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Date: March-August 2011

ISSN: 2231-4539

Rahul Singh
Asstt. Professor, School of Business Management Indus International University,una(H.P)

Foreign Direct Investment in India Opportunities and Challenges

Abstract With the advent of globalization, developing countries, particularly those in Asia, have been witnessing a massive surge of FDI inflows during the past two decades. Even though India has been a latecomer to the FDI scene compared to other East Asian countries, its significant market potential and a liberalized policy regime has sustained its attraction as a favorable destination for foreign investors. This article aims to examine the impact of inward FDI on the Indian economy, particularly after a decade of economic reforms, and analyzes the challenges to position itself favourably in the global competition for FDI. In this context, the article further investigates the likely impact on FDI inflows to India as a result of increasing competition from another major emerging market economy, i.e., China, in the wake of its accession to the WTO and the opportunities and challenges present before it.

Introduction: Foreign Direct Investment (FDI) is considered to be the lifeblood for economic development as far as the developing nations are concerned. Since the liberalization of the Indian economy inflows of foreign direct investment has greatly increased. As far as forting direct investment is concerned, its flow in India is very small as compared not only to China but also to India's potential. Economic Survey for 2005-06 points out that India has potential to absorb $150 billion FDI in the infrastructure sectors alone by 2010.Most of the FDI inflows come from a few countries. Between 1991 and 2005, investments of 10 countries accounted for 71 percent of FDI, the main investor countries being the USA, the Netherlands, Japan, and the United Kingdom. With regard to FDI, U.S. is one of the largest foreign direct investors in India. India is becoming an attractive location for global business on account to its buoyant economy, its increasing consumption market, and its needs in infrastructure and in the engineering sector. Opening and FDI have really created new opportunities for India's development and boosted the performances of local firms as well as the globalization of some of them. Such a trend has undeniably raised Indian's stature among developing countries. Foreign direct investment (FDI) inflows in India is a defining feature of free market, liberalisation and globalization. The important aspect is that how and through what channels impact of FDI inflows affects the performance of companies in developing countries. One major channel through which inflows of foreign capital, of foreign direct investment (FDI) in particular, affect labour markets in developing countries is economic growth. If capital inflows enable the recipient developing countries to increase the investment rate beyond what they could sustain with their domestic savings, they should achieve accelerated economic growth with favourable consequences for employment, wages and labour productivity. Emerging markets possess a lot of potential for foreign direct investment (FDI). FDI in India is on the increase but the country has not experienced a rapid growth of FDI inflow. Theories of FDI suggest that firm size, profitability, trade, interest rates, economy and inflation wield significant influence in attracting FDI. This study explores the factors that contribute to the explanation of FDI in India and tests whether the variables do really influence the flow of FDI into India.

