India: Selected Issues
Author: International Monetary Fund
Publication Date:
10 Mar 2005
eISBN:
9781451818611
Language:
English
Keywords:
ISCR; CR; India; state; bank; FDI flow; FDI location; FDI regime; B. foreign direct investment regime; location of FDI; Business environment; Corporate taxes; Infrastructure; Global
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This Selected Issues paper paints a picture of the Indian economy that has made great strides, but has more to do to accelerate growth and reduce poverty. The paper assesses empirically whether India has entered a new phase of higher trend growth. Two alternative methodologies are used to disentangle underlying structural growth trends from shorter-term cyclical fluctuations around this trend. The paper focuses on a number of the reforms required to ensure that needed high growth can be achieved on a sustained basis.

Abstract

This Selected Issues paper paints a picture of the Indian economy that has made great strides, but has more to do to accelerate growth and reduce poverty. The paper assesses empirically whether India has entered a new phase of higher trend growth. Two alternative methodologies are used to disentangle underlying structural growth trends from shorter-term cyclical fluctuations around this trend. The paper focuses on a number of the reforms required to ensure that needed high growth can be achieved on a sustained basis.

III. Foreign Direct Investment In India: How Can It Be Increased?1

A. Introduction

1. Foreign Direct Investment (FDI) is favored over other capital flows by emerging markets. FDI is not debt creating, is less volatile than portfolio flows, and relatively resistant during financial crises (Albuquerque, 2003). FDI has also been associated with positive spillovers through technology transfer and training to local industry (Blomstrom and Kokko, 2003), and may lead to enhanced export performance and growth (Borzenstein, DeGregario, and Lee, 1998).

Table III. 1.

Foreign Direct Investment in Selected Countries, 2002

article image
Source: World Development Indicators.
Figure III.1
Figure III.1

Foreign Direct Investment as a Percent of GDP for Selected Asian Economies

(1980–2002)

Citation: IMF Staff Country Reports 2005, 087; 10.5089/9781451818611.002.A003

2. FDI flows into India have risen since the 1990s but remain low, compared to other emerging markets (Table III.1),(Figure III.1).2 In 2002 India received FDI inflows of less than 1 percent of GDP whereas China received FDI worth 3.7 percent of GDP. In dollar terms, China received 15 times the FDI than India in 2002.

3. At the same time, investor surveys point to a strong interest in India as a destination for FDI. Surveys by UNCTAD and AT Kearney in 2004 place India as the second and third most attractive destinations for FDI respectively. This indicates that while India is on investors’ radar screens, the interest has not yet translated into actual FDI.

4. The bullishness regarding India implies that further reform could have a significant impact. Recently a number of steps have been taken to simplify and liberalize the FDI regime in India. In 2004, the FDI caps on civil aviation and petroleum subsectors, among others, were raised. The transfer of equity shares between residents and non-residents does not now require approval.

5. 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.

B. Foreign Direct Investment Regime in India

6. 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 The pre-1991 policy considered all FDI proposals 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 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 (FIPB). 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 III.2).5

Table III.2.

Sectoral Caps and Controls on Foreign Direct Investment in India

article image

C. FDI Inflows into Selected Countries: Is India an Outlier?

7. 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.6 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.7 The Global Competitiveness Report 2004, based on investor surveys, lists key constraints to doing business in India (Figure III.2).

Figure III.2.
Figure III.2.

India: The Most Problematic Factors for Doing Business

Citation: IMF Staff Country Reports 2005, 087; 10.5089/9781451818611.002.A003

Source: World Economic Forum, Global Competitiveness Report 2004.

8. The investment climate in other emerging markets in Asia appears to be more conducive to attracting FDI inflows(Table III.3). Compared to selected Asian countries, India’s overall infrastructure quality ranks low (Global Competitiveness Report 2004). 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, whereas for the sample average is 43 days. The enforcement of contracts takes longer in India (425 days) than average (286 days). Also, once in business, firms find it difficult to exit.8

9. We estimate the following reduced form equation using a fixed effects model:

FDIi,t/GDPi,t=αi+βXi,t+εi,t

where, αi is the country specific effect, 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 III.3) are not included in the panel due to insufficient data. The variables used here include the marginal statutory corporate tax rate, proxy for infrastructure development (the number of telephone lines per 1000 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, corruption). These variables are highly correlated and are therefore included in the regressions one at a time to avoid multicollinearity. To check for robustness, we also include alternative measures of institutional quality.

Table III.3.

Snapshot of the Investment Climate in Selected Asian Countries

article image
Sources: World Development Indicators, World Bank Governance Database, Global Competitiveness Report 2004. World Bank Doing Business Database 2004.

Higher values correspond to better outcomes.

Methodology: Protection against dismissal is measured by the 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, if the employer must provide retraining before dismissal among other factors.

A higher rank implies a better outcome.

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 govvernment on changes in policies and regulations.

10. 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 III.4).10 While the results are sensitive to the specification, they are nevertheless indicative of the potential for a large response of FDI to reforms:

Table III.4.

Results of the Panel Estimation of the Determinants of Foreign Direct Investment 1/

article image

Absolute value of z statistics in parentheses; + significant at 10 percent; * significant at 5 percent; ** significant at 1percent.

