Six issues impeding foreign investors in India need urgent attention

Internationalisation is central to sustained Indian economic growth, as firm productivity rises through proximity and engagement with advanced economies. India is a capital-scarce economy. Large volumes of low-cost foreign capital are required to finance domestic investment. Recent trends are concerning. Net foreign direct investment (FDI) has stagnated since 2011. The stock of foreign portfolio investment is not growing. Firms are importing less, and then inevitably exporting less. 

There is no single policy intervention that will alter this trajectory. We must assess the entirety of foreign firms’ interaction with the Indian state. Six elements require focus. 

The first question is whether capital can enter, adapt to commercial changes, and exit. The state runs a central planning system — the capital controls regime — with control of instruments, pricing, restructuring, and exit terms. This interferes in commercial decisions. 

There is a state of fog with thousands of pages of intrusive, detailed law, backed by criminal sanctions. Investors need expensive lawyers to reconstruct their obligations from rules, policy documents, and circulars. This law needs to be consolidated, stable, and intelligible, and step back from intrusion into the world of business. 

Pricing rules are particularly harmful. Regulation operates on the premise that a valuer can discover one official price and eliminate commercial uncertainty. This restricts legitimate risk-taking. It harms smaller firms that rely on flexible financing arrangements. 

Second, foreign investors face international taxation atop domestic taxes. They allocate capital based on post-tax returns across jurisdictions. Tax policy must not merely ask how much revenue can be extracted from income connected to India. The Ministry of Finance needs to be the custodian of India’s growth in gross domestic product, not merely short-term tax revenues. Taxing foreign capital operates like a tariff on an imported input. It makes capital more expensive for the Indian enterprise and makes Indian exports uncompetitive. 

Foreign capital coldly evaluates the Indian state. It moves to jurisdictions offering better combinations of tax, risk, and institutional quality. India operates a source-based taxation policy, but residence-based taxation works better in furthering the Indian interest in economic success. India must compete for foreign capital through attractive low taxation for foreigners, as was done with success by countries like Ireland. 

The third problem is expropriation by the Indian state. Multiple arms of the Indian state — from tax authorities to state governments — have a demonstrated history of harming foreign firms. In developing countries, domestic institutions such as the judiciary and property rights are weak. Bilateral investment treaties provide a safety blanket. They protect foreign investors through international arbitration when domestic institutions fail. The economic function of these treaties is to reduce institutional risk. This lowers the rate of return that foreign investors demand. The money paid out owing to writing strong treaties is the flow of insurance payments in return for stabilising vast sums of foreign money in the country. Each payout to a foreigner should trigger responses in the Indian state to solve the root cause which led to a foreigner being expropriated. 

Treaties cannot substitute building state capacity. They do not protect domestic investors. But solving the infirmities of the Indian state is a long-term project. In the meantime, generous bilateral investment treaties are the way to make progress with foreign investment. 

The fourth problem is trade barriers. Firms receiving foreign investment are more internationalised: They import more and they export more. 

Trade barriers damage India’s internationalisation. Protecting one upstream producer makes all downstream producers less competitive. Local content requirements and non-tariff barriers degrade the economics of locating production in India. Firms view the problems of trade policy as components of the investment regime. India cannot become an important place for the world to produce when the Indian state interferes in international trade. A firm deciding where to locate a global factory evaluates the friction at the border. 

The fifth problem is the domestic financial system. Consider a container ship that reaches Nhava Sheva. From there, the containers reach deep into India through Indian infrastructure. In a similar fashion, once foreign capital reaches the Indian shores, it connects into the Indian economy through the Indian financial system. Trusted pricing on the equity market, liquidity on all financial markets, the ability to hedge currency risk, the trust in banks, the workings of initial public offerings (IPOs), etc: All these features of domestic finance matter in the ultimate investment outcomes for the foreigner. 

Foreigners do not require a government subsidy in the form of price control on the dollar/rupee exchange rate. They require liquid, efficiently priced derivatives to hedge exchange rate risk. FDI investors face rupee exposure through future dividends, operating cash flows, and eventual asset sales over very long time horizons. They require enormous capabilities in the Indian bond-currency-derivatives nexus. But policymakers have damaged these capabilities from 2013 onwards. 

Finally, we come to the rule of law and institutional development. Foreign capital shudders when contracts remain unenforced, tax administration is arbitrary, and regulatory interpretations change without notice. If engaging with the Indian state requires hiring government relations firms, something is going wrong. 

Domestic investors also face all these broken institutions. They have also responded by pulling back from investment, but they are better off as they are able to navigate the human networks of personalised power. This is harder for foreign investors, and foreign investors have more choices about where to invest. Foreign investors are the most fearful ones. They need the rule of law the most, and the drumbeat of economic nationalism and industrial policy in India frightens them the most. 

Subsidies, production-linked incentives, and investment-promotion agencies attempt to compensate for institutional weakness. They work for a few well-connected persons. They cannot replace functioning institutions. 

There is widespread concern about the Indian retreat from economic engagement with advanced economies on capital flows, trade and FDI. We agree with this concern. However, there is no silver bullet. We need progress on all the six fronts shown here. 

The writers are researchers at XKDR Forum