FDI AS DETERMINANT OF REGIONAL DEVELOPMENT: MAPPING INDIA’S SUCCESS by Joan Foltz
When assessing whether economic growth in an emerging region is a speculative bubble ready to burst or sustainable development, tracking the flows of foreign direct investment (FDI) can frame the underpinnings of a region’s prevailing macroeconomic condition and trends. The form of FDI can also indicate the consensus on the sustainability in a region’s economic horizontal and vertical expansion. The debate over India’s capital growth potential highlights the issues many emerging regions face that deter global investors. Strategic policies utilize and direct the inflow of FDI money towards necessary programs that best alleviate hurdles—such as poor infrastructure—and promote capital formation. Critical to evaluating India’s rate of development and long-term potential is the identification of trends in three key areas: policy changes, FDI inflows, and industrial centers. With increasing globalization of financial institutions and liberalization of market economies, distribution of capital liquidity, whether by private investments, offshoring or outsourcing, will determine the direction of each of those key mechanisms, which, if strategically directed, can subsidize India’s economic stability.
JUDGING STRENGTH AND SUSTAINABILITY
Regional studies generally consider the determinants outlined in traditional development theories that focus on regional efficiencies: environmental impacts, infrastructure, labor, market size, and regulatory environment. Now instrumental in current analyses of development programs and economic growth is the monitoring of FDI inflows into a region. Based on the type and direction of investments, FDI can reinforce forecasts that prognosticate emerging trends, the magnitude of the trend, and potential valuations of the next phase of development, including the plausible longevity of the cycle. Investment in a region signals confidence in its stability and economic prospects. Foreign capital inflows in the form of institutional and portfolio investments that induce liquidity could lend an element of speculation and instability—versus long-term investors who seek growth potential with minimized risk. Despite the possible windfalls delivered to early entrants, these long-term investors require an understanding of the immediate regional hurdles to the market and industry and will enter only when the risk/reward ratio stabilizes. Sustainable development in emerging regions typically requires an investment in social programs and infrastructure to create economic growth that will stimulate social advancement. Given liberal policies and open markets, FDI provides capital for the necessary industrial expansion, while enabling the government to focus on social programs. But industrial expansion often requires significant investments in infrastructure prior to realizing market opportunities. India, in particular, faces inadequate infrastructure in all areas of transport and utilities that require significant building initiatives and is a short-term deterrent for manufacturers. Financial institutions and investors seek short-term returns and move in and out of markets quickly, in response to the quirks of market behaviors. For them, government policies dictate opportunities. But for long-term investors who assess the obstacles and additional costs they might incur to establish continuing benefits on their direct investments, infrastructure issues will surface. Mapping the flow of money produces an indicator that signals when economic growth outweighs the cost of eliminating the hurdles as they surface. According to the United Nations Conference on Trade and Development (UNCTAD), FDI is the largest source of external finance for developing countries. When comparing a country’s FDI performance against its potential, the UNCTAD ranks the “Front-runners” as those countries that have high potential combined with high performance.1 In 2006, China was propelled to the forefront with $55 billion of FDI in comparison to India’s inflow of $6.5 billion, despite both having a large population and potential for an expanding domestic market.2 India’s restrictive policies and inadequate infrastructure contributed to the significant difference in FDI performance. While China has high FDI potential, it also applies inflows to capital formation.
HIGH FDI+ PERFORMANCE
LOW FDI PERFORMANCE
HIGH FDI POTENTIAL
Front-runners
Below potential
LOW FDI POTENTIAL
Above potential
Under-performers
An emerging country like India, with low capital savings, depends on more foreign investment than domestic to build out the necessary infrastructure. If FDI growth shifts from emerging markets back to developed countries in 2006-2010 (as predicted by the Columbia Program on International Investment), then one could expect that India’s growth will slow more than China’s, where significant investments in infrastructure are being made.3 However, with India’s increased participation in integrated financial markets, more liquidity in the region could encourage investments in the necessary infrastructure.
