With New FDI Reforms Comes India's Next Challenge: ExecutionPublished: September 20, 2012 in India Knowledge@Wharton
Indian Prime Minister Manmohan Singh has often been called timid by his critics. He lacks a political base, which makes him dependant on others to rally voters. There are times, however, when he is willing to take a stand even when he is unsure of the backing of his own party. For example, in 1999, the then-finance minister ushered in the process of liberalizing the Indian economy. Singh took another leap in 2008, when he backed the Indo-U.S. nuclear deal, which most observers had given up as a lost case.
Last week, Singh was back in this mode. First, the government announced a relaxation of visa rules with Pakistan as a result of Indian External Affair Minister S.M. Krishna's visit to the country. India-Pakistan trade could go up substantially due to the changes, but it is not expected to happen overnight. In an earlier move, India also allowed Pakistani companies to invest in India, though certain sectors, such as defense, remain out of bounds.
On September 13, the government raised the price of diesel by Rs. 5 (about eight U.S. cents) a liter. Diesel is used by farmers to run water pumps for irrigation and is heavily subsidized. The rating agencies have been warning that India, which has already been given a negative economic outlook, would be reduced to junk status if subsidies were not controlled.
Then on September 14, came a series of major announcements designed to reinvigorate the Indian economy. The government will now permit foreign direct investment (FDI) in multi-brand retail up to a level of 51%. This has been the most controversial issue in recent times. A constituent of the government at the Center -- the Trinamool Congress of Mamata Banerjee -- has said it is leaving the alliance. On September 20, a nationwide strike called by opposition parties evoked some response. (For more on the impact of FDI, read the accompanying op-ed by Ravi Aron, a professor at Johns Hopkins University's Carey Business School and a senior fellow at Wharton's William and Phyllis Mack Center for Technological Innovation.)
In addition, FDI in aviation will now be allowed to a level of 49% and, in the area of single-brand retail, the government has relaxed some of its more onerous outsourcing clauses. The change opens the door for companies like IKEA, which had announced plans to open stores in India but was unwilling to commit due to a restriction that companies must source 30% of their products and materials from small companies or craftsmen. Now firms would only have to buy 30% of their materials from Indian companies, which supporters hope will encourage manufacturing joint ventures in the country.
The government also unveiled some smaller changes -- including foreign investment regulations for power exchanges and broadcasting services and a roadmap for disinvestment.
Reaction to the moves was mixed. Ratings agencies are no longer talking downgrades, but most analysts are waiting to see how the implementation process is handled before raising their outlooks.
On the Bombay Stock Exchange, however, the optimism was immediate. The Sensitive Index (Sensex) jumped 443 points the day of the FDI announcements to a 14-month high. Shares of companies such as Kingfisher (aviation) and Pantaloon (retail) were up nearly 20%. (Shares are not allowed to go above that level in one day because of a circuit breaker.) Foreign brokerage houses have increased their targets for the Sensex. The rupee was also up 1.13% against the dollar.
This week, however, some of the gloom returned. The Reserve Bank of India (RBI) was expected to reduce interest rates. It didn’t, opting instead to decrease the cash reserve ratio -- the percentage of deposits banks are required to keep in cash and liquid assets -- by 0.25%. The move is expected to release Rs. 17,000 crore (US$3 billion) for banks to lend. But the problem, according to banking officials, is not in liquidity; companies simply don't want to borrow at such high rates. RBI governor D. Subbarao may be fighting inflation by keeping interest rates high. But he is throttling industrial growth in the process, critics note.
The hope that some observers are expressing is based not on what has happened, but on what can be. Finance Minister P. Chidambaram told a Planning Commission meeting that there could be no backtracking on subsidies. Later, he told journalists that many more reforms were in the making and would be unveiled in the next six weeks.
A Delayed Reaction
"These reforms are actually late by over two years," says Sunil Bhandare, advisor for economic and government policy at the Tata Strategic Management Group. "There have been warning signals from all stakeholders that if reforms were not initiated, there would be low economic growth. It became almost imperative. But nevertheless, now that they have been initiated, we must welcome them."
Industry confidence has received a boost, Bhandare notes, but what is most important moving forward is how effectively the reforms are implemented. "The next four to five weeks will give an indication on how the government will stand up to the threats of the coalition members," he states. "In a way, the patient is out of the ventilator; now we have to see if he can breathe without the ventilator on a sustainable basis. That depends on how keen and serious the government is about the implementation of the reforms that it has announced." Bhandare adds that foreign investors aren't likely to immediately begin pouring money into India. "Everyone is going to be in a wait-and-watch mode. There is much more to be done."
Wharton management professor Michael Useem is more optimistic. "Yes, India is back on the radar," says Useem, who is also director of Wharton's Center for Leadership and Change Management. "The government’s announcement is a very significant development that should make international companies focus that much more on expanding or starting direct investment in India. As they do so, company executives and directors will want to give careful thought to how they will manage their enterprise in India, where business culture is both similar to, but different, from the rules of the road in the U.S., Europe, China and other countries."
Gopal Naik a professor of economics and social sciences at the Indian Institute of Management in Bangalore notes that the political environment of the past few years have made foreign investments hard to come by. "These measures will be an incentive for investors to rethink and make up their minds," he says. "Hopefully, the reforms will continue." But he, too, predicts that implementation will be a challenge. "One does not know if the numbers in Parliament will support the policy announcement in retail FDI. But there are not too many options available to the government."
At the Planning Commission meeting, Prime Minster Singh said that there were several challenges facing the government in the short term. Amid the general economic slowdown, there were three possible roads the country could take. "Scenario one is 'strong inclusive growth' and presents what is possible if the numerous policy actions outlined in the plan are substantially implemented," he noted. Singh referred to the second scenario as "insufficient action," which he said "describes a state of partial action on policies with weak implementation." The third scenario is "policy logjam". If this occurs, according to Singh, India's GDP growth could fall to 5%. There have already been warning signs of a further drop: growth decelerated to 6.5% in 2011-2012 and, in the first quarter of the current financial year, it has fallen further to 5.6%.
The inertia of Singh's own government is widely believed to be one of the reasons for the slowdown -- while the reforms are intended as a growth engine, observers warn that further political gridlock could create even more of an economic drag.