The Indian government recently announced a slew of reforms, including allowing foreign direct investment (FDI) in multi-brand retail up to a level of 51%. A policy requiring that single-brand retail multinationals source 30% of products and materials from small businesses and craftsmen was changed to mandating that the same amount come from Indian firms. In this op-ed, Johns Hopkins University professor Ravi Aron, who is a senior fellow at Wharton’s William and Phyllis Mack Center for Technological Innovation, argues that opening up FDI will not only lead to a greater variety of products for sale and increased consumer choice, but also penetrate deep into the hinterland of Indian economic activity and do much to improve the country’s “shunned sectors” — infrastructure and logistics.

The direct FDI impact in the short term from retail chains will be modest. If you look at the numbers — as per [financial information services firm] CEIC Data — FDI in 2008 was in the ballpark of US$35 billion and declined in 2009 and 2010. FDI in 2011 came in at around US$27 billion or so. So if we ask the question: Will international retail chains in the shorter term — an 18-to-24 month horizon — bring in US$8 billion to get back on track, the answer is probably not.

Large retail chains when they venture abroad do so in three phases. In Phase One, they often set up a test case/pilot project. This can be done through a partnership with local chains (with risk and revenue sharing), or a few flagship stores that serve as brand broadcasters. The chains employ this initial-phase entry strategy to learn lessons about the local markets. They assess demand, test merchandizing strategies and set up operational capabilities. In this phase, they bring in some investment to cover their set-up costs and for establishing their sourcing (supply) footprint. This usually takes 18-to-24 months.

In the second phase, firms expand their demand footprint; they open more stores and increase both the scale of operations (volume of products sourced) and scope of products that they feature. There is considerable investment in this phase in the form of real estate acquisition, putting in operational infrastructure, establishing sourcing relationships, establishing supply chains and massive logistics capabilities. This is volume-independent investment — that is, investment meant to gear up for volumes of business to come, but not calibrated to the current volume of business.

In the third phase, the investment keeps pace with the rate of expansion. As volumes grow and urban and semi-urban retail locations get saturated, companies look for new locations and bring in investment that is calibrated to growth in volumes. It is in the second phase and the third phase — which come after the initial 18-to-24 months — that large investments manifest themselves.

Other Impacts

The arrival of foreign retail chains has twofold impact. First, those companies set up supply chains and logistical capabilities, spurring significant improvements in the infrastructure needed to source, ship, store and deliver products (covering all aspects of value chain and supply chain activities, including storage, warehousing, and information-intensive operations). Second, their entry and expansion induce domestic competitors to invest in infrastructure and logistics, as well as greatly speed up the emergence of product standards (especially in perishables and personal consumables), and begin the process of bypassing monopsony buyers and traders that dominate procurement in many product categories today.

For these reasons, foreign investment in retail has an impact that goes beyond its direct investment impact. It is a force multiplier that induces even more investment from competitors.

Impact on Mom-and-Pop Retailers

FDI is often opposed on the grounds that it will put mom-and-pop stores out of business. This is very unlikely for several reasons.

The big-box retailers, when they venture into developing markets, do not use the same business model as they do in the U.S. Walmart — the most iconic of these companies and the one most often cited as a threat to Indian mom-and-pop stores — is by no means the lowest-price retailer in China. Walmart U.S. is based on “everyday low prices.” The firm has an activity system that is meant to help Walmart compete as a cost leader. The company began by locating in rural areas and then moved to suburban and semi-urban areas in the U.S. In China, the rural areas and semi-urban areas are not where the money is. Consumers in China — unlike their American counterparts living in suburbia – do not drive miles and do bulk purchasing, nor do they have massive storage facilities at home. In India, China, Brazil, Indonesia, Thailand and Mexico, the vast majority of educated middle and upper classes live in the cities (and not in semi-urban and rural areas) where real estate is very expensive and population density is high.

The foreign retail chains will need to make very expensive real estate investments. They will have a very high variable cost of operation. Their fixed, volume-independent costs are also likely to be much higher than the mom-and-pop convenience stores. These chains will operate with price points that are much higher than those featured by the mom-and-pop shops.

These firms’ real competition will be the domestic multi-brand retailers. A recent study by the CII and Boston Consulting Group estimated the size of organized retail of US$28 billion in 2010 to be 6% to 7% of the total retail market in India. The study predicted that the size of retail — total retail sector size, not just organized retail — would grow to US$1.25 trillion by 2020 if the efficiencies that typically come from greater competition and modernization of retail supply systems were to be unleashed. Under this scenario, the study predicts that the size of organized retail could grow to US$260 billion or about 20.8% of the total market. So even under this scenario, the idea that a fractional segment that accounts for 20.8% of the total economic activity of a sector can drive the remaining 79% of that sector out of business does not stand the scrutiny of reason.

The CII/BCG study also estimates that if the organized retail sector is not modernized — the “as is” economic scenario, as the study calls it — the size of the sector will be about US$170 billion. This underperforms the earlier scenario by about 35% or so. That difference could be a job creation deficit of about 1.4 million jobs with an even higher potential loss of economic product since organized retail pays better than local, scale-deprived mom-and-pop establishments. This is without taking into consideration other jobs that would not be created in economic activities that span infrastructure and logistics.

Supply Footprint: Traders — Not Farmers — Beware

The foreign retail chains will have a more significant impact on traders that dominate procurement of commodities and perishables, including grains and cereals. It is not surprising that these traders are the most virulent opponents of FDI in retail (the main opposition party that derives its support from the trading castes and traders has openly stated that “traders’ interests will be harmed by FDI in retail”). Indian farmers and many other rural producers are at the mercy of large and well-organized monopsony buyers. Very often these traders dominate geographies and account for nearly all procurement in their geographies. In many states, the food ministry determines who it will buy from and this is usually a small number of traders who in turn dominate direct procurement from farmers in their geographies. These are economic fiefdoms that they dominate and exploit. When the Carrefours, Walmarts and Tescos set up direct procurement mechanisms where sophisticated procurement systems are put in place and information about demand (prices, product varieties and quantities demanded) becomes more easily available, it becomes more difficult for the middlemen to dominate local geographies and restrict competition. The emergence of these supply chains that drive transparency of information will bring significantly more competition in sourcing.

The CII-Boston Consulting Group study found that an Indian tomato farmer earns about 30% or even less of the final price paid by the consumer (in developed countries, that percentage can be as much as 70%). For this reason alone, farmers and producers should welcome this development (and for this reason alone, traders oppose it). Indeed, the Indian Farmer and Industrial Alliance (IFIA), a joint venture of the Consortium of Indian Farmers Associations (CIFA), recognized the potential benefits of eliminating middlemen and has expressed its support for opening the retail sector to foreign investment.

As with any other sector, the entry of foreign players introduces competition that will benefit some and will work to the detriment of others. The beneficiaries in this case are the Indian consumers, the lower middle class, which will benefit from the well-paying jobs that will be created, and the producers of goods — including farmers — that have been at the mercy of middlemen and monopsony buyers and trader monopolies. As usual, the interests that are threatened have sought to portray this move as detrimental to India. In another time, it was said in the U.S. that “what was good for [General Motors] was good for America.” It took some time for that belief to lose its status as an axiomatic truth. It is time that India reexamined its axiomatic beliefs. After all, the East India Company left more than 100 years ago.