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Private Foreign Investment in IndiaAugust 1999

Authors:

Suma Athreye, Manchester School of Management, EnglandSandeep Kapur, Birkbeck College, University of London, England

Address for correspondence

Sandeep KapurDepartment of Economics Telephone: 44 171 631 6405Birkbeck College Fax 44 171 631 6416Gresse Street email [email protected] W1P 2LLUNITED KINGDOM

Abstract

Private foreign capital, whose presence in Indian industry was long regarded withconcern and suspicion, is now touted as a panacea for India’s economic problems. Thispaper compares the relative performance of domestic and foreign-controlled firms inIndia, and evaluates the contribution of foreign investment over the last five decades.We assess the impact of government policy towards foreign capital, and outline policyimplications for the future.

Keywords: India, foreign direct investment, MNCs, reform

JEL classification: F21, F23, L6

Foreign investment in India

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Private Foreign Investment in India*

August 1999

Abstract

Private foreign capital, whose presence in Indian industry was long regarded withconcern and suspicion, is now touted as a panacea for India’s economic problems. Thispaper compares the relative performance of domestic and foreign-controlled firms inIndia, and evaluates the contribution of foreign investment over the last five decades.We assess the impact of government policy towards foreign capital, and outline policyimplications for the future.

Keywords: India, foreign direct investment, MNCs, reform

JEL classification: F21, F23, L6

* We thank the Company Finances Division of the Reserve Bank of India for data and guidance; JohnCantwell and Ron Smith for comments.


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1 Introduction

The 1990s have seen a marked increase in private capital flows to India, a trendthat represents a clear break from the two decades before that. In the 1970s therewas hardly any new foreign investment in India: indeed, some firms left thecountry. Inflows of private capital remained meagre in the 1980s: they averagedless than $0.2 billion per year from 1985 to 1990. In the 1990s, as part of wide-ranging liberalisation of the economy, fresh foreign investment was invited in arange of industries. Inflows to India rose steadily through the 1990s, exceeding $6billion in 1996-97. The fresh inflows were primarily as portfolio capital in theearly years (that is, diversified equity holdings not associated with managerialcontrol), but increasingly, they have come as foreign direct investment (equityinvestment associated with managerial control). Though dampened by globalfinancial crises after 1997, net direct investment flows to India remain positive.

Table 1: Recent foreign investment in India, net inflows in $ billion

1990-1 1991-2 1992-3 1993-4 1994-5 1995-6 1996-7 1997-8 1998-9Direct investment 0.10 0.13 0.32 0.59 1.31 2.13 2.70 3.20 2.06

Portfolio investment 0.01 0.00 0.24 3.57 3.82 2.75 3.31 1.83 -0.06

Total 0.10 0.13 0.56 4.15 5.13 4.88 6.01 5.03 2.00Sources: see appendix

Table 1 highlights the growth in inflows. To put these figures in perspective, notethat the total stock of private foreign equity capital in Indian industry was about $2 billion in 1990 (Rupees 40 billion at 1990 exchange rates). Or, comparing theflow to broad external sector aggregates, India’s current account deficit, about $10billion in the crisis year of 1990-91, was financed primarily through commercialloans and external assistance: private investment flows were paltry. By 1997-98,foreign investment inflows of $5 billion could finance a sizeable chunk of the $6.5billion current account deficit.

India was not unique as a recipient of increased inflows in the 1990s.International flows of private capital to most developing countries rose sharplyover this period. The historically low interest rates in the US encouraged globalinvestment funds to diversify their portfolios by investing in emerging markets.International flows of direct investment, which had averaged $142 billion per yearover 1985-90, more than doubled to $350 billion in 1996, with the developingcountries receiving $130 billion. Host country policies did influence the choice oflocation for this investment. China received the largest chunk: at $42bn, FDI


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inflows accounted for as much as a quarter of its gross capital formation in 1996.Other developing countries, most notably those in the Pacific Basin, also receivedsizeable flows. Foreign direct investment flows to India were paltry incomparison: at $2.5bn in 1996 -- less than 4% of domestic capital formation—they remain marginal to the investment process.

The question then is not, why have inflows to India grown so much, but whythey remain low compared to other emerging markets? Some commentatorsbelieve that if only India could attract enough foreign capital it could, as Chinahas, move on to a higher growth path. Official policy statements in India seems toendorse this belief: the progress of economic reforms is measured in terms ofcumulative foreign capital inflows or, even more optimistically, in terms ofapprovals granted for foreign inflows. Reality has trailed behind officialexpectation—over the period 1991 to 1996, actual inflows of foreign directinvestment averaged no more than one-fifth of total approvals.

The case for foreign capital is usually made as follows. Foreign investment cansupplement domestic investible resources in a developing economy, enablinghigher rates of growth. As a source of foreign exchange, it can relax potentialbalance of payments constraints on growth. Profit remittances on account offoreign equity are related to the performance of investment projects, unlike theinflexible repayment obligations of foreign debt: this risk-sharing feature makesforeign equity preferable to foreign debt. Foreign firms contribute to thetechnological base of the host economy, directly and through technologicalspillovers to other firms in the industry. Besides, in the right circumstances, thepresence of foreign firms reduces market concentration and promotes a morecompetitive market structure.

Critics of multinational firms have long argued against this rosy picture. Theyclaim that multinationals monopolise resources, supplant domestic enterprise,introduce inappropriate products and technology, and aggravate the balance ofpayments problems through high remittances. They may also come to wieldconsiderable political influence, distort the path of development, exacerbateincome inequality, and exploit the weak environmental standards in developingcountries (recall the Union Carbide disaster at Bhopal in 1984).

Is foreign capital a pain, or is it a panacea for India’s problems? To a largeextent, the answer depends on the nature of foreign direct investment (FDI) and itsmotivations. Some FDI is motivated by the high rates of return in a vibranteconomy, and aims to benefit from better international organization of productionand location. Crudely speaking, we could refer to such FDI as growth-led andefficiency-seeking. But even a stagnant economy may attract rent-seekingmultinationals that have a comparative advantage, over domestic firms, inextracting monopoly rent in protected markets. The relative mix of these two


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types of FDI determines the long term benefits and costs of foreign capital.Ideally, a country would like to attract efficiency-seeking FDI and exclude rent-seeking FDI. Of course, from practical or regulatory points of view, it is not easyto distinguish ex-ante between the two types of FDI. Typically, a permissiveregulatory environment may end up admitting both types, while a restrictiveenvironment may exclude both. In the perverse case, the regulatory environmentmay create hurdles that rent-seeking FDI alone can jump over. One way to reducethis risk is to promoting a regulatory environment that makes it hard to generatemonopoly rent, thus making investment less attractive for rent-seeking FDI.

To assess the relevance of these arguments for the Indian case, we scrutinisethe role private foreign capital has played in India over the last five decades. Inparticular, we compare the conduct and performance of foreign-controlled firmsrelative to domestic firms; unlike previous studies that have looked at this issueover short periods of time, we examine long-term trends in relative performance.Our study focuses on aggregate behaviour; this allows us to explore an issueignored in previous studies, namely the macroeconomic linkage between policytowards foreign capital and its contribution to the Indian economy.

Section 2 reviews the policy framework towards foreign capital in India, andSection 3 examines the long-term trends in foreign investment. Section 4 assessesthe importance of foreign-controlled firms in Indian manufacturing, and theirperformance relative to domestic firms. Section 5 attempts to evaluate thecontribution of foreign capital to the Indian economy. Section 6 outlines thepolicy implications that emerge from our analysis.

