237.6609.7344.1110.5
Roads, paved (percent of total roads, 1999)45.791.057.174.575.897.5
Telephone main lines (per 1,000 people, 2003)46.3209.039.4538.3181.6104.9
Bureaucratic red tape and corporate taxation
Number of start-up procedures to register a business (2004)1112121298
Time to start a business
(days, 2004)8941151223033
Time to enforce a contract
(days, 2004)42524157075300390
Time to exit a business (years, 2004)1026223
Protection against dismissal30.90.30.70.30.00.3
Efficiency of legal framework
(rank out of 117)2,4305773381636
Burden of government regulation
(rank out of 117)276304514311
Transparency of government policymaking (rank out of 102)2,5413364251431
Efficiency of the tax system
(rank out of 117)255513546820
Highest marginal tax rate, corporate
rate (percent, 2004)6363030272830
Difficulty in firing index (2004)904070301020
Hiring and firing practices
(rank out of 117)2,71112667414338
Sources: World Bank, World Development Indicators, World Bank Governance Database, and World Bank Doing Business Database 2004; World Economic Forum, Global Competitiveness Report 2005–06; and Botero and others (2003).

Higher values correspond to better outcomes.

A higher rank implies a better outcome.

Methodology: Among other factors, protection against dismissal is measured by taking into account whether an employer has to notify a third party before firing one worker, whether the employer needs the approval of the third party, and if the employer must provide retraining before dismissal.

Defined as the legal framework for private businesses to settle disputes and challenge the legality of government actions and/or regulations.

Defined as to what extent firms are usually informed clearly and transparently by the government on changes in policies and regulations.

2002 data for China.

Hiring and firing workers is impeded by regulations or is flexibly determined by employers.

To examine the potential obstacles to FDI more formally, we estimate the following reduced form equation using a fixed effects model:

where αi is the country-specific effect and the matrix Xi, t contains the lagged independent variables (to alleviate the simultaneity bias), including standard determinants of FDI and institutional quality variables.9 All indicators used in Table 5.3 cannot be included simultaneously in the panel because of insufficient data. However, the core variables included in each specification are the marginal statutory corporate tax rate, a proxy for infrastructure development (the number of telephone lines per 1,000 inhabitants), inflation, and openness (trade as a percent of GDP). Institutional quality is measured by the World Bank governance indicators (voice and accountability, political instability, government effectiveness, regulatory burden, rule of law, and corruption). As these variables are highly correlated, they are sequentially included in the regressions to avoid multicollinearity. To check for robustness, we also include alternative measures of institutional quality.

We find that marginal corporate tax rates, trade openness, and institutional factors, and, to some extent, the quality of infrastructure are significant determinants of FDI (Table 5.4).10 While the results are sensitive to the specification, they are nevertheless indicative of the potential for the large response of FDI to reforms. Assuming that India’s response to a policy change is the same as the average country in the sample:

  • A decrease in the marginal corporate tax rate in India from the current rates to that of China would increase FDI by 1 percentage point of GDP. (For details on investor friendly tax policy, see Chapter 9.)

  • An increase in trade openness in India to China’s level would garner another 0.6 percentage points of GDP in FDI. The benefits from further trade liberalization are examined in detail in Chapter 3.

  • Improving regulatory quality in India to the level of Thailand would add another percentage point of GDP in FDI inflows.

  • If India halves the number of days needed to start a business or halves the years needed to resolve insolvency, FDI could rise by 0.7 percentage points and 1.4 percentage points of GDP, respectively.

Labor market flexibility also appears to be an important factor determining FDI, and India has a relatively inflexible labor market.11 Protection against dismissal is stringent in India (Table 5.3) as in downturns it is exceedingly difficult to fire workers. Correlation between the labor market flexibility and FDI across countries suggests that countries with inflexible labor markets receive less FDI.12

How Do FDI Inflows and the Business Climate Vary Across Indian States?

FDI has been concentrated in a few Indian states. During 2000–03, 5 out of 29 rapidly growing states received 60–70 percent of FDI inflows into India: Andhra Pradesh, Delhi, Karnataka, Maharashtra, and Tamil Nadu. Even among these states, there is considerable heterogeneity. Maharashtra received more than ten times the amount of FDI per capita than Andhra Pradesh in 2000 (Table 5.5). It is also these very states that are most successful in converting FDI approvals into actual inflows.13