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Review of Literature A brief review of literature on FDI and related aspects is provided below Hymer (1960), Caves (1996), Dunning (1993) found that MNEs have both tangible and intangible resources, or explicit and tacit knowledge, in the form of technologies, managerial skill, international networks, capital, and brand names and goodwill (Hymer 1960, Caves 1996, Dunning 1993).Teece (1977) stated that the MNEs can supply these resources to local firms in equity joint ventures (intra-firm), in non-equity strategic alliances, or in arms-length transactions through the external market. The transfer mechanism through the market or intra-firm depends on transaction costs (Teece 1977). Lucas (1990) has also analyzed the issue by examining the question of why capital does not flow from rich to poor countries and critically explored some candidate answers that are based on human capital and capital market imperfections. With regard to human capital, he shows that the rich countrys optimal policy is to retard capital flows so as to maintain real wages at artificially low levels in the poor country. As far as capital market imperfections are concerned, Lucass paper analyzes a borrowing contract between poor and rich countries. In this paper, the focus is on linkages and on the rational behavior of different foreign investors in the face of reform uncertainty. Cheng, (1993) noted the growing importance of cross-border R & D activities and suggested that additional research on FDI should be done on why firms internationalize their R & D. Anand and Delios (1996) documented that the relatively slow growth of FDI from Japanese MNCs in India as compared to China is attributed to the desire to gain only market access in India. Garg, et al. (1996) documented that along with the regulation of product prices, since 1986 the Indian government has limited the profits pharmaceutical companies can earn to approximately 6 percent of sales turnover. From 1970 through the early 1990s, industry pre-tax profitability as a percent of sales declined consistently, one reason for which was the rate of return constraint. Indeed, in 1977- 1978 industry profitability 11.7 percent. In 1982-1983 this dropped to 7.5 percent, further declining to 3.5 percent in 1987-1988. Since 1992, industry profitability has been rising, and by 1996 it had reached approximately 10 percent of sales . Lee and Mansfield (1996) found that the developing country technology polices have often favored the objective of national self-determination at the expense of foreign technology transfer. In particular, host country policies of weak intellectual property protection and forced licensing of technology, although intended to facilitate technology spillovers, are more likely to discourage FDI and the transfer of leadingedge technologies by MNCs (Lee and Mansfield, 1996). Dijkstra (2000), Tybout (2000) and Vachani (1997) found that investment policy liberalisations have major impacts on firms in less developed countries (LDCs) where the pre-liberalisation level of protection was high. Not all firms are affected equally; some will be losers while others will be winners, depending on their characteristics Feinberg & Majumdar (2001) found that Liberalisation of FDI policies offers opportunities for firms as well as threats. If FDI (and trade) liberalisation results in faster growing national economies, then firms face larger, faster-growing markets domestically. The studies of FDI in the US, Japan and Europe have been prevalent, similar research on FDI in India is however limited. Restricted policy environment towards FDI and weak property protection rights have been described to cause significant R&D spillovers in Indian pharmaceutical sector [Feinberg and Majumdar 2001].

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Aditya K.R. Bajaj and Swastik Nigam (2007) in this work made an attempt to analyze and study the impact of globalization in the pharmaceutical industry and FDI spillovers in various forms to the domestic pharmaceutical industry in terms of domestic productivity and competitiveness etc. The analysis of the study reveals thathe spillover effects have had a manifold impact on the Indian pharmaceutical industry, with the new WTO patent regime introduced in 2005, the foreign players have found greater security in operating in India and due to the spillover effects of a competitive environment, the domestic players have substantially increased their productivity, probability and hence compete on stranger footing with the incoming pharma firms. Jaya Gupta(2007) in his paper made an attempt to review the change in sectoral trends in India due to FDI Inflows since liberalization. This paper also examines the changed policy implications on sectoral growth and economic development of India as a whole. Jayashree Bose(2007) in his book studied the sectoral experiences faced by India and China in connection with FDI inflows. This bookprovides information on FDI in India and China, emerging issues, globalization, foreign factors, trends and issues in FDI inflows, FDI inflows in selected sectors. A comparative study has also been conducted on FDI outflows from India and China. This book also revealed the potential and opportunities in various sectors in India that would surpass FDI inflows in India as compared to China. Sudershan K (2007) in his thesis made an attempt to examine the impact of FDI inflows on financial performance and export performance of select pharmaceutical companies and the financing pattern of FDI and Non-FDI based select pharmaceutical companies. The study is conducted for a period of 15 years i.e. from 1991 to 2005 and the data analysis is done using both traditional methodologies, such as common size statements, trend analysis and ratio analysis and econometric modeling such as pooled cross section time series analysis or panel data analysis. Based on the results, the study reveals that higher proportion of FDI will result into better performance of companies. As far as export performance is concerned, the performance of FDI based pharmaceutical companies in India. Tanay Kumar Nandi and Ritankar Saher (2007) in their work made an attempt to study the Foreign Direct Investment In India with a special focus on Retail Trade. This paper stresses the need of FDI in India in retail sector and uses the augment that FDI is allowed in multiple sectors and the effects have been quite good without harming the domestic economy. The study also suggests that FDI in retail sector must be allowed. The review of literature reveals that on a particular sector FDI has a direct impact and on a particular sector it has an indirect impact. A study on the impact of FDI on manufacturing sector reveals that FDI inflows in chemicals, electrical and electronics shows direct impact and FDI inflow in drugs and pharmaceutical sectors shows indirect impact (spillover effects). (Rajit Kumar Sahoo, 2005)

