The Hindu Business Line : Foreign capital and open societies

Building an open and competitive capitalistic India may not be achieved by keeping capital markets open to foreigners. This is not the same as arguing that keeping them closed would achieve those results. That would be a perverse interpretation. The conclusion is familiar but is worthy of repetition: India has to be built by Indians, says V. Anantha Nageswaran.

WRITING in Financial Times (March 13) about the turn towards authoritarianism and intolerance that modern Russia under Mr Vladimir Putin had taken, Ms Chrystia Freeland felt the Russian President has less appetite for a rule-based economy in which every one prospers but more for an economy when every one is seen as getting by, by breaking the rule so that the state, in the guise of restoring law and order, could seize greater control of all economic activity. Others have voiced different concerns. Masha Lipman, writing for Washington Post (March 22), observes that the tendency to re-write history textbooks to omit inconvenient facts has resurfaced. She considers that an encroachment on personal freedom and predicts that it could be a huge hurdle on the way to modernisation.

What am I leading up to? Is this piece going to be a critique of Vladimir Putin's Russia? Hardly. If Mr Putin is an autocrat in the guise of a democrat, then he is in elite company. Largely, today's United States of America with a fearful, unquestioning and pliant press, finger printing of all foreigners, and detention without trial in Guantanomo Bay is not the beacon of democracy. Indeed, many in the US think that there is only one Opposition institution to the Republican Party and that is the economist Paul Krugman. This country's State Department had the gall to declare India a flawed democracy.

Anecdotal evidence suggests democracies deter FDI

In fact, it is possible to state that the only robust democracy in the world today is that of India. The media, if any, is obsessed with being anti-establishment. Constitutionally mandated institutions sometimes overzealously guard their independence and their responsibility to rein in the executive and the political wing of the government. The Election Commission is an obvious example. Issues are analysed ad nauseam and while there is a delay, the final consensus that emerges is durable. Foreign newspapers and their correspondents make innuendoes casting aspersions on the personal lives of top politicians without proof and they continue to carry out their trade with impunity even afterwards. On such occasions, one wishes India were less open and less tolerant.

Indeed, if India were less open and less tolerant of multiple interests, it probably would have drawn in more foreign direct investment (FDI), for research has established that foreign investment and democracy do not go together. Ms Freeland, in her article cited above, notes that many Western investors have sympathy for Putin. According to her, "Western fund managers have assiduously promoted the argument that a strong populist government, untroubled by the niceties of democracy, might be just what Russia needs to reform its economy further."

This is not entirely a surprise. Witness how much of Foreign Direct Investment (FDI) that an Indonesia in transition to a democracy receives compared to what it received under a more authoritarian regime until the mid-nineties? Alternatively, look at Thailand. It is still receiving net foreign investment inflows. However, it is far less compared to the foreign direct investment it received before a more populist and `Thailand first' premier was elected to office about four years ago.

The problem with such anecdotal observations is that they do not control for other factors. For instance, when we comment on the flow of FDI into South-East Asian nations, one cannot forget the role of Japanese FDI into these countries. As the yen strengthened throughout the 1980s and into the 1990s, Japanese corporations invested in manufacturing facilities in SE Asian nations, particularly Thailand. However, the Japanese economy and the corporate sector faced a prolonged period of stagnation in the 1990s. Profits shrank and hence investment activity was curtailed. Naturally, FDI outflows from Japan were lower. That it happened to coincide with the birth of nascent democracy and articulation of domestic priorities in S-E Asia might have been just that. A coincidence.

However, the issue is of considerable importance to India. Western commentary constantly refers to the $50 billion plus that China attracts and the $3 billion plus that India attracts in FDI. They steadfastly refuse to take into account statistical quirks that overstate Chinese inward FDI and Indian inward FDI. The real gap, according to one such analysis conducted in 2002 by Guy Pfeffermann of the International Finance Corporation, between the two is roughly $12 billion — $20 billion for China and $8 billion for India.

