On March 31, the last day of fiscal 2010-2011, the federal government issued the innocuously worded Circular 1 of 2011. In part, it replaces the equally innocuously worded Press Note 1 of 2005. But the provisions of the new circular could bring about a sea change in foreign direct investment (FDI) in India. What it does is to no longer make it mandatory for a multinational to take the permission of its Indian joint venture (JV) partner before investing in another domestic project in an allied area.
Almost simultaneously, in Mumbai, telecom major Vodafone announced that it was buying up the Essar Group’s 33% stake in Vodafone Essar for US$5 billion. In Delhi, two-wheeler manufacturer Hero Honda reported to the stock exchange that two representatives of Japanese partner Honda had stepped down from its board. The Hero Group and Honda have parted ways after 26 years, with Hero in the process of buying Honda Motor’s 26% stake for US$851 million. And in Chennai, Swiss company Rieter said it was selling its entire 50% stake in Rieter-LMW Machinery to its JV partner Lakshmi Machine Works (LMW).
Break-ups Are a Coincidence
That all this happened within a day or two of the circular may suggest that the government’s announcement was some sort of spark. Actually, it is more coincidence, experts say: These break-ups have been many months in the making. But is it a sign of things to come? “Absolutely,” says Rajesh Chakrabarti, assistant professor of finance at the Hyderabad-based Indian School of Business (ISB). “This is almost akin to China’s removal of the mandatory JV condition. [In 2001, China removed some restrictive clauses in its FDI policy.] Now [multinational corporations, or MNCs] will increasingly change from partners to competitors. We should see more pure-MNC plays in India.”
Ashvin Parekh, partner and national leader-global financial services of Ernst & Young (E&Y), feels that these early rumblings are not signs of a summer of break-ups. But there could be an initial spurt. “Almost like any other regulatory boundary when it is opened up, those who want to step out of their present commitments will want to do so at the earliest.” Adds Sunil Bhandare, advisor (government and economic policies), Tata Strategic Management Group (TSMG): “The entire concept of a JV is based on how the relationship has built up over the years. If it is a good strategic partnership then the foreign partner will not move out.”
Corporate Divorces Are Common
How happy have these MNC marriages been? Anecdotal evidence would seem to indicate that compatibility is not the prime criterion; MNCs prefer to go it alone. In the 1970s, when the government insisted that MNCs dilute their stakes in their Indian subsidiaries — either by going public or getting a local partner — IBM and Coca-Cola decided to leave the country. There were several others. Another group agreed to toe the government line under the Foreign Exchange Regulation Act (FERA). But the Indian operations were orphaned by the head office: They were no longer regarded as part of the global network. Some tried name changes: Cadbury became Hindustan Cocoa Products, and Philips India was rechristened Peico Electronics & Electricals.
In the first flush of liberalization, IBM returned in a JV with the Tatas. PepsiCo tied up with Voltas (also a Tata company). But the laws changed even as that deal was underway and Pepsi preferred to come in alone. Coca-Cola, which had bided its time, entered with a wholly-owned subsidiary. FERA, meanwhile, mutated to the friendlier Foreign Exchange Management Act. IBM bought out the Tatas in their JV. And Hindustan Cocoa and Peico became Cadbury and Philips again, after a buyback of the public shareholding.
The complaint from the MNC side is that they put in the money as well as provide the technology and often the training. But if the company is run by the Indian partner, it often doesn’t recognize global priorities, which results in squabbling over strategy. Tobacco-to-hotels major ITC has been having a running battle with parent BAT Industries of the U.K. for many years now.
If the company is run by the MNC, there could be other irritants. To take one example, exports are often an imperative in today’s world. But an MNC would not want its Indian JV to export to countries in which it has operations.
The big problem with a divorce so far was the price to be paid. As the MNC could not invest in another company in the same sector without their Indian partner’s permission, they could be arm-twisted into all sorts of concessions. The alternative was to sell cheap and depart. Honda of Japan will get Rs. 739.97 (US$16.72) per share for its 26% stake in Hero Honda, while the market price is around double that. (Incidentally, Honda has a wholly-owned unit in India — Honda Motorcycles & Scooters. But this was set up in happier times. When the Japanese company made its application to the government back in 1999, the Hero Group was supposed to be its joint venture partner here, too.)
The problem of arm-twisting by both sides is now history. Says Vikram Bapat, executive director (tax and regulatory services), PricewaterhouseCoopers (PwC) India: “The fact that no reference is now required means that foreign investors can independently invest regardless of any existing JVs. In a sense, that makes the marketplace more competitive.”
Tweaking Some Other Rules
What else does the FDI circular bring? “The other changes are marginal,” says Chakrabarti of ISB. Parekh of E&Y goes into more detail. “There are a couple of aspects which are major deviations from the earlier policy,” he says. The relaxation of the JV rule is primary, he notes. Among others: “inclusion of fresh items or issue of shares against non-cash consideration; reform in regard to pricing of convertible instruments; and guidelines relating to downstream investments, which have been comprehensively simplified and rationalized.”
But those changes are not enough, says Bapat of PwC. “The significant aspects of the circular are the miss-outs,” he says. “There is no indication of government thinking on FDI in retail, insurance or defense. The noncommittal approach creates jitters in the mind of potential investors as they are not sure what stance the government — or subsequent governments — will take. The circular clarifies some nitty-gritty.” Adds Parekh of E&Y: “It is one small step towards the larger FDI reforms.”