India Perspective India is the second largest country in the world, with a population of over 1 billion people. As a developing country, Indias economy is characterized by wage rates that are significantly lower than those in most developed countries. These two traits combine to make India a natural destination for FDI and foreign institutional investment (FII). Until recently, however, India has attracted only a small share of global FDI and FII primarily due to government restrictions on foreign involvement in the economy. But beginning in 1991 and accelerating rapidly since 2000, India has liberalized its

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investment regulations and actively encouraged new foreign investment, a sharp reversal from decades of discouraging economic integration with the global economy. India attracted FDI equity inflows of US$ 2,014 million in December 2010. The cumulative amount of FDI equity inflows from April 2000 to December 2010 stood at US$ 186.79 billion, according to the data released by the Department of Industrial Policy and Promotion (DIPP). The services sector comprising financial and non-financial services attracted 21 per cent of the total FDI equity inflow into India, with FDI worth US$ 2,853 million during April-December 2010, while telecommunications including radio paging, cellular mobile and basic telephone services attracted second largest amount of FDI worth US$ 1,327 million during the same period. Automobile industry was the third highest sector attracting FDI worth US$ 1,066 million followed by power sector which garnered US$ 1,028 million during the financial year April-December 2010. The Housing and Real Estate sector received FDI worth US$ 1,024 million. During April-December 2010, Mauritius has led investors into India with US$ 5,746 million worth of FDI comprising 42 per cent of the total FDI equity inflows into the country. The FDI equity inflows in Mauritius is followed by Singapore at US$ 1,449 million and the US with US$ 1,055 million, according to data released by DIPP. Opportunities India has been ranked at the second place in global foreign direct investments in 2010 and will continue to remain among the top five attractive destinations for international investors during 201012 period, according to United Nations Conference on Trade and Development (UNCTAD) in a report on world investment prospects titled, 'World Investment Prospects Survey 2009-2012'. The 2010 survey of the Japan Bank for International Cooperation released in December 2010, conducted among Japanese investors, continues to rank India as the second most promising country for overseas business operations. A report released in February 2010 by Leeds University Business School, commissioned by UK Trade & Investment (UKTI), ranks India among the top three countries where British companies can do better business during 2012-14. According to Ernst and Young's 2010 European Attractiveness Survey, India is ranked as the 4th most attractive foreign direct investment (FDI) destination in 2010. However, it is ranked the 2nd most attractive destination following China in the next three years. The wave of M and As as a driving force for FDI will continue, particularly in crucial sectors such as IT, telecom, financial and pharmaceuticals. These might be aided by trade liberalization, investment in capital markets, deregulation and the fiercer competitive pressures resulting from globalization and technological changes. The Unctad study notes: ``Expanding firm size and managing a portfolio of locational assets becomes more important for firms, enabling them to take advantage of resources and markets worldwide. The search for size is also driven by the search for financial, managerial and operational synergies, as well as economies of scale. Finally, size puts firms in a better position to keep pace with an uncertain and rapidly-evolving technological environment, a crucial requirement in an increasingly knowledge-intensive world economy, and to face soaring research costs. A contributing factor for the increased flow of foreign investment in the 1990s has been the extensive reform by host governments, removal of restrictive policies governing FDI flows and permitting free flows of capital. Approval procedures were simplified and rationalized either by

