By Indroneel Das
The recently published World Investment Report by the United Nations Conference on Trade and Development (UNCTAD) outlined the rather sluggish growth in Foreign Direct Investment (FDI) momentum around the globe. Developing economies were hit especially hard due to the lack of confidence in the growth stories of emerging markets.
Overall, FDI fell by about 14% compared to last year. The world seems to have been making safe bets. Developed economies received the lions share of global FDI, as well as recorded year-on-year growth in FDI inflows. While Asia saw a fall in FDI inflows for the first time in 5 years, the global markets showed much confidence in the growth story of South Asia, which was largely shielded from the slowdown in FDI inflows.
What are FDI inflows?
Put in very simple terms, FDI inflows are a function of the confidence that the world has in an economys ability to generate a good risk-adjusted return on the investor nations capital. The capital dedicated to FDIs and the year-on-year change in that capital depends on the investment climate of all nations in the consideration set of the investors.
Indias growth story and its changing investment climate are of particular interest in this context; even though there are signs of loss of confidence in developing economies globally, India is managing to attract capital from the world over.
What makes India so special?
It is notable that for an economy like India, FDI inflows are much more critical than for competing countries that are significantly ahead in the development curve (read China), or for smaller countries that lag behind India in terms of the pace of development. This is partly because the disparity between the level of FDI inflows and outflows for India is much larger than comparable countries; the quantity of FDI inflow far outweighs outflows. FDI is also a much greater contributor as a percentage of GDP to the needs of a capital intensive developing economy like India.
A case in point is Indian e-commerce. The sector is currently facing a severe cash crunch and looks set for consolidation. It is also a largely untapped opportunity. The extent of penetration of e-commerce in India depends on many factors. These include the extent of internet penetration, the demographics of the user base, the percentage of that base currently using e-commerce platforms to shop and the speed and affordability of internet. Other than the large internet user base in India, we hardly come close to global standards in any other parameter. With such a large yet nascent market, it is easy to see why we are seeing increasing FDI in the form of cross-border mergers and acquisitions (M&As) in this space.
Reforms start to pave the way for investors
Under the Modi government, India has seen a significant liberalisation of inbound foreign investment policies. Reforms have been spread out across all three segments of the economy services, manufacturing, and agriculture. The reforms are encapsulated under the Make in India, Digital India, and StartUp India campaigns. In the last couple of years, most of the sectors have been included in the automatic approval route. This has had the effect of significantly reducing the regulatory burden on hitherto heavily regulated and capital intensive industries such as civil aviation, pharmaceuticals and real estate. Allowing 100% FDI in limited liability partnerships (LLPs) and easing the regulations for setting up offices are among other reforms that are paving the way for increased FDIs. While easing regulatory burden is critical to grabbing an increasing portion of the FDI pie, it obviously isnt enough.
The key to increasing cross-border M&A activity and the growing interest of foreign investors is the strong and stable domestic cash flows of India in a world where most developing economies are volatile. Even though the number of cross-border M&A deals may not have necessarily gone up, the sharp rise in the value of M&A is still of interest. This larger value is derived from big-ticket transactions. While the motivation of the engaging parties might range from tapping into market opportunities to sectoral consolidation or reduction of debt, the merit of the investment lies in the merit of the investee economy.
Key components in India’s favour
Focusing on the investee economy, India has considerable factors in its favour. First of all, political stability of the kind that is currently prevailing in India is difficult to find. A strong and economically focused government and nationwide acceptance give significant confidence to global investors. Further, there is a heavy focus on social identity, providing a more granular framework for social security. This improves consumer spending and economic growth expectations. In addition, the introduction of the Goods and Services Tax (GST) aids in correcting the current, inherent market inefficiency which results from a fragmented and a less-than-transparent taxation system. A more tangible benefit of the GST is net cost savings for the Indian business ecosystem.
With the passage of time, more and more transactions and a consequently increasing business value will shift to the digital marketplace. Indias ability to keep up with this transformation is increasingly owed to the introduction of the Jio digital ecosystem. Its disruptive pricing and impact on the competitive dynamics of the industry (mostly regarding the rate at which the data and telecom industries now adopt new technology) have given India the ability to leapfrog into a future that would otherwise have arrived much later.
Moreover, the savings and investments scenario of the country is looking brighter than ever before. A well-timed combination of the Pradhan Mantri Jan Dhan Yojna, the demonetization move to bring black money into the banking system, low interest rates, and improved government spending create a recipe for long-term growth. The reduced regulatory burden and the economic promise of India are two sides of the same coin; one is incomplete without the other.
The potent combination of these many factors is what makes India unique. This competitive advantage is not shared by Indias peers and competitors, even including the BRICS nations.
Reasons for a possible slowdown
There are, of course, a few concerns. The implications of the current taxation structure in place for FDIs (and cross-border M&As, specifically) make it vulnerable to inefficiencies which might deter the possible incremental growth of FDIs. Ultimately, there are possibilities of what can in effect be double taxation arrangements. Among other problems, there are also grey areas with respect to retrospective taxation and differential taxation once an inbound M&A is completed. Governmental policies and the successive clarifications of the Central Board of Direct Taxation (CBDT) have been largely unsuccessful in furthering transparency and easing the cross-border M&A taxation process. Moreover, there are whispers of Indias investment climate deteriorating in the next few years as economic growth slows.
This school of thought is based on the argument that the Central Statistics Office’s survey indicates that the Indian economy was slowing down even before demonetisation hit. Post demonetisation, the slowdown may be compounded. A complete recovery may not happen anytime in the near future. Absent a reasonable estimate of losses in output and employment, any economic policy will be based on fundamentally wrong assumptions. On a year-on-year basis, Indias gross fixed capital formation as a percentage of GDPwhich is the true benchmark and basis of investmentshad also slumped from 2015 to 2016. This can also be worrying, given that this data doesnt even include the short-term potential spiralling effects of demonetization.
All these factors can shake the confidence of foreign investors. Once that faith is shaken, it will be difficult for India to continue with the same level of capital formation. India can only hope that time alleviates these concerns so that Indias growth story can race on, unhindered.
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