2 Five decades of policy changes

Foreign capital has a relatively long history in India. At Independence in 1947,private foreign capital dominated the narrow industrial base in India. It was three-quarters British-owned, concentrated mostly in extractive industries and trade, andmanaged by expatriate Europeans. The continued dominance of these colonialenterprises was an irritant to nationalist sentiments. Fledgling Indian businesshouses envisioned a future in which foreign interests would be curtailed, andIndian industry and markets reserved for swadeshi (that is, domestic) capital.1

1 The term swadeshi had its origin in the turn-of-the-century Swadeshi Movement that aimed toboycott foreign goods. Subsequently, the term became emblematic of nearly all forms of hostilityto foreign interests. The Bombay Plan (formally, A Plan of Economic Development in India,1944), an early articulation of hostility of Indian business houses to foreign capital. led to theformation of the Swadeshi League. In 1953, the Federation of Indian Chambers of Commerce andIndustry adopted the Swadeshi Resolution. Nationalists were only too conscious of the record offoreign investment in India: the East India Company, arguably the largest foreign directinvestment enterprise in Indian history, had later formed the basis for imperial rule.


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Early statements of government policy echoed these interests. The IndustrialPolicy Resolution of 1948, while conceding that ‘participation of foreign capitaland enterprise will be of value to the rapid industrialisation of the country’,demanded that ‘the conditions under which it may participate be carefullyregulated in the national interest. As a rule, majority interest in ownership andeffective control should always be in Indian hands’, and called for a gradualreplacement of foreign personnel.

One Step Forward...

However, the magnitude of the industrial challenge after Independence called fora more pragmatic approach. The government remained critical of the old foreigninvestment, but new investment was considered necessary, ‘not only tosupplement savings but also because in many cases, scientific, technical andindustrial knowledge can best be secured through foreign capital’. As early as1949, a more conciliatory statement in the Parliament promised that ‘existingforeign interests would be accorded “national treatment”; new capital would beencouraged on terms that are mutually advantageous; although majorityownership by Indians was preferred, foreign control would be permitted for alimited period if it is found to be in the national interest; repatriation of capital andremittances of profits abroad allowed; in case of compulsory acquisition, faircompensation would be paid’. Foreign firms were encouraged to invest inprotected industries like fertilisers and machine tools. Extensive concessions andtax advantages were offered to attract multinational oil companies.

Despite these overtures, inflows remained modest. Kidron (1965) notes thatcapital inflows to India between 1948 and 1953 were a meagre Rs 1.3 billion($270 million), and much of that was due to the oil-majors setting up theiroperations in India. The initial reticence of foreign capital was understandable.Domestic business houses, foreign capital, and the government were locked inwhat Kidron famously called ‘an uneasy triangle’. Individually, domesticindustrialists sought foreign collaboration for access to foreign technology andbrand names. At the collective level industry associations—often dominated bythe same industrialists—sought to preserve the Indian market for themselves, andclamoured for reversal of the open-door policy. The government was not moved:‘the wheels of industry, no matter who owns them, must be kept moving’, theCommerce Minister declared in 1953. Government policy was non-discriminatoryin intent but still vulnerable to nationalist sentiments. The ambivalence ofdomestic business interests, and uncertainty regarding future government policy,kept foreign investors shy of the Indian market.

In the late 1950s policy and circumstance conspired to alter the situationdramatically. The Second Economic Plan, launched in 1957, chose the path of


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industrialisation through import-substitution. The large increase in plannedinvestment expenditure coincided with a severe foreign exchange crisis thatforced a drastic reduction in imports, especially of consumer goods. These eventscreated extremely lucrative opportunities for private investment in India. Toexploit these opportunities, Indian business had to turn abroad for technology. Forforeign capital, this was an excellent opportunity to jump the newly created tariffbarriers. This coincidence of interests overwhelmed any misgivings that Indianindustrialists might have had about foreign collaboration.

The government, keen to achieve its Plan targets, encouraged privateinvestment and, in particular, allowed foreign equity participation to meet theforeign exchange needs of investment projects. At the behest of the World Bank,the government dropped its insistence on majority Indian ownership. The IndianInvestment Centre was set up in 1961 to expedite the approval of foreigncollaborations. The government drew up a list of 26 industries where foreigncollaboration was to be encouraged. Pharmaceutical drugs, aluminium, and heavyelectricals were opened up to joint ventures.

Foreign capital poured in during the 1960s. Its form and sectoral distributionwas affected by the selectivity of government policy. Unlike the existing stock offoreign capital, fresh inflows concentrated on manufacturing, especially thetechnology-intensive industries. Collaboration was the preferred form ofinvestment: joint-ventures with Indian business partners provided localintermediaries, who were better able to cope with the highly regulated industrialregime. Indian participation made these projects more acceptable to the regulators.

... Two Steps Back?

By the end of the 1960s, the honeymoon was over. In the aftermath of twofamines and a humiliating devaluation of the Rupee, the political mood hardenedand turned towards socialist idealism. Major commercial banks were nationalised,and the Monopolies and Restrictive Trade Practices Commission was set up in1969. In such an environment, it no longer seemed politic to have an open-doorpolicy to foreign capital. If anything, there was heightened concern about theforeign-exchange costs of repatriated profits and other remittances. The tenor ofpolicy towards foreign capital changed. Foreign oil-majors were nationalised inthe early 1970s. The government did not rule out new foreign capital—it had setup the Foreign Investments Board in 1968, ostensibly to reduce averageprocessing time for fresh applications—but now wanted it on its own terms.

The Foreign Exchange Regulation Act (FERA) of 1973 is singled out asevidence of the new hostility. It amended an earlier Act of 1947, and a crucialnew clause aimed to limit the extent of foreign ownership at the enterprise level. Itrequired that all firms dilute their foreign equity holdings to 40% if they wanted to


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be treated as Indian companies. Most, though not all, firms chose to fall in linewith this provision rather than risk the more stringent regulations imposed on theso-called FERA companies. However, the view that FERA was unambiguouslyhostile to foreign capital and intended to protect Indian industry from foreigndominance may be a little simplistic. The required dilution of foreign equity to40% was not too onerous. While some multinational firms insist on majorityownership—IBM and Coca-Cola left India in the late 1970s—for many others,40% was sufficient to retain managerial control. Moreover, exceptions in the Actallowed many ‘technology-intensive’, ‘export-intensive’, and ‘core-sector’ firmsto preserve majority foreign ownership, often as much as 74%. Mostmultinationals found it worthwhile to continued operating in India. Indeed, as weshow later, many existing multinationals consolidated their positions in Indianmarket during the 1970s. Thus, FERA proved more hostile to new foreigninvestment than to existing foreign affiliates.

FERA was only a part of the new regulatory regime. Limits on foreign equityholdings were now combined with restrictions on technology imports. Fresh listswere drawn up of industries where foreign collaboration was still considerednecessary; others where only technical collaborations was permitted, withcurtailed rates of royalty payment; and those where the domestic technologicalbase was considered strong enough to obviate the need for imports of technology.To minimise the foreign exchange costs of technology acquisition, as far aspossible technologies were to be acquired through licensing rather than financialcollaboration. Intellectual property rights were severely curtailed by a revisedPatents Act in 1970: product-patents were abolished in industries such aspharmaceuticals and chemicals; the duration of process-patents was shortened.

Overall the technology policy, combined with selective licensing andprogressive nationalisation of some industries, served to concentrate foreign directinvestment in the manufacturing sector. Even within manufacturing, FDI was nowpredominantly in technology-intensive industries such as heavy chemicals,pharmaceuticals, and mechanical and electrical machinery. While this shift wasbroadly desirable, we argue later that the policy regime restricted access to foreigntechnology.

Piece-meal reform

In the 1980s, growing concern about stagnation and technological obsolescence inIndian industry drew attention to the restrictive licensing procedures. Poor qualityand high costs in Indian manufacturing probably contributed to the poor exportperformance, a particular irritant in the wake of the second oil price shock. As aconsequence, there was a softening of the regulatory regime. To encourageexports, firms that produced primarily for exports were granted exemptions from


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the usual FERA restrictions on foreign equity ownership. In an attempt tomodernise manufacturing industry, restrictions on technology transfers androyalty payments were relaxed and, where attempts to acquire technology throughlicensing had failed, foreign equity participation was permitted again.

