The year 2012 was marked by the opening of the Indian retail market to foreign investors. Given the Indian economy’s explosive growth, this event promised billions in profits to retailers. Yet with growth cooling in 2013 and the financial crisis intensifying, foreign capital has been draining out of the country. The foreign metallurgical corporations are running away faster than anyone. Local manufacturers are increasingly turning their attention to countries with lower taxes and more stable operating conditions.
Between 2004 and 2011, India’s economy grew annually at an average of 8%, slowing to 6.5% for the 2011-2012 fiscal year. Forecasts for 2013 predict that growth won’t exceed 5%. The exchange rate for India’s currency on August 27 reached a record low since the country gained independence in 1947, at just 65.71 rupees to the dollar, meaning that since the beginning of the year, the rupee has fallen 17% against the dollar. Naturally, such a collapse in currency would provoke price rises, and inflation this June was almost 10% more than in June 2012. Based on all of the macroeconomic indicators, experts are unanimous in saying that India hasn’t experienced such a financial crisis since 1991.
“The Indian economy is going through a very difficult period,” commented Jayshree Sengupta, a Senior Fellow at the Observer Research Foundation, in an interview with WEJ. “GDP growth is less than 5% due to the decline in industrial growth and stagnation in agricultural growth. Global factors are constraining the growth of the service sector. The current account deficit is unsustainable at 4.5% of GDP. Imports are significantly exceeding exports, in particular gold and oil imports. These factors, of course, put pressure on the rupee, which fell sharply, in large part because of the outflow of foreign institutional investors from the country.”
Experts attribute the worsening of the recession in the Indian economy to a statement from U.S. Federal Reserve Chairman Ben Bernanke on May 22, when he first publicly announced his intention to start cutting back on financial support to the American economy this year. In the event the Fed scales back its stimulus programs (from which some of the money was used by investors to buy assets in developing countries like India), investors will be more interested in American assets. Were this to happen, emerging markets would lose their attractiveness, and the recent influx of foreign investment into developing countries would reverse and flow back out. According to the Government Commission for the Securities Market, India saw an inflow of funds into shares of Indian companies for the first five months of this year totaling $15.3 billion. After the May announcement by the Fed Chairman, beginning in June, $2.6 billion had left the country.
Persis Khambatta, a fellow at the Center for Strategic and International Studies, says that “Most of the investors who left the country did so because of the difficulty of doing business in India due to the bureaucracy, the red tape involved with acquiring land or any other basic resources needed to operate in the country.”
This year alone, three major metallurgy corporations – ArcelorMittal, Posco, and Severstal – cancelled plans to build plants in India. According to Alexey Mordashov, CEO of Severstal, the reason for suspending steelmaking projects is that “the conditions for doing business in this country are not yet ripe. There are problems with access to infrastructure, bureaucracy, and a lot of risks.”
Vikram Nehru, a Senior Associate at the Carnegie Endowment for International Peace, told WEJ: “At present, India has built up a negative balance of portfolio investments. This occurred largely as a result of the global market reaction to the promise of a tighter U.S. monetary policy. Similar reversals in capital are taking place in other emerging markets as well, so India isn’t alone in that. On the other hand, India has maintained a positive flow of FDI, though significantly less than in previous years. At the same time, Indian investors are seeking investment opportunities abroad more and more often. Many of the same factors that slow the flow of foreign investment into the country also force Indians to invest abroad more than in local projects. These include weak infrastructure, an inelastic labor market, a complex investment regulatory framework, and more recently, rising inflation coupled with massive budget deficits and current account deficits. All of this taken together encourages uncertainty in the future trajectory of the exchange rate. Moreover, Indian investors who are looking for investment opportunities abroad seem interested in access to technology, natural resources, and the global market.”
Offshoring or the outsourcing of manufacturing is not a new phenomenon for Indian business. From 2007 to March 2012, for every dollar of foreign direct investment in the manufacturing sector, India accrued $0.65 which Indian companies invested in manufacturing abroad. But now that the crisis has worsened, this trend is growing stronger and offshore enterprises are more in demand by Indian businesses more than ever.
