If the government had to give a Diwali gift to investors, it couldn't have done much better than the new measures on foreign direct investment that it announced on Tuesday. A significant consequence of the Bihar election results is the uncertainty and nervousness that they induce about both the government's ability and its willingness to move down the structural reform path. Legislative reforms will now look even further out of reach, but the key question is whether the setback would make the government more hesitant on executive action as well. The announcements on foreign direct investment or FDI are presumably intended as a signal that at least this route to reform remains open. To that extent, the announcement is to be welcomed and, importantly, in order to reinforce the message, should be followed up by other steps that similarly leverage executive autonomy.
In terms of the specific measures announced, to the extent that they all increase the opportunity and flexibility for foreigners to invest into India, they should have a significant impact on resource inflows. At the level of approvals, the limits that the Foreign Investment Promotion Board worked within have been raised, potentially speeding up the process for a larger number of projects. At the sectoral level, many industries will now have much greater freedom to bring in more funds. Single-brand retailers will now be able to fully own their stores, while also being able to carry out e-commerce. Financial institutions will now have the benefit of "fungibility", which was denied to them in an earlier announcement. In effect, there will now be a 74 per cent limit on aggregate foreign investment, but there will be no sub-limits on portfolio or strategic investors. This should provide an enhanced channel for capital mobilisation for the more successful smaller banks, non-bank finance companies and, over the next few years, the newly licensed payments and small finance banks. The same kind of flexibility is being offered to businesses in the defence equipment sector as well. Construction also benefits from enhanced limits, with an emphasis on investments into affordable housing. All in all, the measures are both broad and substantive.
That having been said, there is little question that higher FDI limits are not going to solve the basic problem of sluggish investment that the economy is dealing with. Even at its peak, FDI, as important as it might have been, was never a very significant percentage of aggregate investment. Ultimately, an investment revival is going to be driven predominantly by domestic businesses. Until this group signals its confidence in business prospects by stepping up investment, it is unlikely that foreign investors will venture into India in significant volumes. A broad-based investment recovery in India will depend on two factors. The first, beyond India's control, is the global excess capacity situation in many industries. The government can only look for ways to provide some safeguards to domestic producers. The second, though, is entirely within India's control. Speeding up infrastructure projects and quickly addressing the ease of doing business parameters are the critical components of this. The FDI announcements, while welcome, are only a first step down this road.