On the surface, India looks like a winning emerging-market investment play, with its populous middle class, robust multinational presence, and relatively stable democratic government. Dig a little deeper, however, and myriad risks start coming to light – a slow-moving commitment to building infrastructure; a need for structural reform in the financial markets; and a legacy of super-protectionist policies.

In such a climate, what are the opportunities for foreign investors, and what can be done to encourage the inflow of capital? These questions and others were on the table at a panel on finance at the ninth annual Wharton India Economic Forum, recently held in Philadelphia. Participants agreed that the challenges were numerous but felt that the latest investments – especially in sectors such as manufacturing and real estate – signaled that interest in the country is broadening rapidly.

Manufacturing Missteps

Early forays into the manufacturing sector in India by foreign companies didn’t work as well as those in neighboring China. Pramod Bhasin, president of GE Capital India and president and CEO of GECIS Global, noted that his company had initially entered India to penetrate local markets, but soon changed its focus to outsourcing various operations and knowledge-based research work. “We tried investing in the manufacturing sector, but it bombed. We couldn’t grow in the local markets because distribution, freight costs, and the cost of acquiring business were high and made it sluggish,” he said. “However, the trend is changing, and Indian companies are tightening their belts. There are hidden jewels in the manufacturing sector.”

Manufacturing is growing in part because the Indian consumer market is becoming increasingly robust. During the past few years, the middle class has begun to play an increasingly active role in the Indian economy. “The tax reforms of the 1990s gave consumers disposable income – peak rates that had been 80% at one time were scaled down to 30%,” explained Renu Karnad, executive director of HDFC. “The import sector was liberalized, and financial reforms were introduced. All this put purchasing power in the hands of a wider base.” The exact definition of the middle class varies depending on the particular income sector targeted; it can be anywhere from 250 million to 500 million people. Either way, “it’s this population that drives investment in India,” said Karnad.

The last decade’s structural reforms also gave people more choices of affordable products, said Karnad. “Producers began focusing on cutting costs and developing new products rather than on getting licenses. The financial system responded to this unleashing of demand.” More importantly, added Karnad, there has been a change in people’s mindsets regarding issues such as debt and credit. Traditionally, Indian consumers shunned borrowing, regarding debt as a shameful burden that should be eliminated rapidly. Today, “the middle class borrows for everything — housing, white goods, etc. There are 12 million credit cards in India, and 80% of car financing is through loans. Banks are wooing customers, rather than the other way around. India is changing from a supply-driven to a demand-driven economy.”

Outsourcing has played a key role, to “It has created jobs and developed a new breed of young people who have no qualms about making or spending money. This is the present and future consumer class of India,” said Karnad.

Indeed, the retail consumption sector has huge potential, added Rajesh Sachdeva of Kingdon Capital Management. “The growth in the motorcycle industry has been 20% to 25% for 10 years. Car consumption growth is high, yet it’s still an under-penetrated market. There’s lots of room to make money.”

The China Factor

For a long time, India has stood by as tens of billions of dollars in foreign direct investment have flowed to countries like China and, to a lesser extent, Thailand and Mexico. Mintoo Bhandari, founder and managing director of The View Group, an international private equity firm, said that corporate FDI is lower in India because overseas Chinese have repatriated a lot of capital to China.

Once the manufacturing sector has more confidence in India’s abilities, said Bhasin, the country should attract major FDI inflows. “China offers more cooperation from its government. Execution of reform in India is very important for the country to able to compete for investment.”

“Where there are a large number of products customized to the customer, India can do a better job than China,” said Sachdeva. “Indian companies are also more ROI-focused than Chinese companies. While China has great macroeconomics, growth, and government policies, India has good companies that are focused on cost. But the country’s low FDI is a function of poor infrastructure; there are delays at many levels, for instance in shipping.”

Sachdeva also pointed out that the nature of businesses in China and India were different. “India has knowledge businesses, which do not require as much capital investment, unlike the businesses going into China.”

Bhandari, however, was not as optimistic about the long run. “Since India has enormous human talent, services and IT should continue to be the focus of investment. The manufacturing sector just doesn’t offer similar opportunities, and Indians may already have lost that battle.” Sachdeva came to a different conclusion: “The entrepreneurial nature of Indian companies has allowed many to succeed despite the government, so the manufacturing sector should survive and grow effectively – and we should see years of growth ahead.”

Long Term Capital

Instead of direct inflows, many investors have chosen to invest in the equities markets. Panel moderator Ravi Chidambaram, president of TC Capital, asked participants whether such pure portfolio flows might trigger a crisis like that of Asia, given their short-term nature.

Sachdeva acknowledged the volatility of the stock markets in India and the risk of sudden exits. “At the same time,” he said, “markets have deepened, and there is far more liquidity and high foreign exchange reserves, so the risks are lower.”

Bhandari echoed this statement. “There is no question that direct investment is longer term and less liquid. Portfolio investments may not be used to fund companies directly, but to acquire shares in the secondary market. But India is also becoming one of the best IPO markets in the world, and given the opportunities, you’ll see hedge funds across the world getting interested in the Indian market,” he added.

Of course, all capital doesn’t have to come from abroad; the panelists were quick to note that domestic interest in investing and the stock market was growing as well, and that it could become a key factor in the near future. In sum, no matter what the source, a growing number of companies in India seem to be saying, “Show me the money!”