ROLE OF GLOBAL FINANCIAL INSTITUTIONS
Understanding all the externalities of developing regions can be out of the realm of a private investor or a corporation making preliminary assessments for site locations or capturing the local economy. However, the complexity is only escalating with the consolidation and cross-border ownership of the financial institutions, which include banks and, recently, stock exchanges. The challenges in governance due to growing connectivity is explored in The National Intelligence Council’s “Mapping the Global Future: 2020 Project.”4 In 2006, the New York Stock Exchange initiated a merger with Euronext, the pan-European stock exchange that encompasses the Amsterdam, Brussels, Paris, and Portuguese exchanges. Then, in January 2007, the NYSE and two other companies each took 5% investment in the National Stock Exchange of India, the minimum ownership allowed by a foreign corporation under current regulation. Shortly after, the NYSE announced a strategic alliance with the Tokyo stock exchange. The NASDAQ also attempted a merger with the London stock exchange after aggressive acquisition of its stock and submitting bids for takeover. These moves by the NYSE and NASDAQ, now becoming global multinational corporations, open the possibility that foreign financial institutions will become a predominant influencing factor with global clout, pushing FDI as a determinant of regional development and policies regarding short-term capital investments. Policy changes opening investment options could draw money-seeking speculative opportunities into a region instead of into long-term investments in infrastructure and other fixed capital. As stock markets become public corporations open to foreign investors, the markets become less of a mechanism for formulating future projections based on valuations. Instead, the exchanges adopt systemic structural changes cultivated by underlying drivers predominant of a corporation and speculators. Open markets, global exchanges, and computerized trading are creating excessive, mobile liquidity around the world. In addition, mergers and acquisitions are expected to drive global FDI, along with increase in private equity financing. Incentives such as changes in China’s preferential tax rate for foreign companies or more openness to foreign ownership in India could shift global investment targets and create disruptions in India’s trends and development trajectories, particularly since these incentives influence long-term investment strategies. Hedge funds, often contrarians to growth, are also anticipating penetration into India with further liberalization. If policy changes enable hedge fund participation, speculation will need to be weighed even more so when assessing sustainability. The potential for India to experience disruption the such as occurred in Mexico and Asian countries in the 1990s depends on how well the newly integrated global financial systems act as an instrument to stabilize or destabilize regions. As a partner in the NYSE’s goal to become a global trading platform, India should benefit from having more access to foreign financial institutions and investors. However, the dynamics of the global financial system may change the behavior of the organizational form of India’s government. World system theories differ on the power that receiving nations have to negotiate or resist the coercion of the promoters of capital markets.5 The ability of India to direct FDI funds toward India’s infrastructure and away from liquid capital investments will depend on how corporations perceive the opportunities derived from more policy changes. The success of those government programs will be reflected in the inflows of both FDI and domestic direct investment. NECESSITY FOR INDUSTRIAL EXPANSION
India has two robust markets: an expanding service market of low-wage professional labor that provides outsourcing services in telecommunications, engineering, financial, and medical fields, and a domestic consumer market that is improving, at a substantially slower pace. Any wage increase in services could spur competition from other countries, making the need to promote other industries essential for India’s continued economic growth in the future. For spillovers from economic development to pervade across sectors, regions, and society, growth must occur in either the buying power of the population that drives the domestic market or in manufacturing sectors that generate exporting opportunities. Further liberalization toward foreign ownership, a reduction of bureaucracy, and an improved infrastructure are necessary to encourage manufacturing companies to commit the needed long-term investments in India. However, if a growing consumer market lends substantial opportunities, companies could weigh the burden of ownership limitations and costs of bureaucratic process against profitable ventures. That leaves the inadequate infrastructure as the immediate hurdle for companies outside the service sector considering