This early softening did not reflect any serious change of heart. Despite theofficial claims of simplified procedures and cleared bottlenecks, foreigninvestment projects were still very vulnerable to bureaucratic discretion: there islittle evidence that policy was any more informed about the needs of Indianindustry or the nature of the technology market. There was only a slight increasein foreign inflows, and the most part, Indian industry came to rely on foreign debtcapital to meet its foreign exchange needs.

Crisis and ‘winds of change’

The 1990s began with a major crisis. In the wake of the Gulf War, and theconsequent expulsion of Indian expatriate labour from the Middle-East, foreignexchange remittances fell. As the balance of payments position deteriorated, apanicked withdrawal of funds deposited in India by ‘non-resident-Indians’exacerbated the problem. The real possibility that India might default on itsexternal obligations led to a downgrading of India’s credit rating. The governmentturned to the International Monetary Fund for help.

As part of the reforms agreed with the IMF, the Rupee was devalued by 20%.The trade regime and the regulatory framework were liberalised. Industriallicensing was abolished in all but a handful of industries. Foreign directinvestment was invited in a wide range of industries, including consumer goods.The government dropped its insistence that foreign equity participation providespecific benefits in terms of technology transfer or export earnings. The limit onforeign equity participation was raised to 51% for most industries, and even 100%in some cases. Foreign investment was especially sought in the infrastructuresectors previously monopolised by state enterprises: power generation, highwayand port construction, telecommunications, oil and natural gas exploration, etc.The services sector, where foreign capital had been gradually eliminated as amatter of deliberate policy, was reopened to foreign investors: they were invitedto invest in financial services, retail banking, and recently, in life and generalinsurance. Restrictions on the use of international brand names were removed.Reforms in the technology policy have provided greater recognition of intellectualproperty rights.

This liberalisation coincided with growing interest in emerging markets,especially among the global pension funds. In a major break from the past, foreigninstitutional investors (FIIs) were allowed to make portfolio investments in Indiancompanies, subject to overall limits on ownership within each firm. Foreign funds


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surged in, initially in the form of portfolio capital, but increasingly in directinvestment projects. In 1997-98, foreign direct investment inflows exceeded$3.2bn. Despite the exceptional political instability after 1995, successivegovernments have continued to court foreign capital even though the liberalstance has not always been consistent. In a sense, the attitude towards foreigncapital seems to have turned a full circle. In a pattern reminiscent of the early1950s, domestic business interests have increasingly lobbied the government forcontinued protection against foreign capital.

In the last five decades, policy towards private foreign capital has movedclosely with exigencies of India’s external payments position, and with changingofficial perceptions of the role of foreign capital in alleviating or exacerbating thatposition. The early liberalisation of the late 1950s was in part motivated by abalance of payments crisis. The restrictive regime of the 1970s, and FERA inparticular, was influenced by the belief that excessive remittances of foreignenterprises were worsening a precarious balance of payments position. Thegradual liberalisation of the 1980s and the major reforms of the 1990s were, todifferent degrees, responses to external payments difficulties. Even when theprivate capital inflow was not large by itself, it was expected that a more liberalregime towards foreign investment would enable other flows, including thosefrom the multilateral lending agencies. The changing policy environment affectedthe extent of foreign capital in Indian industry and its contribution to theeconomy. We discuss these in turn.

3 Private foreign capital in India: long-term trends

At Independence, the total stock of private foreign capital in India was valued atRs 5.8 billion ($1.2 billion at 1948 exchange rates). By 1995, the most recent yearfor which comparable data is available, the stock had grown to Rs 989 billion($31 billion). Table 2 profiles the long-term foreign liabilities of Indian firms overthis period.

Table 2: Stock of private foreign capital in the Indian corporate sector

1948 1960 1970 1980 1987 1992 1995Long-term investment(Rs billion), of which 5.8 5.7 16.4 22.19 133.6 536.5 988.9

1 Direct investment(% share in total)

2.6 5.0(89)

7.4(44.8)

9.3(42.1)

17.4(13.0)

38.4(7.2)

94.2(9.5)

2 Portfolio investment(% share in total)

na 0.5(9.0)

0.9(5.7)

1.2(5.5)

4.6(3.4)

14.8(2.8)

226.2(22.9)

3 Foreign debt na 0.1 8.1(49.5) (52.4)

111.0 483.3(90) (67.6)

This is private long-term capital in firms, excluding banks. The procedure for classifying equity capital asdirect investment and portfolio investment changed in 1992, hence relative shares are not comparable afterthat year. For a discussion of this and all data sources, see the appendix.


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The growth rate of foreign liabilities varied across time and investment categories.Foreign direct investment (i.e., foreign equity holdings associated with foreigncontrol of enterprises) grew steadily at first, its stock rising from Rs 2.6 billion in1948 to Rs 7.4 billion by 1970. Its rate of growth fell in the 1970s, picked up inthe 1980s, but the surge came after 1992: the stock of direct investment rose fromRs 38 billion in 1992 to Rs 94 billion by 1995. In contrast, foreign portfolioinvestment was restricted a matter of deliberate policy for most of this period. Thetotal stock of portfolio capital was less than Rs 15 billion in 1992. Withliberalization these portfolio holdings rose to Rs. 200 billion by 1995, thoughrecent financial crises have seen net outflows on this account. But, moststrikingly, the largest single component of private foreign capital after 1980 hasbeen long-term corporate debt: when foreign equity inflows were restrainedduring the 1980s, Indian firms made up by borrowing abroad. Even in 1995,foreign corporate debt was more than twice as large as foreign equity capital. (Ofcourse, the rupee value of debt is slightly exaggerated by currency devaluation in1991-92.) Thus the commonly held view that the Indian economy was cut offfrom foreign capital is not quite true—more accurately, the corporate sector wasdeprived of foreign equity participation.

Foreign Direct Investment

Table 3 summarises the changing industrial distribution of foreign directinvestment. In 1948, a third of all foreign direct capital was in the primary sector(plantations, mining, and oil), a quarter in manufacturing, and the rest in services(mostly trading, construction, transportation and utilities). By the mid-1990s,manufacturing accounted for about 85% of all foreign direct investment. Inabsolute terms, the stock of foreign direct capital in manufacturing rose from Rs0.7 billion in 1948 to over Rs. 79 billion by 1995. Within manufacturing, thecapital goods sector was the predominant recipient of FDI: engineering and heavychemicals account for two-thirds of all foreign direct capital.

The primary and services sectors now account for less than 10% each of allforeign direct capital. Foreign holdings in plantations and mining fell steadilyafter Independence. The share of oil-refining rose as the oil-multinationals enteredin the early 1950s, but then fell when they were nationalised in the 1970s. Theenergy sector has seen renewed interest among foreign investors in recent years.The share of the services sector fell as many firms were nationalised in the 1970s,but once again there is renewed foreign interest in these sectors.

The changed industrial distribution of foreign capital in India reflects thesuccess of a selective regime. To a large extent, the government managed to directforeign capital to technology-intensive, manufacturing sectors: this was consistentwith the needs of an industrializing economy.


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Table 3: Changing distribution of foreign direct capital stock in India, percentages

Industry/Sector 1948 1960 1970 1980 1987 1992 1995 Plantations 20.4 19.0 16.5 4.1 8.8 8.5 4.8 Mining 4.5 2.4 0.8 0.9 0.3 0.6 0.3 Petroleum 8.7 29.7 16.7 4.0 0.1 2.0 2.9

Total primary sector 33.6 51 34 9 9.2 11.1 8.0 Food & beverages , tobacco 14.2 6.4 5.6 4.2 6.5 4.9 7.3 Textiles 39.4 2.7 3.0 3.4 4.6 2.9 3.9 Transport equipment 1.4 1.2 3.7 5.6 9.9 12.4 10.5 Machinery & machine tools 1.7 0.8 3.8 7.6 12.1 12.6 11.3 Metals and metal products 11.3 2.8 8.8 12.7 4.9 5.1 4.6 Electrical goods 6.8 2.3 6.5 10.5 11.9 11.0 10.8 Chemicals & pharmaceuticals 3.1 6.4 18.8 32.4 29.6 28.0 22.2 Miscellaneous 9.9 6.2 12.0 10.7 6.1 6.4 12.8

Total manufacturing 27.8 30 60 87 85.6 83.2 83.4 Trading 16.3 5.4 2.6 2.3 0.4 1.1 1.3 Construction, utilities, transport 11.9 7.6 1.6 0.6 2.2 1.1 0.7 Total services 38.7 19.5 16.0 4.0 5.1 5.7 8.9

Total FDI (current Rs. Million) 2558 5017 7354 9330 17420 38400 94160

1992 and 1995 figures use the modified definition of FDI. See appendix.

