India needs lasting reforms to attract foreign capital, not stopgaps

Without credible investment protection, the FTA alone is unlikely to attract the manufacturing FDI India needs to create jobs

India’s biggest economic challenge today is creating enough good jobs. Around 10-12 million young people join the labour force every year, but manufacturing — the sector that should create jobs at this scale — has remained stuck at 15-17 per cent of gross domestic product (GDP) for the past two decades. Expanding manufacturing will require higher investment, and domestic savings alone will not be enough to finance it. India needs more foreign direct investment (FDI) to bring in capital, technology as well as jobs. The recently concluded India-European Union free trade agreement (FTA) offers an opportunity to do this. The question is whether India will take it. 

The FDI numbers are sobering. While media discourse mostly focuses on the gross numbers, India’s FDI inflows as a share of GDP have fallen to less than 1 per cent, far below the 5.7 per cent average for Asean economies such as Vietnam and Malaysia. These countries have emerged as the biggest beneficiaries of the China+1 shift, while India has largely missed out despite being a bigger economy. Moreover, much of the FDI that India does attract goes into services rather than manufacturing, thereby limiting its impact on job creation. 

To attract substantial manufacturing FDI, policymakers now have to persuade global firms to choose India for the next phase of their expansion. That will not be easy. It requires addressing the factors that have made India a less attractive investment destination over the past decade. 

One important factor has been the growing uncertainty around investment protection. Between 2016 and 2024, India terminated bilateral investment treaties (BITs) with 77 countries, including 22 EU member states, and replaced them with the much narrower 2015 Model BIT. New investments from these countries no longer enjoy the safeguards that BITs typically provide against arbitrary state action, discriminatory treatment, uncompensated expropriation and unpredictable dispute resolution. As a result, foreign investors have less certainty today about investing in India. 

In addition, India continues to impose average import tariffs of nearly 16 per cent, well above those in Asean economies. Recent bilateral FTAs lower tariffs for a few selected partners, but they are a second-best substitute for the broader trade liberalisation that globally integrated manufacturers need. The growing use of quality control orders (QCOs) has further raised costs by restricting access to imported inputs. India’s decision to stay out of the World Trade Organization’s Investment Facilitation for Development Agreement (IFDA) reinforces this perception, signalling caution at a time when global investors are looking for openness. These frictions matter when firms decide where to locate their next factory. 

Investment protection deserves fresh thinking. For instance, commercial disputes are contractual matters. If a foreign investor and its Indian partner agree to resolve them through arbitration in Singapore or any other internationally recognised forum, the government should not prevent them from doing so. Giving contracting parties the freedom to choose a credible dispute resolution mechanism would send a strong signal that India is serious about attracting long-term investment. 

This is where the recently concluded India-EU FTA becomes important. The EU is the world’s largest source of outward investment, accounting for around 40 per cent of global FDI stock, and is already one of India’s largest investors. The FTA gives European firms a stronger incentive to manufacture in India. But investment decisions are driven by more than market access. Without credible investment protection, the FTA alone is unlikely to attract the scale of manufacturing FDI that India needs. Concluding an Investment Protection Agreement (IPA) with the EU should, therefore, become the next policy priority. 

Europe also brings the kind of investment India needs. European manufacturing FDI is typically long term and comes with technology, research & development and jobs rather than just capital. European firms already earn higher returns in India than in the mature United States and United Kingdom markets, yet their investment in India remains well below its potential. 

The timing matters too. European firms are increasingly concluding that China no longer works for them. That capital is looking for a new home, and India, with its scale and young workforce, is the natural candidate to play the role China once did. But the window will not stay open indefinitely. If India hesitates, Asean countries or Eastern Europe are likely to absorb the investment instead. 

The policy initiatives that India needs to implement are three-fold. First, conclude the IPA that is currently under negotiation with the EU, and do so pragmatically rather than insisting on procedures that trap investors in domestic courts for years. Second, reform the 2015 Model BIT to gear it more towards international norms. Third, lower tariffs on intermediate inputs, progressively dismantle QCOs, and join the WTO’s IFDA. These policy actions would help attract FDI not only from the EU, but also from other interested countries. 

The India-EU FTA has opened a door. But for European firms to build factories here rather than elsewhere, Indian policymakers need to take the necessary steps, and quickly too, in order to take advantage of the next phase of China+1 opportunity and make India a more attractive place to invest. That would not only strengthen manufacturing, but also help address India's biggest economic challenge — creating enough productive jobs for its growing workforce. 

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The writers are, respectively, associate professor of economics, IGIDR, Mumbai, and chief economist Asia-Pacific at Natixis. The views are personal