Is FDI the new engine of growth?
The official discussion paper (DP), Industrial Policy—2017, (goo.gl/jEPs6u) is a welcome effort. That said, while it sets down a laundry list of known constraints, it ignores serious analyses of poor industrial performance. Pedantically discussing competitiveness, the policy paper makes very little reference to trends in global trade, or inadequate domestic industrial demand, falling capacity utilization or negative credit growth (“Economic Reforms And Manufacturing Sector” by R. Nagaraj, Economic And Political Weekly, 14 January 2017).
There is an exception, however. Flagging the boom in foreign direct investment (FDI) inflows, the paper claims it as a badge of success for the official policy. The report says, “Total FDI inflow was $156.53 billion since April 2014 ($45.15 billion in 2014-15, $55.56 billion in 2015-16, and $60.08 billion in 2016-17). Highest ever annual inflow ($60.08 billion) was received in 2016-17. FDI equity inflows increased by 52% during 2014-16 and 62% since the launch of Make In India. India is now ranked amongst top 3 FDI destinations (World Investment Report 2016, Unctad) and ninth in the FDI Confidence Index in 2016, up two places from 2015 (AT Kearney)”.
Laudable as that may be, what did the FDI inflow do for the economy? Did it augment industrial output and investment growth (meeting Make In India goals) as expected in theory? The official paper claims it has. But has it really?
In principle, FDI—as against foreign portfolio investment which flows into the secondary capital market—brings in long-term fixed investments, technology and managerial expertise, together with foreign firms’ managerial control. FDI in green field investment is for fresh capital formation, and in brown field investment for acquiring existing enterprises with the expectation of improving the firm’s productivity and profits.
In practice, however, this may be different. Currently, FDI does not come from leading global producers of goods and services, but from shadow banking entities such as private equity (PE) funds. In 2014-15, PE accounted for 60% of total foreign inflows, and the top three recipients were Flipkart, Paytm and Snapdeal (Bain & Co.’s “India Private Equity Report 2016”). These funds are used to finance retail trade of mostly imported consumer goods to expand their market shares, in order to boost the firm’s market valuations. Since PE investments are highly leveraged (high debt-equity ratios), rising markets valuations help them reap disproportionate gains when they make their exit.
PE firms do not commit to fresh capital formation or invest in technology, as expected of FDI. India being a bright spot in world economy lately, global retailers such as Amazon are rushing here to build their brand’s value and acquire market share using abundant low-cost international capital. Could such financing of retail trade with short time horizons constitute the (new) engine of India’s industrial growth and employment generation? I wonder.
This is why despite rising FDI inflows, domestic capital formation rate, or industrial capacity utilization, have declined secularly. What is going on, I would contend, is foreign capital financed import-led consumption growth, not augmenting domestic output to meet Make In India goals. Therefore, the current growth pattern would only contribute to economic fragility under free capital flows, as the social costs of servicing the external capital in rupee terms could be significantly high in the longer run.
The official paper also pins hope on outward FDI to strengthen domestic industrial and services capabilities. Since 2000, the outflow has risen remarkably, often seen as the coming of age of domestic enterprises, acquiring factories and firms (and global brands) mostly in advanced economies, best illustrated by Tata’s acquisition of luxury car maker, Jaguar Land Rover. After a brief dip during the financial crisis, the outflows have maintained momentum. But Indian firms are no longer chasing foreign acquisitions; if anything, they are licking the wounds of hasty misadventures over the past decade—for instance, the Videocon group.
So where is the outflow going? Apparently, India is being used as a conduit for routing international capital for tax arbitrage. Olivier Blanchard and Julien Acalin’s research paper (What Does Measured FDI Actually Measure, Peterson Institute for International Economics, October 2016) offers an insightful answer. It shows that inward and outward FDI flows across emerging market economies are highly correlated, responding to the US policy rate. India ranks sixth in descending order among 25 emerging market economies (far higher than China). The study’s sharp conclusions seem instructive: “...‘measured’ FDI gross flows are quite different from true flows and may reflect flows through rather than to the country, with stops due in part to (legal) tax optimization. This must be a warning to both researchers and policy makers.”
Put simply, inward and outward FDI flows apparently represent channelling of global capital via India to take advantage of tax concessions (called “treaty shopping”). Hence such short-term foreign capital movements in and out of the country may contribute little to augment domestic capability. If the findings are correct, then there is a need to re-examine recent FDI’s true contribution.
Subject to closer verification, if the foregoing arguments and evidence are valid, then the recent FDI flows have contributed little by way of augmenting domestic capabilities, output and employment growth. Inward FDI, increasingly from PE funds, has largely financed e-commerce firms, driving import-led consumption boom. Outward FDI, instead of enabling domestic enterprises to access external markets and technology, has instead helped international capital to take advantage of India’s tax treaties to optimize tax burden of global firms.
If the proposed industrial policy is serious about realizing the vision of Make In India, it needs to look elsewhere, not at FDI.
R. Nagaraj is a professor at the Indira Gandhi Institute of Development Research, Mumbai.