The historical dominance of British firms has shown remarkable persistence inpost-imperial India. Three-quarters of all foreign capital was British in 1948. Thisshare declined to 40% by 1992, but since then has been eroded to 25% bydisproportionately large inflows from other countries. The share of US firms hasrisen; Germany, Japan, and Switzerland have a significant presence, too. Theindustrial distribution of foreign capital differs according to the nationality ofinvestors. Multinationals from the US, Germany, and Japan have gravitated totechnology-intensive manufacturing. Traditional investments, such as plantations,are predominantly monopolised by British firms.

Table 4: Countries of origin: stock of foreign direct investment in India

Percent share of 1960 1971 1980 1987 1992 1995 UK 76.6 64.5 53.9 51.7 40.2 28.0 USA 14.5 18.4 21.1 12.9 18.6 24.1 Germany 1.1 3.1 7.0 16.7 12.4 8.9 Japan 0.2 0.4 0.4 3.7 5.5 7.6 Switzerland 2.4 5.0 5.9 3.7 4.8 5.6 Others 5.2 8.6 11.7 11.3 18.5 26.8

4 Foreign-controlled firms in Indian Industry

To what extent have foreign-controlled firms dominated Indian manufacturing?The relative share of foreign firms in Indian industry has been a matter of somecontroversy. Existing estimates—see Kumar (1994) for an excellent survey—are


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based on a variety of methods, data, and working assumptions, so provide a poorguide to the long-term trends.

We estimate the foreign share in Indian industry for the period 1970 to 1994,using unpublished data from the Reserve Bank of India (RBI). The data isconstructed from a sequence of surveys of Finances of Medium and Large PublicLimited Companies.2 The use of this data has some limitations for our purpose.The surveys exclude public sector (i.e., state-owned) enterprises, private limited(i.e., ‘unlisted’) companies, and small companies. The excluded sectors arepredominantly domestically-owned so our estimates probably exaggerate theforeign presence. Moreover, if excluded sectors grow faster (or slower) than thefirms in our data set, changes in foreign presence over time are over- (or under-)estimated. Variations in the coverage of surveys, and in the identification offoreign firms also affect our estimates. Despite these limitations, the data has themerit of being internally consistent and covers a reasonable period of time. Earlierversions of this data have been used for point estimates by Chandra (1977, 1991),and Kumar (1994), among others.

Conceptually, the relative foreign presence can be measured either as the shareof assets that are foreign-owned, or as the asset- or market-shares of foreign-controlled firms. The identification of foreign-controlled firms is not free fromambiguity. Managerial control of listed companies is exercised through ownershipof sufficiently large blocks of voting stock. Majority ownership enables control inmost circumstances, but minority ownership may be sufficient if other share-holdings are fragmented, i.e. dispersed among a large number of small share-holders. Many studies, Kumar (1994) for instance, classify a firm as foreign-controlled if at least 25% of its shares are held abroad. The International MonetaryFund uses a lower threshold: its Balance of Payments guidelines treat a firm as aforeign direct investment enterprise if 10% of its voting stock is held abroad by asingle investor. The choice of the right threshold is largely a matter of convention:Graham and Krugman (1995) discuss the merits of the 10% criterion.

We rely on the classification scheme used by the RBI. The RBI identifies eachfirm by its country of controlling interest. For much of the period under study,Indian regulations treated a firm as foreign-controlled if 25% of the equity washeld by a single foreign investor, or if 40% of the equity was held in any oneforeign country. Effective 1992, the RBI adopted the IMF guidelines foridentifying foreign direct investment enterprises. Thus, over time, changes in theidentified country of control may just reflect changes in the classification rules forforeign investment. Our results must be interpreted with this caveat.

2 These surveys are described in the Appendix.


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We estimate foreign shares in Indian manufacturing as the share of foreign-controlled firms in gross sales; one could equally well measure their share inassets or, indeed, any size-related variable, but this does not seem to affect theoverall pattern. Figure 1 shows that foreign-controlled firms accounted forbetween a third and a quarter of gross sales in Indian manufacturing over period1970 to 1990. The foreign share rose slightly from 1970 to 1976 and since thenhas declined. We believe that the sharper decline after 1991 is an artefact of thedata: foreign firms seem under-identified or under-represented in recent surveys.More detailed results reported in Athreye and Kapur (1999) show that foreignshares are high in electricals (especially dry cells and lamps), chemicals(especially pharmaceuticals, plastics, paints, and toiletries), tyres and tubes,cigarettes, aluminium, automotive components. British-controlled firms have thelargest share: in 1990-91, they controlled 15% of all sales --domestic or foreign --in Indian manufacturing; the share of US firms was a little below 5%.

Our estimates are broadly consistent with others’ who have earlier versions ofthis data (see, for instance, Kumar’s (1994) estimates for 1980-81). Others, withalternative assumptions, produce different estimates. Ganesh (1997) identifiesforeign-control with majority foreign ownership (i.e., foreign ownership in excessof 50%). Among the largest 1000 listed firms in 1995, he found that only 72 firmsare foreign-controlled by this (tighter) criterion, and together control only 9% oftotal sales. Ganesh concludes, on this evidence, that foreign presence in Indianmanufacturing has been exaggerated.

Identifying foreign control by the criterion of majority ownership is probablyinappropriate in the Indian context. Under the Foreign Exchange Regulation Act(1973), many multinationals operating in India were forced to dilute foreignshareholdings to 40%. In most cases, the foreign parent could maintain completecontrol over their Indian affiliates even with this minority shareholding. Typically,the required dilution was achieved through fresh equity issues. Control of shareallocations ensured that domestic shareholdings were fragmented. For instance, 89thousand individuals together made up the 47% domestic shareholding inHindustan Lever, while its parent, Unilever, retained 51% (figures for 1980).State-controlled financial institutions, which often had significant equity holdingsin Indian business houses, did not invest in foreign affiliates -- this removed apossible channel of countervailing power. Even when the government enforcedthe complete Indianization of managerial cadres in India, many minority foreign-owned affiliates found non-equity forms of control over their local management.When foreign exchange was a scarce commodity, control over loans from theforeign parents to the Indian subsidiaries became a indirect channel of control.

Our findings do not support the common-place belief that FERA (1973)curtailed foreign control in Indian industry. As Encarnation (1989) notes, many


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multinationals ‘continued to turn adversity into opportunity’: in exchange forexpanded exports or increased production in priority industries, the governmentallowed more than a hundred foreign enterprises to retain majority-holdings intheir Indian affiliates. The required equity dilutions allowed them to raise freshcapital at a time when access to capital markets was severely restrained by thegovernment. Even though a few multinationals—notably Coca-Cola and IBM—left India in the late 1970s, most chose to stay. Indeed, many foreign-controlledfirms managed to consolidate their position in the Indian market. Overall, FERAallowed incumbent foreign firms to preserve their market shares in India, andsometimes to thrive too, even as it deterred new foreign investment.

