CIRCUIT BREAKER. The short route to FDI

The package of reforms on Foreign Direct Investment announced by the Centre, post-Bihar, has set off a scuffle between Modi supporters and Modi detractors.

The first group is gung-ho that the package will usher in a flood of foreign money and quickly set about creating jobs. The second group is sure that no such thing will happen because the package merely makes incremental tweaks to existing rules.

The reality may lie somewhere in-between. Yes, the new package of measures that cut across 15 sectors is unlikely to bring in a flood of FDI immediately. But ‘incremental tweaks’ may be exactly what some sectors need to get foreign investors interested in the business in the first place.

Studying the trends in cumulative FDI flows in the last 15 years shows that it is not grandiose gestures on sectoral caps or automatic approvals that actually bring in FDI money. It is the ability of a sector to generate a healthy ROI (return on investment) and the leeway to private players within a sector to freely make, market and price their products without regulatory interference.

There are three clear lessons from the official data on FDI flows from April 2000.

The sectoral break-up of FDI flows into India between April 2000 and June 2015 (Source: DIPP) shows that when it comes to wooing foreign investors, sectoral caps really don’t matter as much as the attractiveness of the underlying business.

Sectors that have attracted the lion’s share of FDI are services (mainly banks, financial services), attracting 17 per cent of cumulative inflows, construction/housing (9 per cent), computer software, telecom, autos and pharmaceuticals (5-6 per cent each).

Not all these sectors are completely open to FDI; some have caps set at 49 or 74 per cent. But the thread that runs through them is that these have been some of the fastest growing sectors in the Indian economy.

There are two sets of business in India that have been top wealth creators in the last decade. One, consumer facing businesses that have thrived because of aspirational consumers. Two, service/contract manufacturing businesses that have made a mark in global markets through cost competitiveness.

Foreign investors have been drawn to invest in both, simply because they see them generate a high ROI.

The list of sectors that have drawn barely any FDI in this 15 -ear window is quite illuminating. It includes tea plantations, leather, sugar, fertilisers, air transport, heavy machinery and retail trade (single brand).

Looking at the profit parameters of listed players operating in these sectors should tell you why foreign investors have been less than enthused by them.

Players in sectors such as tea, sugar and fertilisers report losses more often than profits because of draconian regulations that interfere with every aspect of their business. Retailing globally operates on wafer-thin margins and, in India, is further squeezed by high rental costs and negative working capital, leading to low ROI.

These facts should tell us that it is futile to try and woo foreign investors into domestic sectors that are prima facie unattractive to do business in. Undeterred by the lack of interest in tea plantations, the recent FDI package, for instance, has ‘opened up’ other plantation businesses such as rubber, olive oil, coffee and palm oil for 100 per cent FDI. However, given falling global commodity prices, high domestic cost structures and the threat from cheap imports, foreign investors are unlikely to rush in.

Then, there is the matter of when foreign investors are invited to participate in a sector. While relaxing FDI rules for any sector, the primary consideration of Indian policymakers seems to be: “How badly does this sector need money?”

If an industry is neck deep in debt, facing severe profit pressures or starving for capital, it becomes a candidate for liberalised FDI rules. This has indeed been the motivation for some of the recent relaxations in FDI rules for general insurance, asset reconstruction firms, construction, aviation and retail.

But foreign investors seem to track the fortunes of the sectors they intend to invest in pretty closely, before diving in. They like to bet big on sectors in their nascent stage of growth, when demand is rising, pricing power is high, competition is low and costs are yet to catch up.

The Indian housing and construction sector, for instance, proved a big hit with foreign investors during the property boom of 2006-2010 but has seen dwindling interest during the last four years. After attracting nearly $17 billion in FDI until April 2010, this sector has managed only about $1-2 billion in flows in each of the last four years.

However, the crisis situation in the real estate sector is precisely what has driven the Centre to relax its stringent FDI regime for it.

When the sector was first opened up for FDI, the strings attached actually made one wonder if the Centre was more keen to attract or keep out foreign investors. Housing projects needed to have minimum land area of 10 hectares or built up area of 50,000 square metres.

A minimum capital of $10 million had to be brought in within six months, with all investments locked in for three years. At least half the project had to be completed within five years and the responsibility of obtaining the necessary statutory approvals was pinned on the investor.

But in the last couple of years, with the ongoing downturn taking a toll on domestic real estate players, the Centre is now keen to have foreign investors come in and bail them out. Almost all of the above rules have been watered down. But it is doubtful if foreign investors will be enthused to invest in the distressed sector now. After all, there’s no reason for foreign investors to throw good money after bad.

The third factor that would really weigh in on a decision by any new investor to bet on India would be the experience of other multinationals already doing business here. In this context, if vaguely defined laws, adversarial tax authorities, the tendency of sector regulators to micro-manage their constituents and a tendency to keep flip-flopping on policy, pose a big irritant to older players, you can be sure they will keep out new entrepreneurs too.

Real-life episodes such as the Nestle Maggi controversy, Nokia’s plant closure by the tax authorities, and the Vodafone tax case may have a far greater impact on FDI decisions than policy documents paying lip service to a friendly business regime.

When such cases come to light, therefore, it is necessary for the Centre to kick into damage control mode immediately, instead of letting the case wind its way through the labyrinth of the Indian legal system.

Overall, the learning from all this can be summarised into just one finding. Foreign investors will bet on precisely those sectors in India that the domestic private sector finds attractive.

Therefore, if the government is really keen to kick-start the investment cycle, it first needs to tackle the problems and untangle the myriad laws that make it so difficult for the domestic entrepreneur to run a successful business. Once that is done, foreign investors will come in, whether or not we ardently pursue them.