  • A decrease in India’s marginal corporate tax rate to that of China would increase FDI by one percentage point of GDP.

  • An increase in trade openness in India to China’s level would garner another 0.6 percentage points of GDP.

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

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

11. 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 III.3) as in downturns it is exceedingly difficult to fire workers (Figure III.3). Correlation between the labor market flexibility and FDI across countries suggests that countries with inflexible labor markets receive less FDI (Figure III.4).12

Figure III.3.
Figure III.3.

Labor Market Flexibility: Difficulty in Firing Index

Citation: IMF Staff Country Reports 2005, 087; 10.5089/9781451818611.002.A003

Source: World Bank, Doing Business Database.
Figure III.4.
Figure III.4.

FDI and Labor Market Flexibility

Citation: IMF Staff Country Reports 2005, 087; 10.5089/9781451818611.002.A003

D. Indian States: Differences in Investment Climate and FDI

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

Figure III.5.
Figure III.5.

India: FDI Flows by State, 2000–2003

Citation: IMF Staff Country Reports 2005, 087; 10.5089/9781451818611.002.A003

Source: Ministry of Finance.
Table III.5.

Approvals and Inflows of Foreign Direct Investment into Indian States

article image
Sources: Ministry of Finance; and CEIC Asia Database.

13. Investor surveys of business climate are consistent with the observed patterns of FDI flows. A survey of foreign investors (FICCI, 2002) puts Maharasthra in the clear lead in terms of investor perception. In the 2002 CII-World Bank survey of investment climate of Indian states, Maharasthra and Gujarat are classified as the best investment climate (IC) states while Kerala, West Bengal and Uttar Pradesh are classified as poor IC 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.

14. 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 the most man-days lost due to strikes fare worse in terms of FDI inflow (Figure III.6).15 There is some evidence that infrastructure is also a determinant of FDI location. Specifically, states with higher teledensity attract more FDI 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 III.7).

Figure III.6.
Figure III.6.

Indian States: FDI and Infrastructure and Labor Markets

Citation: IMF Staff Country Reports 2005, 087; 10.5089/9781451818611.002.A003

Figure III.7.
Figure III.7.

Indian States: FDI Inflow and the Burden of Regulation

Citation: IMF Staff Country Reports 2005, 087; 10.5089/9781451818611.002.A003

15. 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 to 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, refunds and fiscal incentives for specific industries such as information technology, biotechnology and BPOs. 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.

E. Conclusion

16. 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 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 reform to drastically increase FDI inflows.

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1

Prepared by Sonali Jain-Chandra.

2

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

3

India ranks 41st of 102 countries in terms of the restrictiveness of foreign ownership (Global Competitiveness Report 2003-04). Most other emerging markets fare worse: China (81), Indonesia (95), Korea (68), Malaysia (67), Philippines (83), Thailand (75), Vietnam (84), Brazil (42), while Mexico fares better with a rank of 26.

4

For the acquisition of existing Indian companies (with an equity expansion), approval is required if the following conditions are not met: (i) the equity level of the company should increase without the acquisition of shares by foreign investors, (ii) funds should be in foreign exchange, and (iii) the sector should be under the automatic route.

5

FDI is not permitted in retail trading, lottery business, gambling and betting, housing and real estate business, and agriculture and plantation.

7

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

8

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

9

Data sources include World Development Indicators, the IMF’s International Financial Statistics, RBI Annual Reports, OECD FDI database, World Investment Report, World Bank Governance Database (Kaufmann, 2004), and PRS Groups’ International Country Risk Guide. The countries in the sample are the ones listed in Table III.1. The estimation is done using an unbalanced panel from 1980–2002.

10

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

11

However, for emerging markets data on labor costs are generally not available over time for a number of countries and therefore not included in the above regression.

12

Javorick and Spatareanu (2004) also find that, for a sample of 25 European countries, increased labor market flexibility is associated with larger FDI inflows.

13

This analysis includes data for only 2 years, and it is possible that it takes longer for approved FDI to translate into realized inflows.

14

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

15

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), the best investment climate (IC) states in India have on average 11.9 percent of over staffing, while this number rises to 15.5 percent in poor IC states.

16

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; FIAS, 1999; IMF, 2003; Tanzi and Shome, 1992; UNCTAD, 2004). In fact, Lim (1983) finds a negative relationship between incentives and investment, as the latter compensate for an otherwise unfavorable business climate. A survey of ASEAN firms also shows that the removal of incentives will not have a great impact on investment decisions (Mirza et. al, 1996).

Same Series

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Cover IMF Staff Country Reports
India: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 2005: Issue 087
Publisher:
International Monetary Fund
ISBN:
9781451818611
ISSN:
1934-7685
Pages:
77
DOI:
https://doi.org/10.5089/9781451818611.002

Foreign Direct Investment as a Percent of GDP for Selected Asian Economies

(1980–2002)

India: The Most Problematic Factors for Doing Business

Labor Market Flexibility: Difficulty in Firing Index

FDI and Labor Market Flexibility

India: FDI Flows by State, 2000–2003

Indian States: FDI and Infrastructure and Labor Markets

Indian States: FDI Inflow and the Burden of Regulation