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removing licensing requirements or keeping it to the bare minimum. A survey, by the European Round Table of Industrialists, of the improvements of conditions for investment in 25 developing countries including India, in the wake of liberalization, noted that more companies were willing to invest in the developing world for strategic considerations and to realize the long-term economic potential of these markets. Towards that goal, regulatory efficiency, as opposed to simple deregulation, should be the policy focus. Improved conditions for investment are not automatically, or always, identical with deregulation, much less efficient regulatory framework. The demand for a competition policy and an open investment regime as demanded at the WTO has its genesis in this premise. Challenges However, some important issues can be identified. To what extent can foreign investment serve the overall socio-economic goals in an open regime? Income disparities, employment generation, technology flows, environmental costs of industrial development, commitment to exports are some of the key issues. There could be a crowding-out effect in the face of competition for scarce resources and markets. The pattern of investment and the routes FDI flows might take may undergo a significant change. For instance, M and As may become more common. There could b e takeovers of local firms in a few cases with implications for domestic brands. Takeovers per se are not to be frowned upon. But the ground rules for transparency and prevention of insider-trading practices must be enforced vigorously under SEBI guidelines. Today, this is a weak area in Indian corporate mergers. Improving the country's negotiating power with MNCs needs attention. Information of cost and the status of technology offered and the global strategies of firms are vital to strengthen the bargaining capability. There is likely to be an increasing role of the MNC home countries in controlling the flow of critical or dual technology on so called `security grounds' which issue must be discussed to evolve suitable international standards. With particular reference to portfolio investments and profit repatriation, Government must evolve suitable financial policies and instruments to prevent capital market volatility. As in Budget 2000-01, raising the level of investment by the FIIs which essentially operate in the capital market might have both advantages and disadvantages. The advantage is that this step might integrate India's financial market with the rest of the world. But there is a price: Market volatility could have a destabilizing effect and bearish and bullish trends can be managed at will by large investors as it can be seen in the high volatility shown by stock market in 2008 due to USA financial crisis. This might also be true when more Indian companies have their stocks listed in world capital markets where the volumes traded are high as is the velocity. The solution is not to argue against these measures if we want globalization but to encourage industrialization and improve corporate performance to international standards. Also, the number of good scrips must increase as should the volumes traded. The regulatory framework of the capital market must also improve with the professionalization of brokerage firms, and the enforcement of strict dealing and settlement standards. Increasingly, trading velocity will be much higher, and scripless trading, with networked stock markets to rope in more investors, will be necessary.

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The Malaysian example of placing an embargo on capital repatriation at a time of crisis is not to be emulated. However, to the extent to maintain a globally competitive regime movement of capital cannot have a totally disruptive effect. Otherwise, the experience of East Asian countries and Japan may be repeated. With increased investment by MNCs, there should be effective tools in our tax system and the administrative machinery needs to be adequately adjusted to address the question of transfer pricing. Lastly, evolving good corporate governance and proper internal checks and balances through independent audit committees is a must. So far, this area has been only a talking point among corporate with some leading chambers of commerce even treating this issue as a voluntary measure.

Conclusion The Concept of Foreign Direct Investment is now a part of Indias economic future but the term remains vague to many, despite the profound effects on the economy. Despite the extensive studies on FDI, there has been little illumination forthcoming and it remains a contentious topic. The experience of successful ASEAN countries amply demonstrates how FDI can play a leading role in bringing about rapid, export-led growth. Rapidly rising exports have fuelled the worlds fastest growth rates in some of these economies which, until recently, had made them the envy of the developing world. But economic development is more than growth, as the crisis in these countries has made abundantly clear. The ASEAN countries have not always managed to translate economic growth through FDI into something more durable which builds on existing indigenous capabilities which Indian policymakers should also keep in mind. As evidenced by analysis and data the concept and material significance of FDI ha evolved from the shadows of shallow understanding to a proud show of force. The government while serious in its efforts to induce growth in the economy and country started with foreign investment in a haphazard manner. While it is accepted that the government was under compulsion to liberalize cautiously, the understanding of foreign investment was lacking. A sectoral analysis reveals that while FDI shows a gradual increase and has become a staple for success for India, the progress is hollow. The Telecommunications and power sector are the reasons for the success of Infrastructure. This is a throwback to 1991 when Infrastructure reforms were not attempted as the sector was performing in the positive. FDI has become a game of numbers where the justification for growth and progress is the money that flows in and not the specific problems plaguing the individual sub sectors.

References 1. Anand, J. and Delios, A., Competing globally: How Japanese MNCs have matched goals and strategies in India and China, Journal of World Business. 31, 3, Fall 1996, pp.50-62. 2. Aditya KR Bajaj and Swastik Nigam (Dec 2007) Globalization in the Indian Pharmaceutical Industry FDI spillovers and implications on Domestic Productivity: 1991-2007, is a research project done under IIM Ahmedabad.

