Why is FDI important for India's economic growth and development process?

Xi Jinping came to power in China in 2013, and brought a new emphasis on arbitrary state power and nationalism. This disrupted the “China model” for making progress towards greater prosperity and greater freedom. Many economic indicators show how the China model was derailed from 2017 onwards. Net foreign direct investment (FDI) in China was $291 billion in 2013. In the latest data, for 2023, it was $43 billion. On September 12, Eleanor Olcott and Wang Xueqiao had an article in the Financial Times, in which they described “How China has ‘throttled’ its private sector”. One indicator they show is the pace of venture capital-funded company creation. It went down from the peak of 51,032 in 2018 to 1,202 in 2023. That’s a decline of 97.6 per cent: One vibrant field was essentially extinguished.

Under normal circumstances, once China-centric production arrangements are established at a global firm, change can take place only at a glacial pace because no leadership wants to rock the boat of well-debugged production arrangements. Even when Chinese wages rose, relatively little activity moved out of China through this sensible conservatism of firms. Once the Chinese state lurched into arbitrary state power and nationalism, this triggered a rethink. Most global corporations realised that they were under-diversified. A unique moment arose, where many global firms started shifting activities away from China. The phenomenon of global firms redesigning their production arrangements is a megatrend of the 2018-28 period.

Why is FDI important for national development? Firms from advanced economies contain frontiers knowledge. When they operate in India, they bring superior techniques of management and technology and they directly generate productivity growth by improving the utilisation of Indian labour and capital. In each market they operate in, they challenge incumbent firms and improve the tone of flesh of the entire industry. Indian employees gain their knowledge, and then go out to work for other firms, thus diffusing better knowledge into the economy. FDI is the key to firm internationalisation, which powers productivity growth for firms.

Economic policymakers in countries like Vietnam and Thailand are actively playing for the modified global FDI environment. It is sensible for Indian economic-policy leadership to establish an objective of getting net FDI in India up by 10 times, from the present value of $26 billion in 2023-24 to a level of $260 billion.

What is the report card for Indian gains in the period where global firms were retreating from producing in China? Let us look at the data for Indian merchandise exports and for FDI in India. Discussion on FDI needs to be careful in distinguishing between FDI in India vs FDI by India and, when it comes to FDI in India, net out the repatriation of capital by global firms, which gives the “net FDI in India”. Expressed in nominal dollars, compound growth in the last decade (ended 2023-24) works out to 3.3 per cent for merchandise exports and -1.5 per cent for net FDI in India.

FDI in India comes in two kinds: There are the mainline physical assets for manufacturing or infrastructure and there is services production in India, such as the global capability centres (GCC). Growth in services exports over the decade has done relatively well, at a compound rate of 8.45 per cent in nominal US dollars (USD). Thus, FDI for services is likely to have fared better, and FDI in manufacturing/infrastructure has done worse than -1.5 per cent compound growth in nominal USD.

When all these values (goods exports growth of 3.3 per cent, net FDI in India growth of -1.5 per cent) are adjusted for a US inflation rate of about 3 per cent over this period, the performance looks worse. We thus know that even in the period of the breakdown of the China model, with a substantial retreat by global firms away from activities in China, manufacturing infrastructure FDI in India has fared poorly. This proves that the conventional policy strategy (eg emphasis on infrastructure or production-linked incentive) is not delivering positive growth rates. This is an important problem that requires attention, diagnosis, and resolution.

Can taxpayer money be used to get a 10x gain in inbound FDI? The fiscal resources of the Indian state are too limited to make a material difference. If we think the difficulties of operating in India represent a cost of 10 per cent of exports, and if exports of $1 trillion are desired, such a subsidy comes to $100 billion, or Rs 8.5 trillion, every year, which is infeasible.

To get a 10x gain in FDI, we need to solve the deeper issues. The problems in India are reminiscent of those seen in China, on a smaller scale. There are problems of work visas, capital controls, protectionism, tax policy, and tax administration. Regulators have become an important outpost of the state and they have arbitrary power through fusing the legislative, executive, and judicial branches. The biggest issues are the overall climate of economic nationalism (ie lack of equal treatment for foreign firms), central planning, and the lack of the rule of law. Attempts by the Chinese or Indian government at creating odd technical standards and monopolies interfere with a proper engagement with globalisation. When the executive branch harms a private person, recourse to courts is limited through delays and the chance that a matter is decided incorrectly. Intellectual property theft in India takes place on a smaller scale than what is seen in China. Policymakers need to double down on this with a respectful approach towards foreign technology and process knowledge.

All these problems are eminently solvable through a better process for economic reforms. There would be a cost in obtaining capable research organisations that infuse ideas into implementation teams in departments of government. Through this, it is feasible to get genuine expertise to guide the resolution of issues described above. Public money would have to also be spent on overcoming chokepoints of political economy. These two kinds of cost would work out to small numbers.

The writer is a researcher at XKDR Forum