Hot money is flowing, but rest of India story has gone cold
India, till the other day the flavour of the season for foreign investment, is now attracting more speculative capital than serious long-term money. Blame it on the atmosphere of scams, the delays in reforms and policy paralysis of the UPA.
Have long-term foreign investors stopped buying the India story? For a country that has successfully retained the mantle of being one of the most sought after emerging market destinations for some years now, recent trends throw up some worrying signals.
Foreign direct investment (FDI) - money that goes into real projects and companies rather than just to the stock markets - has started tapering down. Inflows have shown a declining trend through almost the whole of 2010-11, and the recently-released Department of Industrial Policy and Promotion (DIPP) figures show a dramatic fall of 28% from the year before - a drop of $11 billion (nearly Rs 50,000 crore).
While a decline was understandable when the world was in the throes of a recession and risk-aversion was at its highest, 2010-11 was the year the world economy was on the mend and cautious optimism had returned.
FDI and foreign institutional investment (FII) flows have been robust in the rest of the emerging markets. But in India the two appear to have delinked from each other: FDI is down, but FII inflows have held up well.
While 2008-09 (the year of the Lehmann Bros collapse) saw outflows of $15 billion, the very next year there was a huge surge to $29 billion - the highest-ever received in a single year by India.
The worry: why is long-term money turning shy when hot money (i.e. FII) flows are healthy? Why is India attracting more speculative money than stable investment?
A host of factors is responsible for this FDI slowdown, from policy and procedure-related issues to delays in opening up FDI in sectors like insurance and retail. Most importantly, it's likely that the atmosphere of scams and scandals has put off investors. They are probably waiting for the dust to settle before they take a call on India.
The Reserve Bank of India (RBI) has been flagging the fall in FDI as a serious issue in a situation of rising current account deficits (the country's net foreign exchange earnings from trade and services) and sees policy changes as the only way out of the current situation, though this view is divided.
So what exactly happened?
In 2010-11, inbound FDI into India fell by as much as 28%, the second consecutive year of decline and the first such large decline since the opening up of the economy in 1991-92. As a result of this decline, the present level of $27 billion of FDI inflows is the lowest in four years.
A large part of the progress made in FDI inflows over the boom years has now been reversed, with flows down by almost 29% from their high in 2007-08. This trend, more than just being odd, is also worrying when seen in the context of the fact that the past four years cover the recessionary period as well.
In other words, flows did not decline as much during the bottom of the recession as they did in 2010-11, when they were bouncing back in the rest of the world. In fact, during 2009-10, the flows were almost flat, showing a mere statistical decline of 0.2% over the previous year.
What makes it puzzling
The decline in FDI in 2009-10 could be explained by the fact that it was a year when recessionary effects were visible in the global economy. All BRIC countries (Brazil, Russia, India and China) saw declines in FDI flows during that year.
According to the United Nations Conference on Trade & Development (Unctad), flows into China fell by over 12% and to Russia and Brazil by as much as 49% and 42% from the previous year.
However, a number of emerging markets have shown substantial recovery in 2010. The RBI pointed to Unctad figures to show that countries like China, Brazil, Mexico and Thailand had in 2010 shown a rebound in FDI of between 6-53 percent. Indonesia apparently showed a three-fold rise from the previous year.
In India itself, FII flows have been on the rise over the past two years on an annual basis, with only 2008-09 being a year of sharp outflows. In fact, the outflow of $15 billion was more than made up by inflows of $29 billion - their highest ever - in 2009-10. This level was largely maintained in 2010-11 as well, with a small increase.
Both these factors go on to show that the decline in FDI into India in 2010-11 is not the result of a weak global situation or investor risk-aversion. The causes really lie elsewhere.
So why exactly are investors shying away from longer term investments in India?
FDI flows showed a dismal performance in almost every month of the previous financial year, with May being the only exception. By the end of the third quarter, it became clear that FDI inflows would be nowhere close to what they were the year before.
The RBI highlighted this in its quarterly 'Macroeconomic and Monetary Developments (MMD) study released in January 2011 and suggested some reasons for the trend as well.
According to the bank, the "major reason for the decline in inward FDI is reported to have been the environment-sensitive policies pursued, as manifested in the recent episodes in the mining sector, integrated township projects and construction of ports, which appear to have affected the investors' sentiments."
The Ministry of Environment had recently questioned the ecological viability of the Korean steel giant, Posco's proposed plans in Orissa, which could be one of India's biggest FDIs ever.
The MMD review further goes on to observe that there are other reasons for the decline as well, such as "persistent procedural delays, land acquisition issues and availability of quality infrastructure".
Indeed, delays in decision-making are visible in sectors like defence and multi-brand retail, discussions on which have been long in the works. The Department of Industrial Policy and Promotion (DIPP) had floated a discussion paper on defence in May 2010 and on multi-brand retail in July 2010.
Feedback on these was received by parties interested in the sector, but a decision on allowing FDI into these sectors is still nowhere in sight.
The Finance Minister's budget speech too had mentioned an intention to further liberalise the FDI policy, however there has been no movement so far. One of the major reasons why India has so far been able to attract higher levels of FDI is the progressive relaxation in investment regulations over time. This has now come to a halt.
Dun & Bradstreet points out that "the recent licensing issues in the telecom space and series of corruption cases in real estate financing are likely to have impacted investor sentiment, thereby limiting the FDI inflows in these sectors".
This is corroborated by the numbers. Both telecom and real estate have seen an above-average decline in FDI flows during the year. While flows into telecom declined by 35% to $1.6 billion, the flows to housing and real estate declined by as much as 60% to $1.1 billion.
How serious is the issue?
The RBI has been raising concerns about FDI for some time now, given that they are stable investments which provide a cushion when the current account deficit as a proportion of GDP is rising. Dependence on volatile FII flows is not a good option.
The bank sees the FDI issue as "structural" and says the "reform process needs to be expedited to address the impediments". Nomura, too, agrees with the RBI line of thinking in a research note. But, the financial services major is more optimistic, stating that FDI "should return to peak levels by early 2012" and that the current trend is probably cyclical.
While India still remains a strong economy, the recent softening, but consistently rising, inflation, not to mention the anti-graft commotion at the centre, remain factors to the downside. It remains to be seen what comes of FDI.