The gradual decline in foreign market shares, especially in the 1980s, is betterexplained by the restrictions placed on foreign firms by the overall regulatoryframework. Greater selectivity in industrial licensing restrained the growth ofmany multinationals. Many multinationals were unable to compete against well-organised domestic industrial lobbies. Restrictions on monopoly power (theMonopolies and Restrictive Trade Practices Act) and a diminution of intellectualproperty rights (the Patents Act) eroded many of the rent-seeking advantages thatforeign firms had enjoyed in India. Encarnation (1989) argues that India acquiredfinancial autonomy from foreign enterprises at an early stage by mobilisingdomestic and foreign capital, and then managed to unbundle technologyacquisition from equity participation. As a result, domestic enterprises graduallyacquired control over product markets that were previously dominated bymultinationals. Foreign multinationals were also displaced by the growth of state-owned enterprises in some sectors (steel, engineering, chemicals, pharmaceuticals,mining, transport, power), and progressive nationalisation in others (textiles).Despite this gradual erosion in some sectors, multinationals were not quitedislodged from India. Many preserved their foothold in India, and were wellplaced to recover their position in the 1990s.

Foreign-controlled firms: conduct and performance

Did the foreign-controlled firms in India differ from domestic firms in terms oftheir conduct and performance? Kumar (1994) examines the discriminatingcharacteristics of domestic and foreign-controlled firms, using data for 1980-81,and with careful attention to the underlying statistical issues. He found that as aproportion of sales, foreign-controlled firms spent less on R&D (presumablybecause they rely on technology imports) than domestic firms, but expenditure onadvertising was broadly similar for the two groups of firms. However, foreign-controlled firms were significantly more profitable in their operations, a resultcorroborated by other studies. Kumar (1990) concluded that the profitability offoreign-controlled firms was protected by entry-barriers: in knowledge- and skill-intensive industries, their technological strength, access to global marketing


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networks and brand names gave them a clear edge over domestic firms. He foundthat degree of seller concentration did not seem to affect profitability but therewas market segmentation: foreign-controlled firms competed on the high valueend of the market while domestic firms concentrated on the low-value end.

We use the RBI data to compare the conduct and performance of foreign-controlled and domestic firms over the period 1970 to 1994. For each variableunder scrutiny, we compare the (weighted) average for foreign-controlled firmswith that for domestic firms. Figure 2 confirms earlier findings that foreign-controlled firms have persistently higher profit margins, whether measured asshare of net sales or net fixed assets.

How did the multinationals defend these profit margins? Advertising intensity,measured as the ratio of advertising expenditure to net sales, was greater forforeign-controlled firms (see figure 3), but domestic firms relied more heavily onselling commissions (figure 4). Of course, different industrial sectors differ in theadvertising intensity: the overall difference in marketing strategies might reflectthe differences in industrial concentration of foreign-controlled and domesticfirms. Figure 5 shows that domestic firms have increased their expenditure ontechnology imports, especially in recent years, and have overtaken foreign firmsin this respect. Unfortunately, we do not have comparable data for R&Dexpenditure, but these were typically quite small for all manufacturing firms inIndia. On the whole, the observable differences in conduct were not that large.

5 The contribution of private foreign capital

What has been the impact of private foreign capital on the Indian economy? Hasthe presence of multinational corporations helped or hampered growth in Indianindustry? There is no easy consensus on these issues. Those who advocate a moreliberal regime claim that FDI will provide the much-needed investible resourcesand foreign exchange for reviving Indian industry, improve the crumblinginfrastructure, and allow India to modernise its technological base. Moreover,greater competition in Indian manufacturing will benefit the Indian consumer. Onthe other hand, critics of foreign capital point to the poor record of multinationalcorporations in India, their excessive profitability, the adverse impact of profitremittances on India’s balance of payments, and limited technology transfer, andtheir domination of the Indian manufacturing sector. We scrutinise the availableevidence to assess the validity of the rival claims, but it helps to begin on aconceptual note.

Does foreign investment contribute to growth? Casual empiricism does notoffer any simple lessons. Countries like China have experienced large FDI inflowsand high growth in recent years, while Korea grew rapidly without significant


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levels of foreign capital. Many Latin American countries have periods of slowgrowth despite openness to foreign capital, while much of sub-Saharan Africa hasexperienced low growth and poor investment flows. Moreover, even if we did findsome positive correlation between FDI and growth, the issue of causality remainsunresolved. Does foreign capital increase the growth rate, or does the prospect ofhigher growth attract investment flows? Anecdotal evidence apart, cross-countryeconometric evidence does not offer stronger conclusions: de Mello (1997),surveying the evidence, concludes that the relationship between FDI and growthdepends on country-specific factors.

In theory, foreign direct investment inflows affect economic growth throughincreased investment in the economy. The relation between the FDI and domesticinvestment is best explained through the following macroeconomic identity. Totalinvestment in an economy must be financed somehow within each period:

investment = domestic savings + foreign savings

where foreign savings refer to resources received from foreign citizens invest, asforeign equity and foreign debt inflows. Other things being the same, an increasein FDI increases foreign savings, and so increases investment in the economy.However, quite plausibly, increases in FDI inflows may coincide with a reductionin debt inflows (so that total foreign savings remain constant) or be accompaniedby a fall in domestic savings (if there is a consumption boom): in each casedomestic investment does not rise.

The effect on balance of payments can be analysed by rewriting the aboveidentity as

foreign savings = imports - exports

In general, if an increase in FDI increases available foreign savings, it allows thehost country to import more or to accommodate a decline in exports. Thus, at leastin the short run, inflows of foreign capital allow the current account to worsen.3

This is not surprising: indeed, the purpose of foreign savings is to import more inthe short run. Note that the effect on the balance of payments is the flip side of theeffect on domestic savings and investment: FDI can conceivably increasedomestic investment, or provide additional balance of payments financing for anexisting current account deficit, but cannot do both at the same time.

In general, an FDI-financed, short-run, ability to import more could equallywell support a consumption boom or an investment boom. If it is the latter, itwould typically result in faster growth and, possibly, increased exports. After

3 This is not always true: the monetary authority may choose to accumulate inflows as foreignexchange reserves. Large, rapid inflows then present problems for the management of moneysupply: sterlization of flows is not always effective.


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allowing for some profit repatriation on account of successful investment, the hosteconomy would still benefit. However, the long-term outcome is not always sofavourable. Singh and Weisse (1998) note that rapid inflows to Mexico in theearly 1990s fueled a consumption boom, accompanied by large current accountdeficits. Arguably, if inflows are in the form of portfolio capital (rather than, say,FDI in greenfield ventures), they are more likely to result in consumption ratherthan investment booms. Patnaik (1997) notes that a significant fraction of recentinflows to India have been short-term flows of portfolio capital, whose direction iseasily reversed with changes in market perceptions. A sudden reversal of flowshas catastrophic effects on investment, output, and the balance of payments, asevident from the experience of Mexico, and more recently, East Asia. Instabilityin capital flows would then result in increased volatility in economy-wide growthrates.

In view of this, it may be over-optimistic to rely on FDI to increase investmentand growth in India, especially in the short-run. India has had a relatively highsavings rate, and it is quite possible that FDI may merely substitute for domesticsavings.

Savings and Investment

Theoretical possibilities apart, does FDI increase aggregate investment in aneconomy? Fry’s (1995) econometric analysis of FDI flows over 1966-88 to 16large developing countries, including India, cautions against any simplegeneralizations. Correcting for a host of country-specific factors, he finds that FDIinflows seem to have a negative effect on domestic investment. Other studies, forinstance Dhar and Roy (1996), confirm this finding. It could well be that FDIcrowds out domestically-financed investment. Alternatively, it could be that FDIinflows rise in recessionary environments -- note the ‘fire-sale FDI’ in wake of therecent South Korean crisis. Fry’s related finding, that FDI flows do not have anysignificant positive impact on contemperaneous growth rates, is hardly surprising.

FDI inflows may have a more positive contribution in the long-run, and moreso for some countries than others. Fry finds that domestic investment and growthare positively related to FDI flows lagged by 5 years. A sub-sample of Pacific-Basin countries does better than the countries outside that region. For the PacificBasin countries, domestic investment rises by the full extent of the FDI inflow,with generally beneficial effects on growth. Outside the Pacific Basin, FDIappears to substitute for other kinds of foreign flows: FDI inflows wereaccompanied by lower investment, lower savings and slower growth. In otherwords, FDI could even be immiserising.

