Strong FDI flows need stability

Current investment driven by hope of future change

International capital flows are driven by various considerations. Investors enter specific businesses but some factors affect every business in a given country. Relative growth rates and relative inflation rates are only the most obvious of the macro variables cross-border investors consider. Ease of currency conversion and size of local markets are also important. Investors judge the capacity of institutions and regulators, and the transparency of legal and tax systems. They also assess political stability.

Few countries score high on all parameters. Different types of investors also have different needs. Some investors are short-term, some long-term. Some are portfolio investors looking at listed companies. Depending on type, their focus will lie in different areas.

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A short-term portfolio investor will focus on capital gains rates and mechanisms. Capital controls determining the ease of entry and exit will also be important. Such an investor will demand evolved financial markets and track volatility.

A long-term portfolio investor will not be concerned about volatility but want an independent central bank and independent regulators. A direct investor who is bringing in foreign direct investment (FDI) to set up a business will be concerned about political stability, fair contract laws, independent judiciary and acceptable dispute-resolution mechanisms.

It might seem counter-intuitive but a direct investor may not care much about democracy, or desire a transparent, honest legal system. In practice, a corrupt but stable dictatorship, may be easier to deal with. Dictatorships have continuity. People who are bribed will stay in power indefinitely. A crony capitalist can get favours from a corrupt regime.

Complications arise in democratic regimes like India. On many parameters, India receives good scores. It has large domestic markets. It has sophisticated capital markets. It has a reasonably open capital regime since money can enter and exit quickly. It has good growth and independent regulators. On paper, India has an excellent legal system, though it is very, very slow in practice. However, there are downsides. India's complex laws and red tape make it hard to launch a start-up and it also is a very slow process. Capital is expensive. Infrastructure is poor. The tax regime is complex with lots of discretionary powers to officers. The federal nature of government with the division of power between states and the Centre makes it hard for businesses to go pan-India.

India also has plenty of corruption and that is a "revolving chair" because of change in regimes. Hence, different people may need to be bribed every so often. There can also be peculiar and unexpected hurdles such as retrospective taxation. In many Asian nations, capital comes from overseas investors with strong ties to the concerned nation. China, for example, receives a lot of FDI from overseas investors of Chinese origin, who are comfortable with the peculiarities of investing in China. India has a large, successful diaspora but many NRIs are professionals rather than businessmen. Hence, the FDI contribution of non-resident Indians (NRIs) to India is not as high as the FDI contribution of overseas Chinese to China.

Portfolio investors have tended to be fairly comfortable with India because of a good capital gains tax regime and many double-taxation treaties. There is some anxiety over the imposition of a new tax regime with the General Anti-Avoidance Rule (GAAR) from April 2017. Also poor earnings growth for the past two financial years and projections of low earnings growth for 2016-17 has made portfolio investors unenthusiastic.

However, FDI inflows increased in 2015-16, even as foreign institutional investor (FII) contributions dipped. NRI remittances also dipped because Indians in the Gulf are feeling the pinch. FDI investments are supposedly driven by more "permanent" factors because FDI is committed for the long term. If permanent factors are changing for the better, FIIs will return. Indeed, March saw strong portfolio inflows, though FIIs were net sellers through the financial year. However, some of the current FDI investments are being driven by hope of future change, rather than current changes. Investments could easily bog down unless there is delivery on the taxation and legislation front.

Another consideration is political stability and continuity. A series of state elections is due through the next 12-18 months. If there is a lot of violence in those election campaigns and/or the Bharatiya Janata Party loses ground in them, there could be a negative re-rating of India as an FDI destination.