a presence in India. Growth in the auto sector, a heavy industry requiring improved ports and roads, indicates the growing strength of the domestic market’s demand for autos, which could begin to offset the added cost of insufficient infrastructures. The recent acceleration of foreign auto manufacturers’ interest in the region, particularly that of BMW, which intends to building a facility for export manufacturing, is pivotal in shifting the sector from a domestic supplier in the local market to an expanding export manufacturer in the global market. The auto sector’s growth is spawning vertical expansion as well, with the components parts industry expected to reach $23.2 billion by 2010.6 Foreign automobile manufacturers and parts suppliers are locating around the auto industry’s established core in the Chennai area in southern India, often dubbed “Asia’s Detroit.” The already congested area of Chennai, with minimal land available for expanding roads or building new plants, has prompted industrial centers outside Chennai in areas such as Sriperumbudur, anchored by a Hyundai plant. If the auto industry quadruples as the government estimates (with $145 billion in sales by 2016), other auto manufacturers will contribute to the expansion of the periphery, outside cities and changes in the cross-regional economic landscape.7 The growth of the industry and its dispersion is already noted by the speculation that Honda will build a plant outside Delhi, with Toyota and Daihatsu targeting the Bangalore area. Even more significant are the announcements by Volkswagen and BMW, who are building their first plants for export production.
AGGLOMERATION OF REGIONAL DEVELOPMENT
World-class infrastructure in both the urban and outlying areas is essential for India’s expansion. Due to constraints of land availability and rising real estate prices, consideration of alternative site locations in the rural areas necessitates connectivity between urban centers and ports to rural areas. In addition to inefficient transport options, these areas also contend with frequent water shortages and power outages. With the encouragement of the World Bank, India started privatizing public utilities, dams, ports, and highway projects in the 1990s. Yet infrastructure projects have not attracted FDI from outside the country as expected. To entice FDI, the Indian government has approved proposals for 170 special economic zones (SEZs) backed by free trade zones and export processing zones to foster industrial centers. Supported with state government incentives, SEZ locations are intended to support local initiatives for highway, power, and other infrastructure projects, such as the state of Kerala’s free trade warehousing zone at the Kochi port SEZ. The Golden Quadrilateral, a new highway system now under the National Highway Development Programme (NHDP), plans to connect Delhi, Mumbai, Kolkata, and Chennai with expressways. Even though taking years to complete, this project will likely direct investment into concentrated clusters along its corridors. How quickly the development of the infrastructure occurs depends on investors’ confidence that the construction projects are planned and not corrupt, and if other building along the corridor substantiates sound investment. With states continuing to have financial problems, infrastructure development will likely concentrate around the SEZs that successfully draw foreign investment into industrial centers. The positive effects for both horizontal and vertical growth from clustering of industries, or agglomeration, often triggers momentum with foreign investors in addition to creating spillover effects in the local economy. India’s strategy to build sustainable development is evidenced by their use of SEZs to promote specific regions and industries, which has manifested STZs, Special Tourism Zones. Approved in late 2006 by the National Tourism Advisory Council, these zones will concentrate on urban development around the major tourist destinations and cities along the coastline. Public–private partnerships will be encouraged to build shopping facilities, restaurants, hotel rooms, and other city amenities.8 The economic stimulation should pressure airport and port infrastructure upgrades as well. Adding to the agglomeration effect of special zones that funnel direct investment to specific locations is the government’s drive to expand the auto industry, an industry that attracts market-seeking FDI aimed at penetratinglocal markets. Typically an industry with a long-term commitment based on domestic strength, the auto industry can leverage investments in fixed capital to mitigate risks associated with inefficient port and highway systems necessary for this heavy industry. However, agglomeration can be positive for FDI while also having a negative impact on the economy. Concentration of investment can cause rapid over-accumulation of capital in limited sectors or regions by speculators. The culmination of speculation and concentration results in the lack of intra-regional FDI and expansion of infrastructure improvements across regions essential to spatially enlarge opportunities and diffuse production activity beyond the clusters.9
