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Competing with Cambodia

The author asks why FDI is not attracted to India - and why Indians themselves are unwilling to set up productive enterprises

Devesh Kapur
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The finance minister is currently on a road trip to the United States and Canada, following his trips to the Far East and Europe, to try and restore confidence in India and drum up foreign investment into the country. This follows earlier actions aimed at rectifying the severe damage done by his predecessor, who, in his fixation with pulling down the man who had been his underling in the mid-1980s, had little qualms in pulling the country down as well.

While there can be little doubt that in this government the finance minister is unmatched in his ability to sell the India story, the task he faces is daunting. Few in Indian officialdom are willing to accept just how much the country's reputation has been damaged and the severity of the challenges which roadshows can only do so much to alleviate. A simple way to illustrate the intensity of the looming crisis can be posed by two simple questions. One, why is foreign direct investment (FDI) in labour-intensive sectors, when seeking to diversify from a that is becoming more expensive and geopolitically more risky, willing to go to - a country with multiple and severe weaknesses from governance to human capital - but not to India? Two, why are Indians investing so much in non-productive assets like gold and real estate but so little in productive enterprises? If even Cambodia is more attractive than India for in labour-intensive manufacturing sectors, and if Indians themselves are unwilling to set up productive enterprises, what does it say of India's prospects?

Perhaps the most fundamental mistake that Indian policymakers have made in the trajectory of reforms in recent years is to constantly try to dress the country in ways to appear attractive to FDI, rather than a more basic, albeit banal, reality: which is that if the focus was instead on what it would take for small and medium enterprises (SMEs) to thrive in India, it would automatically create the permissive conditions that would be conducive to attracting FDI, rather than repeatedly having to make sales pitches and provide sweeteners to the latter. A thriving SME sector is critical for job creation, greater competition and creating a healthy eco-system that attracts large companies. But that is simply not happening.

To be sure, India did need to make policy changes to lower the barriers to FDI, from sectoral caps on foreign control to transfer pricing to taxation regimes. Even today, it is baffling that India would insist on spending tens of billions of dollars on defence imports but refuse to raise FDI sectoral caps on defence, thereby undermining both its long-term defence preparedness and domestic manufacturing capabilities, all in the name of protecting poorly-performing public-sector defence units. But then, what is more important: The country's long-term national security interests, or the jobs of unions that underpin the support base of a defence minister?

The challenge is greatest in manufacturing, where India is facing de-industrialisation even as the labour force is growing exponentially. Today, the Indian state has stacked the deck against so starkly that it would be foolish to advise someone to become an entrepreneur in manufacturing, rather than in services or speculate in land or real estate. The analysis in Sanjoy Chakravorty's new book, The Price of Land, suggests that the new is almost certain to raise the price of land several-fold even for SMEs that require a relatively modest amount of land. Perhaps even more, the severity of governance failures in India are making Indian manufacturing increasingly uncompetitive.

It is common knowledge that corruption in India has moved from speed money to outright extortion. The licence raj has morphed into a regulatory state, where regulatory checkpoints are often manned by stationary bandits, ready to extort rents. At one level, this is sharply raising basic infrastructure costs. When a private-public partnership (PPP) project in a highway is complete and a new state government demands several hundred crores in bribes just to allow it to open (and, presumably, the builder had already paid homage to the previous government), but reassures the developer that this astronomical sum can be recovered by increases in tolls, one way or the other, the public will be held holding the bag - and transportation costs will be higher. The situation is similar in power, and indeed across a range of PPP projects in infrastructure, where renegotiated contracts have allowed all parties to make money - at the expense, of course, of the ultimate user.

When entrepreneurs face extortion, the behavioural implications are obvious. One, they will shift out of tradable sectors such as manufacturing, where international competitive pressures simply do not allow them to pass on costs to consumers. Little wonder that India today is importing even Ganesh idols from China. Second, within tradable sectors, entrepreneurship will move to areas where regulatory intensity is less. Hence the attractiveness of services, relative to manufacturing. Third, investment will move to non-tradable sectors, where international competition is less and it is easier to pass on the cost of all the payoffs to consumers - with real estate and infrastructure being good examples. Else, it will simply move to non-productive assets, like gold. This is undoubtedly an additional factor contributing to the stubbornly high rates of inflation in India.

India's growing economic challenges, and its solutions, can at best be alleviated by foreign inflows. The roots of the problem lie in the sheer dysfunctionality of India's governance and the emergence of a mafia-like extortionary state in many parts of India. One could argue that to the extent that it is state governments that hold the key on many of these issues, the finance minister's persuasive manner notwithstanding, there is only so much that he can do. But to the extent that the venality of the Indian state grew by leaps and bounds in the decade that India has been run by the United Progressive Alliance, there is only so much that the finance minster can disavow.

The writer is director of the Centre for the Advanced Study of India at the University of Pennsylvania

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