It is argued that these diverse experiences are related to the overall economicregime of the host country, and that countries with a ‘favourable environment for


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investment’ do better with FDI than countries with distorted financial or tradingsystems. Of course, the ingredients of a favourable environment are not easy tospecify, ex-ante. Balasubramanyam, et al (1996) claim that countries with aliberalised trade environment grow better with FDI than countries with distortedtrading systems.

Balance of payments

Fry (1995) finds that foreign direct investment inflows tend to worsen the currentaccount in the short run, a tendency consistent with the theoretical expectation.The long-term effects on the balance of payments depends, among other things,on the operating characteristics of FDI enterprises, notably their exportpropensity, the extent to which they rely on imported inputs, including technologyimports, and on the volume of profit-repatriation. Of course, there are indirecteffects too. Multinationals can conceivably increase the export-propensity ofdomestic firms through spillover effects. Further, if domestic production bymultinationals substitutes for previously imported goods, FDI can reduce the totalimport bill. Unfortunately, these indirect effects are harder to measure in firm-level data.

The relative export propensity of foreign and domestic firms has been acontroversial issue. Figure 6, based on the RBI data, reveals that exports as shareof net sales were broadly similar for foreign-controlled and domestic firms,though foreign-controlled firms have performed slightly better in recent years.Our estimates are in keeping with Kumar’s (1994) finding that the exportbehaviour of foreign-controlled and domestic firms for 1980-81 did not differsignificantly.

Some studies, typically not as robust as Kumar’s, conclude that multinationalsexport more. Lall and Mohammad (1985) found that industries with high foreignshares (as measured by the share of dividend paid abroad) tended to be moreexport-intensive. Majumdar and Chhiber (1998) find that, among foreign-controlled firms, there is positive correlation between the level of foreign equityownership and export performance, but only when foreign affiliates have majoritycontrol. They conclude that majority ownership is essential for effective foreigncontrol, and the latter essential for export performance. Such findings, even whentrue, have to be interpreted cautiously. In the post-FERA regime, firms thatexported a ‘significant part of their output’ were allowed foreign shareholdingsabove the usual 40%. In other words, greater foreign shareholdings could be areward for good export-performance, rather than its cause. Besides, anecdotal


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evidence that foreign-controlled firms often used ‘third-party exports’ to meettheir export obligations makes it hard to formulate simple policy conclusions.4

Of course, export behaviour is only a part of the picture when considering theoverall impact on balance of payments. Comparing earnings and expenditures inforeign exchange – the latter includes imports of raw materials, royalty payments,technical fees, and dividend remittances -- Chandra (1977, 1993) estimated thatthe net foreign exchange contribution of foreign-controlled firms was negativethrough the 1960s and 1970s. While this is a reasonable (and frequent) criticismof multinationals, we find both domestic and foreign-controlled firms in India didbadly by this criterion. Figure 7 suggests that the net foreign exchangecontribution of foreign-controlled firms and domestic firms was broadly similarand, indeed foreign firms may have done better in recent years. Even the RBI’s(1985) fourth survey of foreign collaborations found that, in the post-FERAperiod, majority foreign-owned subsidiaries exported more than they imported.Besides, it helps to get a sense of the absolute sums involved. Our calculationsbased on RBI (1993) show that total outgoings of foreign-owned firms (technicalfees, royalties, and dividends) averaged $120 million per year through the 1980s.While this was not insubstantial, even moderately successful export performancecould have financed these flows.

The real issue, then, is the poor export performance of all manufacturing firms,foreign or domestic. The average export propensity in manufacturing remainedlow, at around 5%, for most of this period. Nayyar (1978) had arrived at similarestimates for an earlier period. The high profitability in the sheltered domesticmarkets probably blunted the incentive to export, both for domestic and foreign-controlled firms. As a high-cost economy, India was an unlikely export base formultinationals: regardless of the government’s motives, the major motivation offoreign investors was to jump the quota- and tariff-barriers to the Indian market.in that sense, much of the foreign capital in India was of the rent-seeking variety.There are exceptions: more recently, India has emerged as an export base for USfirms in the computer software industry, a sector in which India has substantialskills at low cost.

Technology: policy and reality

Host country governments often encourage foreign investment in the hope ofimproving the productivity of domestic firms. Foreign direct investmentpotentially brings new technologies to the host economy. Technology inflows canalso improve the productivity of domestic firms through ‘spillovers’, as better

4 For instance, there is evidence that Peico Electricals, the Indian subsidiary of the electronics giantPhillips, met its export obligations by exporting ‘marine products’ (mostly shrimp).


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production and management techniques diffuse in the host economy. Markusenand Venables (1998) believe that foreign investment can be a catalyst for growth.

Wang and Blomstrom (1992) isolate two channels for this spillover process.The more disembodied aspects of superior technologies used by foreign firms canspread to domestic firms through the mobility of trained workers and managers,and through technical guidance provided to vertically-linked domestic suppliers.Thus, the mere presence of foreign firms exposes domestic firms to superiortechnologies: this is the demonstration effect. Two, competitive pressure exertedby foreign firms (in the form of lower prices or higher product quality) forcesdomestic firms to improve their technologies. Productivity gains materialise onlyif competition is effective – that is, it encourages domestic firms to catch up, andif domestic firms have the ability to innovate or imitate successfully. The latterrequires that the technological gap should be small enough relative to learningcapabilities of domestic firms. If it is not, isolated instances of foreign entry candegenerate into foreign monopoly. At the same time, the extent of spillovers maybe limited by the tendency of multinational firms to concentrate their R&Dactivity in their developed country headquarters – the so called ‘headquarterseffect’. The relative importance of these effects may explain why spillover effectshave been stronger in some countries and for some sectors.

Empirical evidence on the nature and extent of spillovers from foreign todomestic firms is mixed. For developing countries in general, de Mello (1997)finds a negative relationship between FDI and total factor productivity at theeconomy-wide level. Kokko (1994, 1996) finds that large foreign shares and largetechnology gaps may produce negative spillover effects on productivity. On thebasis of firm-level data for Morocco, Haddad and Harrison (1993) find that thespillover from foreign firms to domestic firms varies across sectors. In industrialsectors that were protected, foreign investment had a significantly negativeinfluence on productivity growth of domestic firms. In sectors without protection,they found no statistically significant effect of foreign presence. Conceivably,protected sectors attract rent-seeking FDI, and perhaps inappropriate technology.Indeed, Haddad and Harrison found that liberalisation weakened the negativeinfluence of foreign presence on domestic productivity growth.

For the Indian case, Basant and Fikkert (1996) find some evidence of positivespillovers in R&D expenditure. Even here, Srivastava (1991) notes thatproductivity growth in Indian manufacturing rose was liberalisation in the early1980s. Kathuria (1998), in a study of firm level data concludes that there was apositive productivity spillover from foreign to domestic firms.

Undoubtedly, in the Indian case the policy environment had a role to play inthe nature and extent of technology transfer. The regulation of private foreigncapital was accompanied by restrictions that sought to minimise the total cost of


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technology acquisition, and to unbundle technology acquisition from foreignequity participation. Manufacturing was divided into three categories. Whereindigenous technological capability was deemed to be sufficient, no technologyimports were permitted. Where the technology was considered simple or stable,licensing was the preferred mode of technology acquisition. Foreign equityparticipation was permitted only if the technology was sophisticated and unlikelyto be available through licensing. Foreign technology collaborations werepermitted more readily in sectors with large technology gap, but the imperative toavoid duplication in technology-acquisition through ‘repeat licensing’ remainedstrong. Taken to its regulatory extreme, this imperative was bound to createmonopolists.