Table 5.4.Results of the Panel Estimation of the Determinants of Foreign Direct Investment1
Openness0.0220.025
(2.94)*(3.60)*
Corporate tax−0.176−0.157−0.172−0.062−0.067−0.101−0.082−0.033−0.176−0.195−0.179−0.158−0.191−0.181−0.191
(2.27)**(2.22)**(2.07)**−0.88−0.9−1.25−1.01−0.43(1.87)***(2.08)**(1.95)***(1.74)**(2.24)***(2.26)**(2.24)**
Inflation−0.033−0.036−0.0160.0310.0270.0030.030.013−0.02−0.025−0.03−0.024−0.0130.018−0.013
-0.88−1−0.49−1.04−0.88−0.09−0.98−0.42−0.55−0.67−0.8−0.64−0.34−0.47−0.34
Telecommunications18.40210.8056.3796.0676.3379.3079.4613.2936.256.0567.8272.5062.1152.506
(1.91)**−1.18−0.79−0.72−0.7−1.1−1.13−0.3−0.57−0.55−0.74−0.23−0.21−0.23
Voice and accountability−1.096
-1.41
Government stability0.521
(2.58)*
0.521
(2.58)*
Law and order1.278
(3.55)*
Corruption0.786
(1.90)**
Days to start-up−0.015
(1.73)***
Years to resolve insolvency−0.25
(1.83)***
Days to enforce a contract−0.006
(2.12)**
Corruption2.016
(3.41)*
Rule of law1.993
(2.99)*
Regulatory quality1.45
(2.21)**
Government effectiveness2.188
(3.42)*
Political stability2.145
(3.98)*
Constant7.0755.4947.6624.4134.0085.244.6013.5198.939.2928.8965.7544.0793.7874.079
(2.90)*(2.33)**(2.95)*(2.02)**(1.68)***(2.04)**(1.81)****−1.46(3.03)*(3.15)*(3.10)*(1.85)***−1.3−1.35−1.3
Source: Author’s calculations.

Absolute value of z-statistics in parentheses. ***, **, and * indicate significance at 10 percent, 5 percent, and 1 percent levels, respectively.

Table 5.5.Approvals and Inflows of Foreign Direct Investment (FDI) into Indian States and Territories
FDI Inflows
(2000–02)
(In billions of rupees)
FDI Approvals
(2000–02)
(In billions of rupees)
FDI/State DomesticFDI/
RealizationProductPopulation
Ratio200020012000
Andhra Pradesh8.817.051.90.20.33.3
Assam0.10.00.00.00.0
Bihar0.00.35.00.00.00.0
Gujarat4.324.217.70.00.10.6
Haryana0.06.70.00.00.00.0
Himachal Pradesh0.08.10.00.00.00.0
Karnataka27.942.865.10.61.311.0
Kerala1.87.224.70.10.11.7
Madhya Pradesh0.24.05.60.00.00.1
Maharashtra114.4103.0111.01.71.237.0
Meghalaya0.00.00.00.00.0
Orissa0.02.40.00.00.00.0
Punjab0.00.40.00.00.00.0
Rajasthan0.15.61.50.00.00.0
Tamil Nadu26.461.942.60.40.68.9
Uttar Pradesh0.011.20.0−0.10.0−1.2
West Bengal2.312.518.60.20.02.9
Chattisgarh0.00.20.00.00.00.0
Chandigarh10.10.52,003.64.00.1181.2
Dadra and Nagar Haveli0.00.0500.00.9
Delhi123.763.5194.74.7178.3
Goa1.94.741.022.8
Pondicherry3.08.535.30.08.80.0
Sources: Ministry of Finance; and CEIC Asia database.

Investor surveys of business climate are consistent with the observed patterns of FDI flows. A survey of foreign investors (Federation of Indian Chambers of Commerce and Industry, 2004) puts Maharashtra in the clear lead in terms of investor perception. In the survey of investment climate of Indian states by the Confederation of Indian Industry and World Bank (2002), Maharashtra and Gujarat are classified as the best investment climate states while Kerala, West Bengal, and Uttar Pradesh are classified as poor investment climate states. While the perceptions of business climate in states are appropriately correlated with the inflows of FDI, there are outliers. For example, Delhi gets much more FDI than would be indicated by an assessment of its business climate, probably reflecting its role as India’s capital.

Differences in FDI appear to be explained by differences in the functioning of labor markets, regulatory burden, and infrastructure quality.14 Labor market flexibility appears to be important in determining FDI as states with poor labor market indicators (such as the most person-days lost due to strikes) fare worse in terms of FDI inflows (Figure 5.2).15 There is some evidence that infrastructure is also a determinant of FDI location. Specifically, states with a higher density of telephone lines attract more FDI (Figure 5.2). Finally, the burden of regulation also influences the location of FDI. States where it takes longer to enforce contracts and clear customs are also states with lower FDI (Figure 5.3).

Figure 5.2.Indian States: Foreign Direct Investment (FDI) and Infrastructure and Labor Markets

(In percent of responses)

Sources: Ministry of Finance; Indiastat; CEIC Asia database.

Figure 5.3.Indian States: Foreign Direct Investment (FDI) Inflow and the Burden of Regulation

Source: IMF staff calculations.