“Target countries for Indian foreign investments are quite diversified and choosing this or that country depends on the motivation of Indian investors. Those who want access to resources look to Africa, Latin America, and a few resource-rich countries in Southeast Asia. Those who want to bid on technology and skills invest in Europe, the U.S., and Singapore. And those who are trying to diversify their manufacturing and create supply chains invest in China, Korea, Mauritius, Indonesia, and Vietnam,” explained Mr. Nehru.
A portion of manufacturing also leaks out into the Persian Gulf. It was only last year that Alpen Capital investment bank helped finance operations to build two factories of Indian companies in the UAE: one that manufactures fertilizer at a cost of $800 million and a sugar plant ($250 million). It’s obvious that a large portion of the products manufactured at these factories will be exported to India. Cheap energy and a favorable business climate make building a factory in this country more profitable than building one in India. On top of that, more than 40% of India’s total international air transport goes through transit points located in the Persian Gulf.
The biggest concern is the “travel bug” attitude of Indian heavy industry. State mining company Coal India has monopoly rights to one of the largest raw reserves in the world. But instead of expanding production at home, the state corporation plans to spend billions of dollars buying up mines abroad.
“The government’s failure to deal with current issues, bureaucracy, poor infrastructure, and an abundance of stifling laws have led Indian industrialists to run offshore manufacturing, where it’s easier than expanding it at home,” said Ms. Sengupta.
Attempts to curb the outflow of capital and the falling rupee
Under such circumstances, the Indian government is, of course, making various attempts that could steady economic activity inside the country and correct the balance of payments. There were big cuts in fuel subsidies. And foreign retailers were for the first time allowed to own up to 51% of the shares of Indian companies engaged in retail trade. Yet none of the global giants have yet to take advantage of this opportunity because of the absence of a thorough legal framework for this type of business on the Indian market. Back in 2012, the government tried to institute changes to the 1982 double taxation agreement with Mauritius, which allows Indian residents and foreign investors to invest in India via Mauritius, thereby earning tax-free income. The government’s main goal in revising the agreement was to gain the ability to levy taxes on any capital gains from investments redirected from Mauritius, in an attempt to clamp down on tax evasion. Mauritius, however, declined the proposals, and India decided not to renounce the agreement unilaterally.
In an attempt to stop the devaluation of the rupee, the government raised taxes on the import of gold. India, as is well known, is the largest consumer of this precious metal in the world. And recently, buying gold from abroad has meant an outflow of capital. In addition, a ban on the purchase of real estate abroad was introduced. The transfer of funds abroad was also limited: Whereas residents could previously transfer $200,000 freely each year, now it’s only $75,000.
According to Ms. Khambatta, these measures will only work for the short term and don’t solve the fundamental problems. “Attempts to stop the flow of currency could bring temporary benefits, but a more important aspect is actually the need for structural economic reforms at the domestic level, including infrastructure projects, increasing access to energy and natural resources, focusing on building manufacturing capacity, and increasing productive employment. These are the issues that should be solved by the government in order to see real economic improvements and development for the country. Much depends on the upcoming national elections, before which it is unlikely that any serious reforms will be adopted. Depending on who wins the election, either fairly quick adoption of vital solutions for structural economic issues is possible, or these reforms could be delayed for several years in the event that weak coalitions or the Third Front come to power in 2014.”
Vikram Nehru, a former chief economist for the World Bank, commented to WEJ on the prospects of Indian economic recovery: “In the short term, Indian economic growth is likely to continue to slow due to stagnation in the global economy and corrective macroeconomic measures such as tightening monetary and fiscal policies. As for the government, it is unlikely they will undertake any serious structural reforms before the 2014 general elections. Quick growth can only resume in the event the next government is willing to restore macroeconomic stability through prudent fiscal and monetary policies and the introduction of structural reforms. There are a number of needed measures, including the adoption of new laws for land acquisition in order to stimulate the development of infrastructure, as well as the further liberalization of trade and investment legislation.”
All of the experts interviewed by WEJ agreed that the key to returning to industrial growth is higher levels of investment. So instead of preventing offshoring, the Indian government should implement reforms that improve the attractiveness of the domestic market for business.
Text: Olga Irisova