Restraints were placed on the royalty payments: standardised rates of royaltywere specified for many industries. The duration of collaboration agreements wasoften restricted to five years in the belief that long-term agreements might be‘exploitative’. Intellectual property rights were severely curtailed when thePatents Act was modified in 1970. At one stage, government regulations evenrequired that Indian partners in technical collaboration agreements be permitted tosub-license acquired technology freely to other domestic firms.

To a large extent, the technology policy succeeded in its self-definedobjectives. The average duration of collaboration agreements fell and royaltypayments were kept in check. Domestic R&D was afforded limited protection insome sectors. Taking advantage of increased competition in internationaltechnology markets, Indian firms managed to unbundle technology from foreignequity, especially after the 1970s. Of course, the policy was not always successful.In some cases where royalty payments fell, the less-regulated lump-sum paymentsrose. Sometimes success was achieved at a cost. Where FERA managed to reduceforeign ownership and control, it induced multinationals to tighten contractualprovisions of technology agreements. Restraints on equity participation clearlyaffected the quality and quantity of technology transferred. The requirement thatIndian subsidiaries be free to sub-license technologies made foreign partners waryof transferring valuable technologies. In some sectors, notably electrical andmechanical engineering, domestic R&D filled the gap admirably, and at muchlower cost. In others the exclusion of foreign technology and capital contributedto growing technological obsolescence.

Lee and Mansfield (1996) find that foreign investment by US multinationals,and the magnitude of associated technology transfers, depends significantly oninvestors’ perceptions about the security of intellectual property (IP) rights in hostcountries. In their 1991 survey of 100 US multinationals, India was perceived tobe a country with poor IP rights regime. About 44% of the multinationalsconsidered IP protection in India too weak to permit them to transfer their newest


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or most effective technology to Indian subsidiaries or joint-venture partners, or tolicence technology to Indian firms. In chemicals and pharmaceuticals, thisreluctance was reported by 80% of the firms. The perception of India was worsethan the 13 other large developing countries in their study. Lee and Mansfield findthat the volume of FDI flows was directly related to perceived levels of IPprotection, correcting for other variables, such as openness to trade, degree ofindustrialisation, etc. Further, they find that in countries where IP protection wasperceived to be poor, a greater proportion of the US firms’ direct investments wasassociated with pure sales and distribution or rudimentary production.

At the same time FERA, by reducing the likelihood of new foreign investing inIndia, eliminated the potential technological threat from international competitors.Together these policies allowed existing foreign firms to operate technologies thatwere internationally obsolete, but nevertheless superior to those used by domesticfirms. In many sectors the elimination of effective competition, domestic orforeign, resulted in a more concentrated market structure.

Market Structure

Generally speaking, the relationship between openness to foreign investment andmarket structure is complex. Caves (1996) notes the positive relationship betweenthe extent of foreign investment and the degree of market concentration found inempirical studies. In theory this could be due to rent-seeking foreign investmentbeing especially attracted to sectors or countries with high concentration (and highprofitability). Even so, the short-run effect of foreign entry, especially when it isgreenfield investment, is to increase the number of firms and reduceconcentration. The long-run effects depend on the nature of competition betweenentrants and incumbents. If incumbent firms are moderately competent, there maywell be virtuous cycles of technological competition. On the other hand,inefficient domestic firms with poor learning capabilities would lose market shareto foreign firms. Insurmountable technological barriers and economies of scalemay drive incumbent firms to the fringes. Foreign entry might thus increasemarket concentration through mergers and acquisitions, and occasionally, throughpredatory-pricing.

In the Indian context, there is evidence that industrial concentration and foreignpresence was positively correlated across industrial sectors. Figure 8 shows that,at the level of 3-digit industry sector classification, there is positive correlationbetween foreign shares and the Herfindahl index of industrial concentration. Onceagain, correlation does not imply causation. For most of this period, both foreignshares and the pattern of industrial concentration in India were influencedprimarily by industrial policy, and its attendant control of production capacities.


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There is a marked tendency towards increasing concentration, especially afterthe 1991 liberalization. Basant (1999) points out that multinational companieshave been remarkably active in mergers and acquisitions, and have probablyincreased their control of the Indian corporate sector. Typically MNCs have usedtheir controlling block of shares to increase their equity shares: there have beenvery few greenfield investments. For example, British American Tobacco hastried to consolidate its position in its Indian affiliate, ITC, by buying shares at adiscount. Anecdotal evidence confirms the tendency towards agglomeration.Hindustan Lever, a 51% foreign-owned subsidiary of the Anglo-Dutch Unilever,is one of the largest multinationals in India, with interests in soap, detergents, tea,processed food, cosmetics, edible oil, etc. In a series of mergers and acquisitionsafter 1992, Hindustan Lever has acquired Tata Oils (its principal rival in oil),Brooke Bond Lipton (previously an associate company, India’s largest in food andbeverages), Pond’s India (cosmetics), Kwality, and Milkfood (both processedfoods). It has also formed joint ventures with many US firms keen to invest inIndia, and has acquired a pre-eminent position in its sectors of operation.

There are many sectors in which the absence of competition -- foreign ordomestic -- has contributed to poor performance. Protecting Indian industry fromforeign multinationals was an exercise in the best traditions of infant-industryargument but often produced home-grown brats. In many sectors monopoly powerengendered supply scarcity, poor product-quality, and technological obsolescence.All this makes a case for allowing new entrants and, if necessary, a more openstance towards foreign capital. Whether this alone will create a more competitiveenvironment depends on the form in which foreign capital arrives. Foreigninflows that amount to increased shareholding in existing multinationals areunlikely to have any impact on market concentration. Greater openness to foreigninvestment may not be a substitute for an active competition policy.

6 An evaluation of the policy regime

Control of foreign capital took various forms in India. Hostility to foreign capitaldid not quite reach the level that multinationals most dread—confiscation oroutright nationalisation of foreign assets—but FERA (1973) forced themultinationals to ‘Indianise’ themselves by diluting their foreign ownership.Many multinationals, especially those operating in high technology or prioritysectors, managed to retain majority share holdings through special exemptions.Multinationals not granted such exemptions diluted their holdings to 40%, andthrough a wider distribution of Indian shares, control remained in the hands of theforeign parent. Thus dilution of equity holdings did not quite diminish the level offoreign control. On the whole, multinationals that chose to remain in India largely


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retained managerial control and valuable access to protected Indian markets.Indeed, even as new foreign investment fell, many existing multinationalsexpanded and diversified their Indian operations. The profitability of their Indianoperations was typically higher than that in other parts of the world.

Restraints on foreign ownership were supplemented by restrictions on theoperational freedom of foreign-controlled firms. To conserve foreign exchange,foreign remittances were curbed by direct and indirect means. Preference wasgiven to projects that were at least neutral in terms of their balance of trade, thatis, whose foreign exchange requirements could be met through equity inflows andfuture export earnings. To encourage exports, foreign firms were allowed higherforeign equity thresholds if they exported a significant proportion of their output.

The obsession with foreign exchange costs was combined with what is bestdescribed as technological fundamentalism. After the 1970s there was a statedpreference for technology acquisition with no or low foreign equity participation.The underlying assumption was that bundled technology had more hidden chargesand higher remittances. The imperative to reduce the overall cost of technologyacquisition resulted in a policy regime that did not quite appreciate the market fortechnology. Poor protection of intellectual property reduced the incentives totransfer technology to India, and deterred FDI inflows in some technology-intensive areas. The price of technology acquisition was distorted by variousrestrictions, which did not always work to domestic advantage. Even when thepolicies succeeded in their immediate objectives, the long run costs, in terms oftechnological obsolescence, were probably high.