Parekh’s prescription to attract more FDI is to open up more areas to foreign investment and re-examine the ceilings. “There is a need to do this in areas such as infrastructure,” he says. Bhandare of TSMG agrees that the government needs to remove caps. “But more important is the need to improve the ease of doing business in the country,” he notes. “The instability of policy, perceptions of corruption, and lack of transparency are all bottlenecks.” Bapat of PwC has a similar prescription. “Implement ‘single-window’ in its true spirit, cut down multiplicity of regulations and have a consistent and continuous fiscal policy,” he says.
“Opening up new sectors, raising caps and simplifying regulations are standard recommendations,” says Chakrabarti. “But the bigger issue is to ensure that greenfield projects do not face policy uncertainty [on land acquisition, mining rights, environment, etc.] at the site level. This should be worked out in consultation with civil society groups rather than following a reactive, ad-hoc, case-by-case approach, which gives the impression that the foreign investor needs to be able to better “manage” the political environment to be successful in India.”
FDI Has Dropped Sharply
This renewed debate on FDI has been provoked by a simple fact: FDI coming into India has been falling drastically. According to Reserve Bank of India (RBI) data, FDI fell more than 25% during April 2010-February 2011. These first 11 months of the financial year saw US$25.95 billion in FDI infows, compared to US$36.55 billion a year ago. A Business Standard analysis shows a worrisome trend in the longer term. “Growing from December 2008, FDI in India at the end of June 2009 stood at US$145 billion, while increasing to US$167 billion at the end of December 2009,” says the business daily. “It further grew to US$178.3 billion in June 2010 and to US$198 billion till December 2010. In sharp contrast, portfolio investment increased to $US95.9 billion at the end of June 2009 and jumped to US$117.2 at the end of December 2009. This was again followed by a sharp surge to US$135 billion in June 2010 before touching the US$172 billion mark by December 2010.” Portfolio investment — money brought in by foreign institutional investors (FII) — can be taken out practically overnight, while FDI — which is normally invested in assets on the ground — is far more stable. “Unfortunately the FII inflows look for short-term opportunities and flow out of the Indian market whenever the return arbitrages occur,” says Parekh of E&Y.
There are differences of opinion on what this FDI famine implies. How important is foreign investment? “Absolutely imperative,” says Bapat of PwC. “The India growth story since 1991 has been built on the edifice of FDI. Foreign exchange reserves today are over US$300 billion from a mere US$5 billion in 1991, and that’s the obvious benefit. Attracting foreign resources to supplement domestic talent and demand is the optimal recipe to maintain current and achieve higher growth going forward.”
“FDI plays a multidimensional role in the overall development of the host economies,” says an August 2009 whitepaper by the National Council for Applied Economic Research (NCAER), a Delhi-based think tank. “It may generate benefits through bringing in non-debt-creating foreign capital resources, technological upgrading, skill enhancement, new employment, spillovers and allocative efficiency effects. While FDI is expected to create positive outcomes, it may also generate negative effects on the host economy. The costs to the host economy can arise from the market power of large firms and their associated ability to generate high profits. Much of the existing empirical evidence suggests that the positive effects offset negatives, thus providing net economic benefits for the host economies.”
FDI Means More Than Investment
“As a fraction of the total investment in the country, FDI, though far from insignificant, is not such a game-changer in India,” says Chakrabarti of ISB. “It is roughly in the 10%-15% range of gross fixed capital formation. But its implications are different because of the kind of investment it brings in and the technology linkages it offers. Also, looking ahead, in the 12th Plan [2007-2012], India expects to invest about a trillion dollars in infrastructure. Much of it is expected to come from abroad. So the FDI moods matters.”
“In India, the current contribution of FDI is around 4%-5% of GDP,” says Bhandare of TSMG.” It needs to be encouraged on a larger scale than what is happening at present. This is not just for the quantitative aspect but for the qualitative aspect that FDI brings with it. Qualitatively, FDI is a powerful tool for modernizing the Indian economy. When foreign players enter the market, Indian players are forced to improve their technologies and all aspects of their performance.”
He, for one, is not worried. “Some fluctuations in FDI inflows are not a source of great concern,” he says. “In some years, there is bunching of inflows because of lumpy capital intensive projects and consequently a slowdown in other years. One has to look at FDI inflows over a three-year horizon. In 2010-2011, investors were also probably watchful of the impact of the global economic scenario of the previous years. FDI inflows have dipped across the globe.”
“As long as India, as an economy, continues to demonstrate the cost-arbitrage potential and expands its domestic demand, FDI flows will continue,” adds Bapat of PwC. E&Y’s Parekh adds a note of warning. “FDI inflows are significantly linked to the reform process,” he says. “Government policies influence FDI inflows. In various sectors including insurance, retail and others, the government has taken far too long on policy areas. This is holding back the inflows into the economy through this route.”
A recent report by financial major Nomura of Japan concludes that it will be a passing phase. Nomura says India is still the second best spot for FDI (China leads the league) despite the downturn. “Inflows will return to the pre-crisis peak by early 2012,” concludes the report.