Hence, this issue of democracy and FDI deserves a more serious examination. Prof Adam Resnick of Western Washington University in Washington State, US, has dwelt at length on this topic not only in his doctoral dissertation but also in subsequent research papers. Formal analysis reaches a similar conclusion

In a private e-mail correspondence, Prof Adam Resnick suggested to the author that greater attention be paid to his two journal papers — one published in International Interactions in 2001 and the other in International Organisation in 2003. We focus on the results of the second journal article. In this paper, Prof Resnick and his co-author Quan Li suggest three avenues through which democratic systems affect FDI.

First, democratic constraints over elected politicians tend to weaken the oligopolistic or monopolistic positions of multinational corporations (MNCs). Second, these constraints further prevent host governments from offering generous financial and fiscal incentives to foreign investors. Third, broad access to elected officials and wide political participation offer institutionalised avenues through which indigenous businesses can seek protection. In each case, the increased pluralism ensured by democratic institutions generates policy outcomes that reduce the MNC's degree of freedom in the host developing country.

On the other hand, democratic institutions promote FDI inflows by strengthening property rights protection. The representation of the interests of common citizens in the legislature prevents the state from predatory rent-seeking. Constraints over elected politicians further guarantee contract enforcement for businesses. These effects generate credible property rights protection, reducing risks for foreign investors and encouraging foreign investment. Hence, the net effect of democratic institutions on FDI inflows to the developing countries is contingent upon the relative strength of these two competing forces.

Based on their empirical analysis of data for 53 countries during the period 1982 to 1995, the authors conclude that democratic transition that improves property rights protection boosts FDI but find that, after controlling for enhanced property rights, `democratic institutions reduce FDI inflows'.

`Democratic disadvantages' for investment could be offset

Admittedly, their research does not suggest that the chances of democracies attracting FDI are close to nil. However, what it does effectively is to raise questions about the paeans that are usually sung for FDI by its apologists. It does suggest that the often chaotic and arduous task of building democratic, representative and open societies does not really interest foreign investors. They would rather have their property rights protected and that is about as far as their interest is, in democratising their host societies.

Some might reckon that the author has done a disservice to the cause of reforming the Indian economy by writing this article. That is, Indians might reconcile or resign themselves to the fact of receiving less FDI than China because India is a democracy while the latter is not. Such complacency might prevent them from focussing on the improvements that the country could undertake on other areas that could mitigate the natural disadvantages that a democracy poses for a foreign investor who looks for above-normal returns. This is a genuine concern.

In a democracy, multiple interests find a voice and are heard and a foreign investor does not have the option of easily paying off government officials or colluding with local governments and businesses without running the risk of being exposed. Hence, higher transaction costs associated with operating in a democracy would deter them from choosing democracies to invest in, other things being equal. However, other things need not be equal. For example, India has a large reservoir of talent in the English language, the lingua franca of global business and in technical skills. That could be and is an important consideration. Further, if the Indian bureaucracy were less cumbersome, intrusive and arbitrary, foreign businesses would be willing to tolerate other transaction costs of operating in a democracy such as protests from local communities, environmentalists, a vigilant media, etc. Hence, democracy need not be an excuse for receiving scanty FDI.

Indeed, even local businesses would welcome such changes too. This author has always believed that governments should explore creating a favourable environment for investment in legitimate and sustainable economic activity. Then, foreign investment would automatically find its way into such a country.

India has to be built by Indians

The purpose of this note is to argue that, while democracy need not be a deterrent for FDI, it appears almost impossible to further the cause of a more open, competitive and democratic society through keeping capital markets open. Research appears to cast doubts on the hopes articulated by Ms Raghuram Rajan Luis Zingales in their book, Saving Capitalism from Capitalists that keeping capital markets open would save (democratic?) capitalism from capitalists. There is no cause and effect. Foreign capital is unlikely to be interested in a just and fair society in their host countries. If anything, the evidence suggests that they might favour the opposite!

Therefore, building an open and competitive capitalistic India might not be achieved by keeping capital markets open to foreigners. This is not the same as arguing that keeping them closed would achieve those results. That would be a perverse interpretation. The conclusion is familiar but is worthy of repetition: India has to be built by Indians. Hence, all Indians eligible to vote must cast their votes in the coming elections. India can be just, fair and prosperous if Indians demand it of their elected representatives and appointed bureaucrats.

(The author is Director, Global Economics and Asset Allocation, Credit Suisse, Singapore. The views are personal. Please address feedback to nageswar@singnet.com.sg)

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