INDIA’S MOVE TOWARD LIBERALIZATION—POLICY REFORMS
The key issues for monitoring the efficacy of India’s policy restructuring are increases in: (1) partnerships or ownership of large corporations with Indian firms, (2) the manufacturing sector, and (3) inflow of capital toward infrastructure projects. Improvement in these areas defers the chance of instability caused by international monetary transfers primed by short-term investment opportunities. Despite lessons learned from the Asian crisis of 1997, the FDI trend continues to accelerate as liberalization of foreign capital has proven to be a successful development strategy.10 Reflecting on the problems caused by the fast-shifting money during the Asian crisis, India created restrictive policies intended to limit the speculation of short-term investors. However, the protectionism resulted in limiting foreign direct investment, particularly that regarding corporate ownership. India’s restrictive policies and extensive public sector, coupled with an encumbering bureaucratic system, had prevented foreign investment necessary to economically stimulate the impoverished country. Not only were the federal government’s regulatory bodies slow and boundless, most projects were also dependent on individual state governing bodies, which were often influenced by local sentiment influenced by labor parties and rampant corruption. Foreign investors were restricted from most sectors. Those sectors open to FDI were limited by the allowed percentage of ownership, which required a company to enter into a joint venture or shared technical collaboration without substantial management control. Under the Industrial Policy Resolution, new reforms were initiated in 1991, with the primary focus on building the technology and communication service sectors. The liberalization of their technology sector catapulted India into the forefront of the emerging markets as a leader in outsourcing of communication technologies and software programming, which expanded into other engineering and high-tech services. The diffusion of professional outsourcing now proliferates in medical and financial services. In consideration of the success, India continuously addresses liberalization policies in many other sectors. To increase its participation in the global financial market, India recognized the need for further reform of its economic trade policies and the need for a world-class infrastructure. The emphasis to build the appropriate infrastructure is reflected in their tenth Five-Year Plan. The goals of India’s Five-Year Plan (2002-2007) include: ·Modernize legislations on intellectual property. ·Increase highway capacity. ·Improve urban infrastructure. ·Develop ports. India’s next phase of reform attempted privatization of its large public sector with the intent to attract FDI to targeted critical public utility projects to revamp the inefficient infrastructure. But the initial projects received little interest from investors, due to the minimal revenue generated by the power plants and port projects. Now, with incentives to support the growing industrial sectors and an increase in ownership, foreign investment in infrastructure projects is increasing, along with the changes in policy regarding participation mostly in the BOO (build-own-operate) and BOT (build-own-transfer) agreements. Now, most of the public sector has been privatized or open to FDI participation with limitations other than atomic energy and railway public projects. Policy changes that minimize bureaucratic processes have been emended with a new “automatic route” that reduces licensing time for corporations by eliminating the requirement to obtain prior governmental authorization except in sectors where an industrial license is required, which include areas in manufacturing of alcohol, tobacco, defense equipment, and pharmaceuticals. In addition to the “automatic route,” the Foreign Investment Implementation Authority (FIIA), along with the Fast Track Committee from 30 federal departments, assist foreign investors in the application process and resolution of grievances. Despite opening of many sectors, policies continue to limit foreign ownership of corporations to 51%. Still protective of small and medium enterprises (SMEs), particularly the textile, arts and crafts, cottage industries, and small retail shops that employ 70% of the working population, India’s central government continues to restrict FDI in those sectors in response to the protests of local businesses and as protectionist support for villages.11 However, retail is slowly opening up, allowing 51% majority ownership in single-brand name stores, such as Nike or Starbucks. The recent joint-venture between Wal-Mart and the Indian telecom company Bharti Enterprises Ltd. makes Wal-Mart the first foreign retail chain store.
