Policy flip-flops keep out FDI

India's foreign direct investment (FDI) has recorded a sharp decline in FY-11. This is cause for serious concern, coming as it does after the strong inflows that expanded by a whopping 51 per cent compounded annually over the five years ending FY-10.

The decline is disconcerting for multiple reasons: One, the country's high current account deficit is left to be financed more by the volatile foreign portfolio investments; two, some of the fast-growing service sectors will be bereft of funds; and three, India is the lone South East Asian country to witness a decline in FDI flows.

The experience of FY-11 tells us that the mere easing of regulations governing FDI may not suffice to improve FDI flows.

‘HOT MONEY' PROBLEM

The RBI in a recent statement expressed its concern over increasing portfolio investments as against the more stable long-term FDI. This statement follows the widening gap between FDI inflows and portfolio flows for the 11 months ending February 2011. Over this period, FDI inflows to the country stood at $18.3 billion against portfolio flows of $31.4 billion – a 42 per cent gap between FDI and FII. Such a significant gap was last seen in FY06, after which revised FDI policies in key sectors resulted in a sudden surge in foreign direct money.

As portfolio investments are generally considered hot money and not sustainable, the RBI has been emphasising the need for quality capital flows to sustain the country's balance of payments situation over the medium term.

AUTOMATIC ROUTE DOWN

Increased liquidity in the Indian bourses and vibrant corporate performance can be cited as some of the reasons for higher portfolio flows into India. Leaving the gap between FDI and FII if we look at the decline in FDI flows in FY-11 , over a similar period the previous year, it was a good 30 per cent in dollar terms. Let us look at where the fall was pronounced. FDI flowing in to the country is classified broadly as: those coming through the automatic route which does not require approval of Central Government; two, money flowing through the Foreign Investment Promotion Board/Secretariat for Industrial Assistance (FIPB/SIA); and three through acquisition of existing shares of a domestic unit by a foreign player.

Among these, it is the all-easy automatic route which has been hit by the steep decline in fresh money in FY-11. Compared with the $19 billion received through the automatic route in FY-10, the country received $12.3 billion up to February FY-11. This decline is significant, as post 2003-04 money coming in through this route has been expanding at a fast pace and did not see a dip even in the sedate years of FY-09 and FY-10.

This appears to suggest that even in sectors/areas where FDI could have come without having to seek approvals, foreign investors may have deliberately withheld investments.

On the other hand, money through the acquisition of shares route made up for the above decline to some extent as its share increased to 23 per cent from 18 per cent in FY-10. Note that acquisition of shares such as Holderin Investments buying Ambuja Cements does not necessarily add to fresh economic activity. To this extent, the addition here may not be beneficial to GDP growth.

If money coming through the automatic route has declined it seems to suggest that simplified entry norms alone are not enough to attract FDI. There are other reasons for the decline.

GOVERNANCE HURDLES

Of the top 10 sectors that receive FDI flows, money going into housing and real estate as well as construction activities that include road and highways has more than halved, while that received by the telecom sector has fallen by 45 per cent. Significantly, the inflow into each of these sectors is lower than their 2008-09 figures.

On the other hand, metals, petroleum and natural gas and chemicals sectors saw increased inflows in FY-11. The decline in the first-mentioned sectors appears to suggest that uncertainties in domestic policy, scams and corporate governance — issues that have impacted these sectors — may have hit foreign investor interest.

Taxation issues in SEZs as well as the marked slowdown in infrastructure order flow are disturbing factors that could well have influenced investor decision.

There was a quantum jump in FDI from 2006-07; after revision of FDI policy in infrastructure, housing and townships in 2005 and enactment of the SEZ Act in 2006. Hence, while the entry route was made easy in these sectors, ushering a strong flow initially, lingering structural/policy issues could well have curtailed the flow.

POLICY UNCERTAINTY

The RBI had earlier attributed the FDI decline to the financial crisis in several European economies. However, the United Nations Conference on Trade and Development (UNCTAD) reports a strong FDI flows into Asia and Latin America in 2010.

The 21 per cent jump in FDI in Latin American countries and the 18 per cent increase in South, East and Southeast Asian nations defies the case for a slowing FDI flow into emerging markets. India is, in fact, the only South-east Asian nation to witness a sharp fall. Clearly, inflationary pressures and upward bound interest rates has not deterred FDI flow in to these nations.

This leads us to believe that FDI flows were affected by India-specific factors. Apart from easing FDI policies in other sectors, improved transparency, clear policies and better corporate governance can help revive these flows.

A hefty tax demand from Vodafone for a deal done ages ago and the uncertainty faced by Cairn India after concretely adding to the domestic product of the economy are embarrassments that could have been overcome with better policies.

The unorganised auctioning of spectrum, or the Income Tax Act suddenly overruling a law of the SEZ Act, could not have helped the investment climate either. With even smaller developing economies, including the likes of Chile, Mexico and Indonesia, vying for FDI with attractive policies, India should take care not to lose its share of the pie.

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