Direction of foreign investment is key to a new phase of growth

The role that foreign direct investment (FDI) has played in India’s economic success has been the topic of much debate recently. With growth rates reaching 19- year highs and investment inflows increasing, many correlate India’s growth story with the reform and relaxation of India’s rules on foreign ownership.

The reality, however, may not be as clear-cut. While it is true that the relaxation of rules governing what foreigners can own has contributed to India’s growth, its effect has been fairly concentrated rather than benefiting all the sectors that have been opened up.

The rules on FDI were originally drafted to protect sectors of strategic importance from foreign competition and to create domestic champions in these sectors. Industries such as atomic energy, insurance, print media, broadcasting and retail were shielded from full foreign competition. While some point to such protection as a barrier to growth, certain sectors have benefited.

The telecommunications industry is an example where foreign ownership restrictions have not prevented growth of the industry or the entry of foreign investors in minority roles. Indian telecommunication companies have sustained double-digit growth in recent years and this trend looks set to continue in the near term. The domestic airline industry is another example of a sector that has grown at breakneck speed under regulatory protection. Such regulation has not stifled market forces; overcapacity in the sector has forced airlines to merge in order to protect their positions.

This is not to say that India does not need FDI. The ease with which FDI can flow into the service sector has helped to create successes, especially within the IT and business process outsourcing (BPO) fields. However, success was as much a result of foreign investment as it was of favourable domestic factors, such as freedom from overbearing federal and state regulations. The success of the IT and BPO industries can be contrasted with the power sector, which benefits from the same liberal policy stance towards foreign investment, but has languished due to a lack of comprehensive reform at state level.

The debate on foreign inflows has overshadowed India’s growing investments abroad. So far this year, Indian companies have already invested more money abroad than they did in the whole of 2006. Although the figure is still fairly minor in comparison to inflows into the country, it is an added facet to the debate on FDI that many have ignored.

Manmohan Singh, India’s prime minister, has promised further reform of the foreign investment rules. Recent changes allowing foreign investment, although with a number of restrictions, in real estate development and single- brand retailing are clear indicators of the government’s desire to liberalise sectors previously considered off-limits to foreigners.

However, the government’s recognition of the need for foreign capital is not always clearly reflected in how rules are articulated and implemented. Foreign investors are eager for clear and consistent guidance from all regulatory agencies, both about market entry and market exit. The debate over the merits of further relaxations of FDI restrictions will certainly continue. Domestic companies have proved they are capable of making the Indian tiger roar; FDI just makes it louder.

The author is an associate in the London office of White & Case