The regulation of private foreign capital had its rationale. The aim was to tiltthe balance of incentives away from old foreign capital of the rent-seekingvariety, and in favour of new growth-oriented foreign investment. The impositionof export obligations and the outright regulation of the technologicalcharacteristics of foreign-collaboration agreements aimed to create entry barriersthat would deter rent-seeking FDI, without shutting the door to growth-orientedforeign investment. In theory, this was a valid intervention. In practice, theregulation did not work according to the intention. The recurrent concern withforeign exchange outflows created a regime with a whole range of ancillaryregulations. Restrictions on operational freedom of firms, combined with poorprotection of intellectual property rights, choked-off fresh inflows of technology-intensive FDI. Of course, much of the existing foreign capital, predominantly ofthe rent-seeking variety did not leave. Apart from the standard hysteresis effectsthat accompany investment decisions, various restrictions (say, on ‘repetitivetechnology imports’) preserved pockets of monopoly rent in the economy, makingit worthwhile for incumbent multinationals to thrive. For them, even smalladvantages, in terms of technology and marketing networks, translated in to


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substantial profit differentials over domestic firms. Thus, for multinationals thathung on, the ability to operate in protected markets constituted an indirect subsidythat more than compensated for the costs of operating in a regulated regime.

Overall, this perverse outcome proved costly. India wanted foreign capital toboost exports; the kind of FDI that survived was attracted primarily by access tothe Indian market. India wanted foreign capital to improve its technological base;the absence of sufficient safeguards to intellectual property rights was asubstantial impediment to the transfer of technology. The absence of foreigncompetition exacerbated monopoly power in many industries.

Policy implications

The current euphoria surrounding international capital flows has generated a newenthusiasm for foreign investment in India. Proponents of openness argue forfurther liberalisation of the economy, and for altering the economic regime toattract foreign capital. Large inflows of foreign capital, they claim, are necessaryfor transforming India’s stagnant economy. Critics of liberalisation point to thedangers of excessive openness. They point out that openness only encourages theinflow of ‘hot money’, whose volatile flows expose the economy to destabilisinginfluences, and that large-scale foreign investment will undo the carefullyachieved self-reliance in Indian industry.

Should India adopt a more open stance to private capital flows? Rodrik (1999)argues that the benefits of openness to foreign capital are generally exaggerated. Itis hard to deny that Indian industry needs fresh investment but the hope thatopenness to FDI alone can achieve this is misplaced. The contribution of foreigncapital to overall investment is likely to be marginal in India. FDI inflows in 1996were only 4% of gross domestic capital formation. In the Indian context, growth-led FDI is more likely outcome than FDI-led growth. Foreign capital is neithernecessary nor sufficient for growth in India. What is needed is a sound investmentpolicy to improve the incentives for long-term investment. Openness is arguablyan element of a sound investment policy, but it is not a substitute for it. Thenationality of investors is a secondary issue.

What are the elements of a sound investment policy? By internationalstandards, the investment environment in India is still highly regulated. Inhindsight, the performance of all firms -- foreign-controlled or domestic -- wasinfluenced directly by the regulatory environment. Investment decisions are stillsubject to discretionary control, and that control is used to protect entrenchedpublic sector and private sector companies. Tatas, a domestic business house, hasrepeatedly been denied entry to the partially-privatised airline sector. Even whenthe government resorts to market-friendly methods of allocating investment rights,it does not quite get it right: the auction of telecommunication licenses was


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followed by ex-post changes in the allocation rules. In the absence of politicalstability, policy changes carry little credibility amongst investors. Surveys ofinternational business investors refer repeatedly to the ‘difficulty of doingbusiness in India’, a portmanteau term that refers to anything from lack oftransparency to poor infrastructure facilities that lower the economy-wide returnon capital. (As evidence of procedural complexity, consider the phraseology ofreformed policy requirements: even in sectors where foreign investment is readilyallowed, firms must secure ‘automatic approval’.)

Some commentators believe that foreign investment can play a crucial role inremoving infrastructural bottlenecks, and thereby increase productivity of existingcapital. Infrastructure has largely been a state-monopoly in India. In view of thepoor performance of public sector enterprises, and the reluctance or inability ofthe domestic private sector to invest in these sectors, the hope is that foreigninvestment will take care of power generation, highways, ports, roads, etc.However, the principal reasons that makes these sectors unattractive for domesticinvestors, namely the low levels of anticipated return on investments, hold forforeign investors too. Does it make sense to use direct incentives to attract foreigninvestment in infrastructure, say, as in the provision of profit guarantees to attractEnron Corporation in power generation? Evidence suggests that the net pay-off tosuch sweeteners is negative in the long run; they often encourage ‘roundtrip’capital flows and may even prove counter-productive if they generate hostilitytowards foreign capital. The frequent calls for a ‘level-playing field’ betweenIndian and foreign-controlled firms are indicative of this hostility. The creation ofa broad political consensus is a crucial to maintaining inflows.

How should technology policy be reformed? In general, there is a case forallowing firms greater freedom in their technology acquisition decisions, andgreater recognition of their intellectual property rights. To some extent, suchreforms are likely to be forced upon India as part of the WTO reforms (note theiremphasis on TRIPs and TRIMs). For most sectors, this is not necessarily toIndia’s disadvantage. However, in some sectors the allocation of intellectualproperty rights may have stark implications. For instance, patent rights conferredupon biotechnology firms may have drastic consequences for agriculture; patentrights of pharmaceutical firms may have implications for the availability of low-cost drugs in India. Indeed, if the new WTO regime makes it harder to denyintellectual property rights, it may even make sense to inhibit foreign investmentin these high-risk sectors. However, for most of the manufacturing sectors, thegains from greater recognition of intellectual property probably exceed thedownside risks.

Within manufacturing, is there a case for selectivity or preference amongindustries? Critics of foreign capital complain that an open door policy towards


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foreign capital has encouraged investment in ‘inessential’ consumer goods andother non-priority sectors. Foreign entry in the more visible consumer goodsindustries—Pepsi, Coca-Cola, Kentucky Fried Chicken, etc.—provide readyammunition for these critics. While there may be a case for influencing theindustrial composition of FDI, it is sobering to note that discretionary controlfailed miserably in the past. Policy-makers in India were usually poor judges ofIndia’s needs, and there is little reason to believe that they will do better in thefuture. Once we discard the model of unitary state, there is the risk substantialdivergence between the policy-intent and the bureaucratic implementation of it.Besides, a discretionary environment also creates the possibility of lobbying andrent-seeking behaviour, especially in industries that have concentrated domesticinterests. Cross-country experience suggests that multinationals have acomparative advantage in rent-seeking, and may be able to use a discretionaryregime to their advantage: Enron did negotiate itself out of all politicalobstructions. A non-discriminatory system would be safer. For the same reason, itis best to avoid discretionary environments that favour foreign capital in export-oriented sectors or in technology-intensive sectors: once entry has occurred, it ishard to monitor fulfilment of export obligations or to penalise the failure to do so.

Should multinationals be regulated at all, and if so, how? The anti-competitivebehaviour of some multinationals is a legitimate cause for concern. Multinationalsthat entered India through joint-ventures have sometimes tried to oust their Indianpartners. Hindustan Lever’s mergers and acquisitions after 1992 have been asubject of monopoly enquiry, and correctly so. On the strength of anecdotalevidence, the aims of greater competition seem far from being the reality. In thepast monopoly regulation has concentrated on identifying monopolies andrestricting their growth through licensing. An altered regulatory environment isnow needed to check anti-competitive conduct: to focus on the abuse of monopolypower and to promote competition.


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References

Aitken, Brian and Ann Harrison (1992), ‘Does Proximity to Foreign Firms InduceTechnology Spillovers? Evidence from panel data’, mimeo, MIT.

Athreye, Suma and Sandeep Kapur (1999), ‘Foreign-controlled firms in Indianmanufacturing: long-term trends’, mimeo, UMIST, Manchester.

Balasubramanyam, VN, D Sapsford and M Salisu (1996), ‘Foreign directinvestment and growth in EP and IS countries’, Economic Journal, 106, 92-105.

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Note: Manufacturing covers medium and large public limited firms that are classified underSIC codes 310-590: this excludes plantations, mining and services. Data after 1991 is notstrictly comparable with that for earlier years.

1970 1975 1980 1985 19900

5

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25

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35

Year

Figure 1: Market share of foreign-controlled firms in manufacturing gross sales, percentages

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