Why India Should Adopt Urgent FDI Reforms

With India's economic growth faltering as a result of weak governance, policy paralysis and opposition to reforms, investors feel the urgent need to push for plans to allow foreign direct investment (FDI) in financial sector and multi-brand retail trade.

FDI in India slumped 78 percent to $1.2 billion in June 2012, compared to $5.7 billion in the same month in the previous year. It plunged 67 percent to $4.4 billion in the April-June quarter, compared to the same period in the previous year as investors continued to worry about the investment climate in the country, which is affected by the lack of encouraging policy from the government.

"With elections due by May 2014, this policy paralysis is likely to get worse during the coming two years and there is also a growing risk of populist decisions. Looking further forward, there is no guarantee that reform prospects will improve after 2014," Andrew Kenningham, an economist at Capital Economics, said.

Several policy announcements by the government have adversely affected the investor confidence. The decision to retrospectively tax overseas merger and acquisition activity related to companies based in India was one such case.

However, investors hope that the government will announce some measures to slow the increase in the budget deficit and perhaps to review tax legislation rules. However, gaining parliamentary support for more substantive liberalization will be a difficult task for Finance Minister P Chidambaram.

When the government's allies and opposition parties say moves to allow the FDI will be disastrous to the country, they fail to note its positive impacts on the economy, which are essential to rejuvenate its losing growth momentum. India's gross domestic product (GDP) grew by 5.5 percent in the first quarter, up from 5.3 percent in the previous quarter but down from 8 percent in the same period the earlier year.

Last month, in its policy statement, the Reserve Bank of India (RBI), cut its growth forecast for this financial year (April-March) from 7.3 percent to 6.5 percent. Investors worry that even this rate can turn out to be too optimistic with the global economic condition worsening and the disappointing governance policy.

The government is struggling to control the inflation which has been hovering around the double-digit mark since December 2010. According to the Reserve Bank of India, the FDI in multi-brand retail will help control the inflation if it is implemented properly. As noted by RBI Deputy Governor K C Chakrabarty, it is considered that if the FDI in multi-brand retail is effectively implemented, then prices will decline. And if prices decline, inflation will fall naturally.

Political parties opposed to the move are pointing that it will be suicidal for small and marginal farmers and would affect thousands of traders in the sector. According to the 2010 Economic Survey report, India's retail sector provides job for 35 million people and this makes it the second largest employer after agriculture.

A major factor to be considered is that India has a big population in the working age group, which is between 15 to 59 years. According to the 2010 report by the Ministry of Labor and Employment, about 64 percent of the population in the country will belong to the working age group by 2012. It is crucial to understand the employment potential it offers while considering the FDI policy.

The government's decision would pave way for global retail giants such as Wal-Mart, Tesco and Carrefour to set up their mega store retail chains in the country. The initial estimates by the government is that it will create over four million jobs in the small and medium industries and another 5-6 million jobs in the logistics sector in the coming three years, according to Commerce and Industry Minister Anand Sharma.

Though this can be a tall order to achieve, certainly it will boost the employment opportunities in the rural and urban areas of the country. The opening up of the multi-brand retail sector can be the right move to help farmers. It will also generate employment in various sectors, including agro-industry and food processing. It is also the correct step to support and promote infrastructure, including cold chains, warehousing and logistics.

On a similar note, the possible expansion of the international banks in India with plans by the government to allow financial FDI is also seen with lot of suspicion. The employees of the public sector banks held a two-day strike in August against the plan. However, many investors and financial experts are of the opinion that the FDI in the banking sector has become a necessity for India's economic growth.

"FDI will bring the latest technology in banking sector to the country which will help to improve its growth rate and eventually the economy of the country," said Anand Nair, a financial advisor based in Mumbai.

It is suspected that the entry of multinational banks will force the domestic banks to adjust their portfolios in line with these banks. There is the fear that foreign banks, which have the attributes of low cost and low risk, will attract the customers and, as a result, the domestic banks will be left with borrowers showing higher risk levels.

However, the situation in the country is such that it is in need of capital. The current account deficit climbed to 4.5 percent of GDP or $21.7 billion in the January-March quarter, up from $6.3 billion in the same quarter in the previous financial year.

"The country is in need to fill huge gap in capital requirements. This necessitates the need to have foreign capital. FDI essentially make sure that this necessity is fulfilled," said Jacob Alexander, an economist based in New Delhi.

Ensuring the liberalization of the financial sector and encouraging foreign investment will be moving in the right direction to lift the market confidence. However, it has to be seen whether the government will show the courage to take the necessary measures in this direction amid fears of being non-populist.