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3. FDI Inflows in Indian Industry and Bhupal Singh (2005). Methodology, Compilation and Reporting of Foreign Direct Investment Statistics: The Indian Experience, Reserve Bank of India, Mumbai 4. Caves, Richard. 1996. Multinational Enterprise and Economic Analysis, 2 nd Cambridge University Press. ed. Cambridge:

5. Cheng, Joseph L.C. 1993, The management of Multinational R& D : A neglected topic in international business research, Journal of International Business Studies, 24(1) ;1-18. 6. Dijkstra, A. Geske. 2000. Trade Liberalization and Industrial Development in Latin America, World Development, vol. 28, no. 9, pp. 1567-1582. 7. Feinberg, Susan & Majumdar, Sumit K. 2001. Technology spillovers from foreign direct investment in the Indian pharmaceutical industry, Journal of International Business Studies, vol. 32, no. 3 (Third Quarter), pp. 421-437 8. Fujita, Masahisa, Paul Krugman, and Anthony J. Venables, 1999, The Spatial Economy (Cambridge, Massachusetts: MIT Press). Lee, J.Y. & Mansfield, E. 1996. Intellectual Property Protection and US Foreign Direct Investment. Review of Economics and Statistics, 78: 181-186. 9. Garg, R., G. Kumra, A. Padhi & A. Puri. 1996. Four Opportunities in India.s Pharmaceuticals Market. McKinsey Quarterly, 4: 132-144. 10. Hymer, Stephen. 1960. The International Operations of National Firms: A Study of Direct Investment. Ph.D. dissertation. Boston: MIT Press. 11. Jaya Gupta(2007), Gloablisationa and Indian Economy: Sector-wise Analysis of FDI inflows 12. Jayashree Bose(2007), FDI Inflows in India and China A Sectoral Experiences, ICFAI University Press, Hyderabad 13. Krugman, Paul, 1991, Increasing Returns and Economic Geography, Journal of Political Economy, Vol.99 (June), pp.483-99. 14. Lucas, Robert E. Jr., 1990, Why Doesnt Capital Flow from Rich to Poor Countries? American Economic Review, Vol. 80, No. 2, pp. 92-96. 15. Rajih Kumar Sahoo (2005), Foreign Direct Investment and Growth of Manufacturing Sector: An Empirical Study on Post Reforms India, is a doctoral thesis submitted to the University of Mysore 2005. 16. Reserve Bank of India (2002), Report of the Committee on Compilation of Foreign Direct Investment in India. 17. Reserve Bank of India (2005), Financial Performance of FDI Companies in India, Reserve Bank of India Bulletin. 18. Sudershan K (2007), FDI in India and its impact on the Performance of Pharmaceutical ndusry in India, is a doctoral dissertation submitted to Department of Commerce, Osmania University, Hyderabad, 2007.

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19. Tanay Kumar Nandi and Ritankar Sahu, Foreign Direct Investment In India With Special Focus On Retail Trade, Journal Of International Trade Law And Policy, Year: 2007, Vol.: 6,Issue: 2,Page: 40-53,Emerald Group Publishing Limited. 20. Teece, David. 1977. Technology transfer by multinational firms: The resource cost of transferring technological knowhow, Economic Journal, vol. 87 (June), pp. 242-261. 21. Tybout, James. 2000. Manufacturing Firms in Developing Countries: How Well Do They Do, and Why? Journal of Economic Literature, vol. XXXVIII (March), pp. 11-44. 22. Vachani, Sushil. 1997. Economic liberalizations effect on sources of competitive advantage of different groups of companies: The case of India, International Business Review, vol. 6, no. 2 (April), pp. 165-184 23.United Nations Conference on Trade and Development (UNCTAD) report on world investment prospects titled, 'World Investment Prospects Survey 2009-2012'. 24. 2010 survey of the Japan Bank for International Cooperation 25. UK Trade & Investment (UKTI) Report-2010 26. Ernst and Young's 2010 European Attractiveness Survey