State-specific policies and incentives to attract FDI are not a substitute for improving the overall business climate. The federal structure in India empowers the states to design their own investment policies to attract FDI, along with instituting specific incentives for certain sectors. A one-stop clearance window is now available in most states for investors to meet all regulatory requirements and obtain all approvals. In addition, some states have offered tax concessions, capital and interest subsidies, and reductions in power tariffs. For instance, Karnataka has been aggressive in attracting FDI and has outlined a series of policies, such as investment subsidies, exemptions for export-oriented units, and refunds and fiscal incentives for specific industries such as information technology, biotechnology, and business process outsourcing. While incentives make it easier to conduct business, they are unlikely to be the main determinant of the location of FDI.16 This is borne out by the experience of states such as Haryana, Himachal Pradesh, and West Bengal, which offer incentives, but attract little FDI.

Conclusions

The most important factors influencing FDI into India are not FDI-specific policies but, rather, broader economic policies including corporate taxes, trade openness, and other business climate issues, such as regulatory quality and burden. India has made considerable progress in liberalizing its FDI regime, which is a necessary but not a sufficient condition to attract significant FDI inflows. The differences across Indian states in attracting FDI further underscore the importance of the business climate in determining FDI rather than FDI-specific incentives. With the current international attention on India’s tremendous potential for FDI, it would be an opportune time to push for rapid progress on structural reforms to drastically increase FDI inflows.

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The Indian authorities revised the FDI data to conform to international standards by including reinvested earnings. The data used here are the revised FDI data net of outflows.

India is perceived as a future “hot spot” for FDI, second only to China, according to the United Nations Conference on Trade and Development (2004). This finding relies on available relevant leading macroeconomic and microeconomic indicators influencing future FDI flows, as well as the findings of the three UNCTAD global surveys.

India ranks 26th of 117 countries in terms of the “impact of rules on FDI” (see World Economic Forum, 2005). A lower rank is better. Most other emerging market countries fare more poorly: Thailand (39), Mexico (51), Indonesia (66), China (68), the Philippines (79), Brazil (80), and Poland (81). In the same survey, India ranks 36th of 117 countries in terms of the restrictiveness of foreign ownership. Most other emerging market countries again fare more poorly: Malaysia (37), Mexico (42), Korea (61), Thailand (66), Indonesia (69), Brazil (70), China (80), and the Philippines (107).

For the acquisition of shares in an existing Indian company in the financial services sector and where the rules of the Securities and Exchange Board of India apply.

See Bajpai and Sachs (2000). Progress in the liberalization of the FDI regime has taken place since this paper was written.

A.T. Kearney surveys highlight the different perceptions about China and India, with China as a leading manufacturer and the fastest growing consumer market and India as the world’s business process and information technology provider with longer-term market potential.

Gorg (2002) examines U.S. investment in 33 countries to conclude that exit costs are more important than incentives to attract FDI.

Data sources include the World Bank’s World Development Indicators, the IMF’s International Financial Statistics, RBI Annual Reports, the FDI database of the Organization for Economic Cooperation and Development, the World Investment Report, the World Bank Governance Database (Kaufmann and others, 2004), and Political Risk Services (PRS) Group’s International Country Risk Guide. The countries in the sample are the ones listed in Table 5.1. The estimation is done using an unbalanced panel from 1980 to 2002.

Regressions using the between panel estimator conclude that the quality of infrastructure is a determinant of FDI.

However, for emerging market countries time-series data on labor market indicators are generally not available and therefore they are not included in the regression analysis.

Javorcik and Spatareanu (2004) also find that, for a sample of 25 European countries, increased labor market flexibility is associated with larger FDI inflows. For a sample of 11 emerging market countries, the correlation between FDI as a share of GDP and the World Bank’s “difficulty of firing index” is -0.52.

This analysis includes data for only a few years, and it is possible that it takes longer for approved FDI to translate into realized inflows.

The absence of consistent time-series data for Indian states precludes a rigorous econometric investigation.

While there are national labor laws, states do have the power to amend national legislation. According to an assessment of the investment climate by the World Bank (2002), Indian states with the best investment climate have on average 11.9 percent of overstaffing, while this number rises to 15.5 percent in states having a poor investment climate.

Most studies conclude that tax incentives neither affect significantly the amount of direct investment nor usually determine the location to which investment is drawn (Wells and Allen, 2001; Chang and Cheng, 1992; Foreign Investment Advisory Service, 1999; International Monetary Fund, 2003; Tanzi and Shome, 1992; and United Nations Conference on Trade and Development, 2004). In fact, Lim (1983) finds a negative relationship between incentives and investment, as the latter compensates for an otherwise unfavorable business climate. A survey of firms in member countries of the Association of South East Asian Nations shows that the removal of incentives will not have a great impact on investment decisions (Mirza and others, 1997).

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