The Hindu Business Line : FDI needs micro-micro reforms

Foreign Direct Investment enters a country only if it is competitive so that foreign firms can benefit from its presence. On the other hand, FDI is also expected to enhance a country's competitiveness. Reform of grassroots bureaucratic processes is one of the most important steps to be taken to make India competitive, says Sumit K. Majumdar.

ANALYSIS has shown that a strong relationship exists between foreign firms in India and the productive efficiency of industry as a whole.

Therefore, the notion that foreign firms' capabilities can spill over to other sectors of industry finds support in the overall data for Indian industry over five decades.

Past efforts to limit the presence of foreign firms in India was short-sighted, to say the least. Productivity benefits that would accrue to the economy from the presence of foreign firms were lost. Even more short-sighted was the extraordinary support given to encourage the growth of government firms in Indian industry. Their growing presence, perhaps, because of the crowding-out effect, has had a deleterious effect, as revealed by the strong long run negative relationship between the growth of government firms and productive efficiency for Indian industry as a whole for the same five decades.

Therefore, there can be no doubt that promoting the growth of foreign firms in India, via the encouragement of foreign direct investment (FDI), is a critical policy contingency. Foreign firms, relative to their domestic private and government counterparts, have a significant positive impact on India's industrial performance.

Yet, though the presence of foreign firms and FDI is growing in India, their relative proportion to the total number is small.

Nevertheless, the growth in the number of foreign firms in India has been large since 1991; it averaged 8.5 per cent for 1991-92 to 2001-02, but the growth since 1995-96 has been at over 10 per cent per year. Even the proportion of foreign firms to the total, while it has dropped from 1991-92 to 1996-97, shows a positive growth from 1997-98.

To be sure, some of this decline was due to the resurgence of private domestic entrepreneurial activity in India. Yet, the positive growth in the proportions after the mid-1990s portends an interest in India by the suppliers of foreign capital. So what is right and what is still not? The ambiguity and ambivalence displayed towards foreign investment, especially from the early 1970s, has been replaced by a change of spirit. Or has it? The first important property rights policy change was the automatic approval for foreign firms to hold 51 per cent ownership.

Only when foreign firms have 51 per cent ownership, do Indian companies display superior profitability. This is explained by the notion that superior performance is a function of the superior capabilities of foreign firms and which they are loath to transfer to India unless they hold majority ownership in Indian companies. Thus, the automatic availability of property rights affects the incentive of foreign firms to set up operations in India.

The second property rights-related change is the extension of automatic approvals for having ownership stakes of up to 74 per cent in all but a few sectors such as media and telecommunications. This happened in 1997. As a consequence, in 1997-98, the number of foreign firms operating in India grew by over 13 per cent, and it was in this year too that a positive growth in the proportion of foreign firms to the total was noted.

Thus, basic property rights changes have had significant effects on providing incentives for foreign firms to operate in India. Yet, policy pronouncements have to be consistent so that encouragement for entry is material.

There has also been a policy paradox, with unfortunate consequences. The various policy measures on liberalisation have been influenced by Indian entrepreneurs. During the period of the closed economy, they had virtual monopolies under the licensing system. Previously, the government had decided on the entry of foreign firms into India and the maximum shareholding they could hold.

Such discretion was taken away by allowing automatic entry; yet, the government managed to give the veto rights to the private sector on certain aspects of the entry of foreign firms into India by promulgating Press Note 18 in late 1998.

At the time the Note was promulgated, a coalition government was in power. One of the planks its constituents supported was swadeshi, an expression evoking a purely domestic industrial sector. A crisis of confidence among entrepreneurs could have arisen, since a large body of Indian firms had gotten used to operating within the parameters of a closed system in which there was no competition. As a result, there were pressures to have this note promulgated.

While this seems surprising given that private domestic firms were also being established in large numbers after 1991, it could have been a minority element in the ruling coalition that managed to have the note promulgated.

Conversely, the pro-protection lobby — the Bombay Group — could have been strong enough to have its ways implemented by appealing to the swadeshi lobby within the government, which would then have organised the issue of Press Note 18.

Nevertheless, the promulgation of this note has signalled significant inconsistencies on the part of the government, which simultaneously has sought to encourage foreign investment and then control its disposition.

According to Press Note 18, if foreign investors planning entry had a previous joint venture, technology transfer or trade mark agreement in the same or related field in India, they could not use the automatic route for a new joint venture or technology transfer agreement and would have to apply specifically for new investment in another enterprise.

Thus, further de novo enterprises could be set up but not additional collaborations. Second, the foreign investor or technology supplier would have to justify to the Foreign Investment Promotion Board how the new proposal would not jeopardise the interests of the existing joint venture, technology or trade mark partner.

The psychological implications of this pronouncement are quite profound. A signal that could quite easily have been sent is that the Indian partners were lacking confidence and, thus, wanted to retain control rights, using the government as a proxy to decide on how foreign firms could conduct their business strategies in India.

The Note is one that caused concern among foreign investors, as it put substantial powers in the hands of private sector industrialists, who already had relationships with foreign companies; they could effectively prevent foreign investors coming into India even if their own joint venture were not doing well.

It is difficult to speculate on the precise number of foreign companies that were scared away by this note, but given that India's annual FDI levels have been comparatively low, in financial terms, the number could be quite large.

The Note was repealed in early 2005, showing a recovery of nerve on part of the government.

Subsequent analysis and research can evaluate the impact of this Note on retarding FDI into India between 1999 and 2005. There is also circularity in the process of attracting FDI into a country. FDI enters a country only if that country is competitive, along some dimensions, so that the foreign firms can benefit from its presence in that country.

On the other hand, FDI is also expected to enhance a country's competitiveness.

The issue of competitiveness, however, raises a dilemma. India, while it ranks high on some extant FDI outlook, it fares low on the global competitiveness index.

In particular, what earns its opprobrium are the levels of bureaucracy that still exist within the system and the levels of corruption. Thus, a particular issue to be addressed is what steps are to be taken for India to be competitive to attract FDI?

A class system is not feasible. Unlike in China, where foreign firms are treated as first-class entities and enjoy several privileges that speed up the administrative processes involved in setting up operations, while domestic companies are treated as second-class entities, in India, all firms, whatever their nationalities, are treated equally. In fact, this neutrality greatly benefits the Indian environment.

The more important reforms still due in the economy are needed at the local administrative levels in the various States where projects are actually implemented. In doing so, there are several operational steps to be gone through.

While the role of the Centre is insignificant, that of the State governments becomes paramount. It is at the level of the States where the impact of the various bureaucratic processes is felt first hand, and where India has a significant disadvantage relative to China and other developing countries trying to attract FDI.

Reforms of grassroots bureaucratic processes are, therefore, one of the most important steps to be taken to make India competitive.

These are micro-micro reforms, and considerably harder to undertake than simply issuing a notification whereby an existing rule is altered.

Nevertheless, if these reforms are not put in place, India's ability to attract FDI will remain as limited as it is today.

(The author is Professor of Technology Strategy at the University of Texas at Dallas. He can be reached at majumdar@utdallas.edu)

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