PACING PROGRESS
India’s central government continues to reform policies that enhance the country’s attraction in the global market as a mechanism for obtaining needed capital for funding improvements. Particular reforms have more significance on capital formation than others. The Secretariat of Industrial Assistance, an arm of the Ministry of Finance, initiated changes in their real estate policies that now allow up to 100% ownership in large real estate development projects. The chance to invest in real estate, coupled with reforms regarding ownership in financial institutions, should significantly boost the region’s progress. The noteworthy emergence of liberalization of India stock exchanges, which includes allowing limited ownership of the exchange and loosens restrictions on foreign institutional investors, also could be a significant stimulus for not only rapid transformation of India’s financial industry but for the country’s entire economy. Further policy changes are under consideration for the commodity institutions and also hedge funds. However, foreign venture capital investors still find being restricted to investing in only publicly listed companies as a deterrent to the region. Concentrating on expanding the successful technology sector, a new Semiconductor Policy proposes a fiscal incentive package worth 25% of expenditures that could include investment grants, tax credits, or interest subsidies, to draw semiconductor fabrication facilities to designated high-tech areas.12 The telecom industry’s FDI cap increase to 74% also confirms the government’s commitment to the sector’s expansion. Each successful project increases India’s move toward an open market and an integrated global player as the potential for substantial opportunities for foreign investors pressures government policies. Strong domestic economic growth also forces reforms in the public sector, as exemplified by the much debated decision by India’s NICto allow privatization of the Mumbai and Delhi airports. The demands of increasing air traffic and forbidding costs of airport construction necessitated the government to solicit private investors for these two major airports. In its preliminary Policy on Airport Infrastructure, the Ministry of Civil Aviation states that “looking at the quantum of investment required, the answer to all the problems lies in the infusion of private (including foreign), investment in this sector.” The NIC also proposes upping foreign equity participation to 74%, with automatic approvals and up to 100% with special permission.13 With government initiatives such as the “power for all by 2012,” and upgrades for cruise terminals, foreign investors will likely fuel the construction of most of the major infrastructure upgrades essential in shaping the region’s development process.
INFLOWS
The success of India’s reform policies and restructuring plans will be reflected in the level of FDI inflows, and whether, with these reforms, investors still foresee growth potential. With continued reformation, direct investment is expected to reach $8 billion in 2007, up from $6.5 billion in 2006.2 The impact on the country’s macroeconomic environment and its measurable sustainability will be dependent on whether the money primarily targets clustered areas. According to LOCOmonitor, a consulting firm that tracks FDI projects throughout Asia, India had an increase in projects from 591 in 2005 to 980 in 2006, with the largest percent in information communications technology.14 The implication derived from the concentration of FDI projects toward specialized business functions, such as software programming or financial services, is the limited effect on job creation across the working population. Becauseof the lesser chance to transfer skills and technology, or to raise productivity as a whole, regional economics may be more vulnerable to sector rotation. FDI PROJECTS IN INDIA
Industry Clusters
Percent
ICT
31%
Business and Financial Services
13%
Electronics
12%
Heavy Industry
9%
Transport Equipment
8%
Property, Tourism and Leisure
6%
Light Industry
5%
Life Sciences
4%
Logistics and Distribution
4%
Chemicals, Plastics and Rubber
3%
Consumer Products
3%
Food/Beverages/Tobacco
2%
Source: OCO Consulting 14 While there was a significant decline in the agriculture sector’s percentage of GDP from 22.9% in 2004 to 19.9% in 2006, financial services had a growth rate from 4.5% to 9.7%.15 Expansion of outsourcing services in the financial sector, coupled with new policies for investors, created residual effects that boosted the sector. Increases in construction establish progress with sustainability, as the sector compounds fixed capital, unlike the service industries, which have outflows and create limited assets. Likewise, an increase in manufacturing generates spillovers that expand the labor market and create more economic opportunities for SMEs. These increases in fixed capital and productivity, which should be noticeable with FDI shifts to sectors other than technology and business services, set the foundation for sustainable regional development.
