Putting aside security implications of allowing foreign investors into crucial sectors, the Government of India has announced one of the biggest reform push, allowing 100 per cent Foreign Direct Investment (FDI) in most sectors of the economy.
Triggering the Indian stock markets, Prime Minister Narendra Modi’s government has announced its intention to radically liberalise norms in single brand retail, airports, civil aviation, food products, pharmaceuticals and animal husbandry sectors.
While the announcement about the FDI policy was very stimulating, especially in the wake of the exit of the Reserve Bank of India (RBI) Chief Dr Raghuram Rajan, the easing up on the FDI policy is likely to provide new avenues for business and employment opportunities. The move is also expected to benefit much awaited foreign companies, such as Apple, IKEA and a few more in the civil aviation and defence sectors.
While the Modi government’s major reforms have the potential to bring about an incredible transformation in the Indian economy, enthusiasm for FDI has to be tempered with caution and paramount attention must be paid to its effect on domestic investment. While economic theory gives some guidance on what to expect from FDI, empirical studies present unsettled views on the relationship between FDI and domestic investment.
It will be therefore interesting to see how local investors perceive and actually respond to this move over time. In the long run, we have to see if the domestic firms will be able to sustain the pressure generated by FDI. On the one hand, an increase in FDI can have a positive spill-over effect and lead to higher amounts of domestic investment.
This is termed as the ‘crowding in’ effect. Let us take a hypothetical example to understand this scenario. Let us imagine that we welcome a new foreign friend to our family, hoping that the new foreign friend will help the family prosper.
So our foreign friend arrives and of course, in the long run, we would expect our friend to support the existing members of the family and let them grow. There are two critical aspects to note here. First, the way the remaining family members respond to or rather react to the foreign friend will be interesting to watch. Secondly, not just their pre-arrival perception, but post-arrival perception will also matter.
On the other hand, an increase in FDI has the potential to either drive down or even eliminate domestic investment. This is referred to as the ‘crowding out’ effect. Going back to our foreign friend example, crowding out is where the foreign friend drives out either few or most of the existing members of the family. In such an event, the foreign friend is merely replacing or substituting the existing ones. If this happens, is it really essential to replace family members?
In real life, while there can be numerous reasons for this to happen, let me share a couple of them. Having access to both global and local markets, multinational firms are usually more efficient than the domestic ones. Foreign players, which enter the market, might perhaps come with more bargaining power. They might borrow money from the domestic market and can eventually raise the interest rates. Given these circumstances and given the fact that India has many small and indigenous businesses, it is possible that domestic firms will perhaps struggle to compete with more efficient and technologically more superior players and hence might be driven out of the market. Of course, this is just a scenario and we wish this may never happen or even if it does, we should aim to discount its impact.
Simply put, few important matters that have to be evaluated carefully are: will the foreign capital flows in the form of FDI stimulate or displace Indian domestic capital? To what extent will FDI crowd out Indian domestic investment and the projects that were previously planned? What will be the effect of FDI on the productivity of domestic firms and through what channels? Will the domestic investors adopt similar production technologies as those used by foreign investors or produce different products to avoid direct competition?
Should the new policy changes not bring the expected gains, not only will India lose its control to build domestic expertise, but the benefits of the policy, in the long run, can seriously be challenged. I believe and hope that through appropriate and timely policy changes, the Modi government is able to successfully steer the economy in such a way that it utilise the full benefits of the new FDI policy, but not at the cost of domestic investors.