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Increasing FDI in India: Does the Budget go far enough?

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In Brief

India and China not only survived the financial crisis — over the course of the financial crisis their economies grew. This is the perfect time for India to attract much needed non-debt creating capital flows through foreign direct investment (FDI). The Indian Budget for 2010-11 has rightly proposed to simplify the FDI regime, maintaining FDI flows particularly by recognising ownership and control issues and liberalising the pricing and payment system for technology transfers, trademarks, and brand name and royalty payments. More importantly, the budget shows an intention to introduce user-friendly regulations and guidelines for FDI.

But while India is macro-economically well placed to attract FDI inflows, merely showing an intention to introduce user-friendly regulations without addressing the core regulatory, institutional and policy issues affecting FDI may not be enough to attract the huge amounts of FDI the country needs.

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Economic surveys in last few years confirm time and again the need for concrete reforms to improve the Indian investment and business climate. While the 2009 ‘Doing Business’ survey prepared by the World Bank showed that India’s indicators have gotten better, India still lags behind China overall. China beats India in crucial indicators such as: registering property, trading across borders, enforcing contracts and closing business (see the table below). In this context, the suggestion in the budget for simplified, user-friendly regulations and guidelines would be useful — provided that after the budget institutions are designed to enforce commercial contracts, in order to reassure investors. In fact, it was expected that the budget would not only demonstrate an intention to simplify FDI rules and regulations, but also propose a proper framework of action for achieving this.

India’s high trade and transaction costs are mainly due to the country’s lack of quality infrastructure. This lack of infrastructure discourages resource-seeking and export-oriented FDI to use India as their base as they do with China. China’s unmatched average growth rate of 10 per cent for more than a decade is due to consistent improvements in physical infrastructure. The 2010-11 Budget does focus on infrastructure development, allocating substantial general funds, which constitutes 46 per cent of the total plan allocation, and doubling plan allocation to power sector and improved allocation for renewable energy in particular. Moreover, some of the budget’s announcements—like allocating coal blocks for captive mining and a proposal to set up a Coal Regulatory Authority to ensure greater transparency—are welcome steps.

The public sector cannot cover the USD150 billion per annum required for the maintenance and creation of infrastructure. India invests around 5 to 6 per cent of GDP on infrastructure whereas China invests 14.4 per cent of GDP. The gap between infrastructure investments in China and India is widening not only as share of GDP, but also in absolute levels given that India’s GDP is only one third that of China. Hence, the private sector must participate substantially in infrastructure development in India. One way of improving the environment for infrastructure development is through public-private partnerships. These require a more stable and secure policy framework; particularly ensuring the protection of property rights and consistency in pricing and subsidy policies. Infrastructure projects need maximum clearances and approvals that sometimes run into innumerable disputes. Therefore, there should be an institutional mechanism for speedy dispute resolution. The politically acceptable cost-recovery based pricing is a must for attracting private investment into the infrastructure sector. Infrastructure projects are capital intensive. A special federal investment law should be formulated to consolidate the many sets of State laws, rules and regulations covering the infrastructure sector. Infrastructure also needs stable financing. Because of this the Rs 20,000 income tax exemption for investment on infrastructure bonds is a welcome step. But the government could do more by allowing financial intermediaries to invest in reasonably rated infrastructure projects and by giving a guarantee to use pension funds, insurance and FII’s to invest in infrastructure projects.

The Budget 2010 intends to simplify and introduce user-friendly regulations and guidelines for FDI but these are mostly at the central government level. However, actual implementation of projects will take place at the state level. Bureaucratic hassles, mainly at the state level, are obstacles to the realisation of FDI. Some of the major issues related to project implementation such as land acquisition, land use change, power connection, building plan approval are at the state level This division of political responsibility creates a delay in implementation. Therefore, a concerted effort is required for better co-ordination between the central and state governments on this issue. An institutional mechanism may be set up for getting clearances of FDI projects from both central and state governments within a stipulated time.

Another way of attracting FDI is by following the Chinese special economic zone (SEZ) model. This is large with state of the art infrastructure facilities and proper infrastructure connectivity to the market. To attract FDI SEZs in India should be designed as China’s are, with proper infrastructure connectivity to domestic and external markets. If necessary, the private sector should be encouraged to set up private airports and ports to service the SEZs through automatic routes and 100 per cent FDI equity. Since it’s hard to connect different kinds of transportation infrastructure in India, SEZs should be established in the coastal regions like in China to make transportation easier. The Budget 2010-11 should have addressed some of these measures to attract FDI much needed by the economy.

While foreign equity participation has increased in most sectors, there are still sectors where there is huge potential for FDI inflows. Further increases in FDI ceilings in sectors such as telecom, civil aviation, power generation, food retailing, insurance, banking, investing companies and the real estate sector will be required to achieve this potential. Most of these sectors need to be opened up further with independent regulatory systems to control market distortions and allow fair competition. Though the budget recognises the importance of ownership and control issues for FDI, no concrete steps have been announced or proposed.

The investment climate can be improved through increasing foreign and private ownership in different sectors, simplifying rules and regulations and developing independent regulatory bodies. But India can only succeed in actually creating a conducive business environment and getting more investment both from private and foreign investors if it focuses on providing quality physical infrastructure. This union budget has done the right thing by allocating USD37 billion for infrastructure upgrades in both rural and urban areas. However, mere allocation is not enough as infrastructure projects are complicated and actual outcomes are quite different from the proposals.

Private sector participation, both domestic and foreign, needs to be encouraged to enable infrastructure development. Though an emphasis on infrastructure development in the 2010-11 Budget would certainly help in achieving more FDI realisation, we also need to work on other important issues related to labour laws, centre-state coordination, better SEZ schemes and proper institutional mechanisms to attract more FDI in future. Foreign direct investment (FDI), which is vital to India’s growth, has lacked a proper policy document and has been administered primarily through a series of press notes over many years. According to the critics, the 177 existing press notes have created new areas of ambiguity while trying to resolve the existing ones. Doing away with the press notes approach will go a long way in making India’s FDI policy transparent and friendly to investors.

India is becoming increasingly attractive to foreign investors. The reforms proposed in this year’s Budget will simplify regulations and guidelines for FDI and make them more user-friendly, paving the way for a better investment climate and sustainable growth. But in India there is huge gap between proposals for reforms, and their implementation. Bipartisan cooperation will help to ensure that reforms are implemented, allowing India to attract FDI and progress toward double digit growth.

Pravakar Sahoo is Associate Professor, Institute of Economic Growth, Delhi.

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