SUMMARY
Tracking the inflows of FDI can validate the rate of development and sustainability of an emerging region. In the case of India, the country’s capital deficit prevents reconstructing the inadequate infrastructure without FDI, which has been confronted with restraining restrictive policies. Recent liberalization reforms and government plans that target investment utilization have opened many sectors to foreign investors and curtailed the bureaucratic process. The success of these efforts will be reflected in the FDI inflows. The rate of regional development and sustainability could be significantly impacted by foreign financial institutions drawing funds away from long-term capital formation and more toward speculative investments. Expansion will occur where foreign direct investment goes, and the utilization of that inflow will be reflected in the capital growth in a range of sectors. An increase in FDI going to long-term real estate development and infrastructure projects exemplifies a consensus of stability and significant growth potential in the region’s overall economic expansion. If India does not direct FDI toward fixing the bottlenecks that are preventing expansion in industries that provide sustained growth, such as manufacturing, then speculative investments could dominate and create economic instability. India’s challenge is to generate a growing economy that benefits all sectors of society, while not relinquishing direction to a market economy. The next phase of India’s development will be determined by the concentration of capital, whether Special Economic Zones cause agglomeration, economic growth expands beyond the professional services sector, and investment in infrastructure projects diffuses across the region. If India continues to liberalize its policies, opportunities presenting themselves will find investors when the risk/reward factor is removed, particularly those regarding caps on corporate ownership. A significant increase in FDI leading to capital formation could manifest into an economic boom rivaling China.
NOTES 1. United Nations. World Investment Report: FDI from Developing and Transition Economies: Implications for Development. United Nations Conference on Trade and Development (2006). 2. Institute of International Finance. Capital Flows to Emerging Market Economies (September 2006). www.iif.com. 3. Columbia Program on International Investment/Economist. 2006. World Investment Prospects to 2010: Boom or Backlash. www.eiu.com. 4. National Intelligence Council. Mapping the Global Future: 2020 Project (December 2004). 5. Schwartzman, Kathleen C. 2006. “Globalization From a World-System Perspective: A New Phase in the Core—A New Destiny for Brazil and the Semiperiphery.” Journal of World-Systems Research 12(2), pp. 271-273. 6. Businesswire India. “Frost & Sullivan Expects Passenger Vehicle Sales Volume to Reach 2.1 Million by 2010” (February 19, 2007). www.businesswireindia.com. 7.Society of Indian Automobile Manufacturers. Launch of Automotive Mission Plan (AMP) 2006-2016 (January 29, 2007). www.siam-india.com. 8. India Daily. “India is considering a proposal to set up Special Tourism Zones (STZs) on the lines of Special Economic Zones (SEZs),” December 3, 2006. www.indiadaily.com. 9.Harvey, David. The New Imperialism (Oxford: Oxford University Press, 2005), pp. 123-4. 10. Yip, Wei Kiat. “Prospects for Closer Economic Integration in East Asia,” Journal of East Asian Affairs Spring (1)108 (2001). 11.Kumar, Manoj. “SME, Agriculture Sectors Pin Low Hopes on Budget,”The Tribune (February 25, 2006). www.tribuneindia.com. 12. Electronic Industries Association of India, Policy, www.elcina .com/policy.asp (accessed February 18, 2007). 13.Ministryof CivilAviation, Policy on AirportInfrastruc‑ ture (preliminary), http://civilaviation.nic.in/ (accessed January 28, 2007). 14.Locomonitor, “India FDI Report,” OCO Consulting, www.locomonitor.com (accessed January 26, 2007). 15.Department of Economic Affairs, Monthly Economic Report, http://finmin.nic.in/stats_data/ (December 2006). Joan Foltz isfounder of Alsek Research providing independent socio-economic research and analysis of global trends, shifts in regional and industrial development, and market behavior. She may be contacted at jfoltz@cox.net.