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Why foreign investment still polarizes India

- September 30, 2014

The following is a guest post by political scientist Sonal S. Pandya of the University of Virginia.
Indian Prime Minister Narendra Modi’s September 2014 U.S. visit included a speech to the United Nations General Assembly, dinner with President Obama at the White House, and a sold-out appearance at Madison Square Garden. At the top of his agenda, however, is something decidedly less glamorous: persuading American firms to invest in India. Between his high-profile appearances Modi is meeting with top U.S. CEOs to pitch his carefully crafted vision of a transformed, business-friendly India.

Modi’s U.S. visit is just the latest stop in his global quest to attract new foreign direct investment (FDI) to India. Modi’s August state visit to Japan netted over $33 billion in new Japanese investments over the next five years. On Sept. 18, Modi welcomed Chinese president Xi Jinping for a visit designed to strengthen economic ties between the two countries. In a striking juxtaposition, the two countries’ troops clashed over disputed border territory while their leaders announced $20 billion in new Chinese investment in India.

FDI is the centerpiece of Modi’s agenda for market-oriented economic reforms. As Modi put it in a recent speech, “FDI should mean First Develop India.” The textbook case for FDI can be summarized in two words: technology transfer. The multinational corporations that undertake FDI are among the world’s most productive firms. These firms introduce their cutting edge technologies and production practices into the countries in which they invest. In the ideal case, FDI increases demand for skilled workers and, eventually, their technologies ‘spill over’ into the local economy.

In order for Modi’s efforts to deliver economic growth, he must confront India’s sharp political divisions over FDI. My research shows that opposition to foreign ownership persists in those industries in which foreign investments produce goods and services for sale in the local market. The flip side of FDI’s technology transfer is that it displaces local producers with whom foreign investors compete. Consistent with this pattern, India has liberalized FDI into many manufacturing sectors but continues to limit foreign ownership in service industries geared toward the Indian market, such as transport, finance, and, most famously, retail. In these industries, foreign investors must undertake joint ventures with local firms who retain managerial control. While ownership restrictions blunt FDI-induced market competition, they also undercut technology transfer. Foreign investors are leery of transferring their most advanced technologies as minority shareholders in forced joint ventures.

The high-profile controversy over FDI in multi-brand retailing illustrates the fundamental economic and political trade-offs that FDI presents. Large western retailers like Wal-Mart and Carrefour have been eager to tap into the growing prosperity of the Indian middle class. The country’s retail sector is valued at over $500 billion. These retailers have the expertise to establish sophisticated agricultural supply chains that can reduce food prices. In a country with one of the world’s highest rates of malnutrition this is not a trivial matter. These innovations however would displace many of the nearly 12 million Indians who own the small mom-and-pop stores that dominate India’s retail sector today. In a democracy, economic displacements of this magnitude are, likewise, no trivial matter. Modi’s party won May’s national elections with an unprecedented majority. This victory was widely interpreted as a sweeping mandate in support of economic liberalization. Against this backdrop, the persistence of FDI restrictions testifies to how politically explosive foreign investment remains.

These political divisions over FDI put Modi in something of a bind. With the world’s second largest population, India is most attractive to foreign investors who want to produce goods and services in India in order to compete within the Indian market. India’s tremendous market potential helps compensate for the many challenges of doing business in the country. Unfortunately, these market-oriented investments are precisely the type of FDI that is so controversial and subject to foreign ownership limits. Political concessions to FDI’s opponents reduce the growth-promoting potential of local market-oriented FDI.

Modi has instead set his sights on export-oriented manufacturing FDI that creates skilled jobs and introduces advanced technologies without intensifying local competition. Yet countries around the world court these coveted investors by providing lavish incentives and robust legal rights. India, with its bloated bureaucracy, rigid labor market, and anemic property rights protections, has long been an unpopular destination for export-oriented FDI. Modi has assigned himself the heroic task of transforming these and other deterrents to foreign investment. Greater export-oriented FDI is one mechanism through which Modi’s promised reforms could translate into growth. The success of his larger economic agenda rests largely on whether he can deliver these reforms.

What do the politics surrounding FDI ultimately mean for India’s economic development? Underlying current debates are two starkly different visions of government’s optimal role in the economy that can obscure areas of potential consensus.

The crucial link between FDI and sustained economic development is absorptive capacity, the broader economic conditions that allow countries to harness technology spillovers from FDI. For example, a large pool of skilled labor can evolve from employees of foreign firms into domestic entrepreneurs who capitalize on their exposure to the investors’ advanced technologies. Public investments in areas like education and infrastructure help expand absorptive capacity. Public spending may even be necessary to channel FDI’s spillovers beyond the half dozen states that receive most of India’s foreign investment.

As Modi makes the rounds in New York and Washington this week, he needs to persuade weary U.S. business and political leaders that he has the vision and skill to transform India. Back home, Modi still needs to persuade weary Indians that FDI is necessary to transform India for the better.