Geopolitical Challenges, Economic Uncertainty Hinder Govt's Efforts to Boost FDI Inflows in India

India's growth projections remain positive, and global firms see India as a key destination to diversify their manufacturing reliance on China. Despite that, several factors have created a challenging environment for attracting foreign investments in India.

While India’s economic growth projections remain positive, the foreign direct investment (FDI) flows into the country are yet to pick up.

According to the World Bank’s Global Economic Prospects, 2023, India is expected to be the fastest growing economy of the seven largest emerging market and developing economies. The UN’s World Economic Situation and Prospects 2023 says that growth in India is expected to remain strong at 5.8% in 2023.

Additionally, global firms see India as a key destination to diversify their manufacturing reliance on China. Despite that, several factors have created a challenging environment for attracting foreign investments in India.

The Reserve Bank of India’s recent annual report shows that in the financial year 2023, India received equity inflows worth $46 billion as compared to $58.8 billion FDI in 2022.

So even as India’s projections are bright, why is FDI taking such a dive? Is this an outcome of increased uncertainty and a reduced appetite for risk among global investors?

The fall in FDI could be attributed to geopolitical factors such as tight monetary policy, global recessionary pressures, and the Russian invasion of Ukraine.

At the same time, domestic factors such as the ‘Make in India’ initiative and production-linked incentive (PLI) scheme, which aim to promote domestic manufacturing and create a favourable investment climate, have not had the desired impact on FDI inflows.

Meanwhile, security concerns have led to a cautious approach towards Chinese investments, impacting FDI inflows.

Also read: How Has the Indian Economy Done Vis-à-Vis Other Nations Over the Past 30 Years?

Relation between FDI and economic growth

FDI has been a significant catalyst for economic growth in various countries such as China, the US, Ireland, etc. In India, however, the role of FDI in the growth process has long been a topic of debate, with some economists contending that it has never played a large role in terms of percentage of GDP and that FDI crowds out domestic investment.

Gross FDI inflows was just about 2.7% of the GDP in FY22.

Several studies say that FDI, adjusted to other determinants, has a significant positive effect on the economic growth, if there is a conducive economic climate.

FDI is different from other forms of investment because it is a major source of technology, production, as well as managerial know-how  through backward and forward linkages. It helps the host country improve their foreign exchange reserves.

Factors leading to weak FDI inflow

Over the last two years, FDI inflows in India have dropped in several key sectors. In FY23, sectors such as computer software, hardware, and automobile, and infrastructure and construction, witnessed a drop in FDI.

Among all sectors, manufacturing saw the largest drop in FDI from $16.3 billion in FY22 to $11.3 billion in FY23.

Financial services is the only sector that saw a rise in FDI from $4.7 billion in FY22  to $6.8 billion in FY23.

Computer services took a major dive from $9 billion in FY22 to $5.6 billion in FY23. Education, transportation, and construction are the other sectors that have witnessed a downfall in FDI inflows.

FDI in the automotive industry, which is fairly integrated with the global supply chain, contracted 72% to $1.9 billion in FY23.

Some experts note that the shortfall in the equity inflows is primarily due to the uncertainty in the global economic environment, the COVID-19 pandemic, and the Ukraine war. They add this has less to do with domestic policies.

The International Monetary Fund says that global FDI flows have dropped to 1.3% of the global GDP between 2018 and 2022 from the highs of 3.3% in the 2000s. Energy prices in Europe increased to unprecedented levels. Global inflation hit 7.8% in 2022 and has remained above 5% in 2023.

As crude oil prices surged, equities witnessed record FPI outflows. This can be attributed to investors being deterred by increasing commodity prices and escalating geopolitical tensions. Additionally, the capacity to deploy large sums of capital is limited by liquidity. So, although global investors want to put more money into India, they are also constrained by the liquidity conditions prevailing in the market.

According to the Kearney FDI Confidence Index 2023, India ranks at the 16th position globally, and second in terms of the most appealing emerging market and developing economy (EMDE) for investors, after China.

China continues to beat India as an FDI destination, both globally (seventh rank) and among EMDEs. Unless India can source components locally, the objective of attracting any significant volume of FDI in the manufacturing sector through the ‘Make in India’ initiative will be difficult.

One of the reasons why ‘Make in India’ has been unable to make a mark is because for global corporations, finding factories that are ISO or BSI certified in India is difficult, whereas in China, a huge majority of operations across most product categories are ISO or BSI certified.

Issues ranging from logistics and infrastructure to availability of land and workers continue to remain as obstacles in India’s plans to create manufacturing hotspots.

In 2020, the Indian government had mandated that all investments from neighbouring countries, including China, would now require the government’s approval. It has asked Chinese mobile phone manufacturers to induct Indian equity partners in their local operations. Chinese mobile manufacturers Xiaomi, Oppo, Realme, and Vivo, operating in the country will now be required to appoint Indian executives in key roles such as CEO, COO, CTO etc.

While this may further block Chinese investments, there are security concerns behind these policies. A change in the FDI policy pertaining to neighbouring countries was brought in to curb the “takeovers/acquisitions” of viable Indian businesses by foreign Chinese interests, due to the COVID-19 pandemic. There are fears that these companies are used by the Chinese authorities for purposes of spying, data theft, and money laundering, apart from being accused of tax evasion and alleged illegal remittances worth thousands of crores.

These concerns are not exclusive to India. This week South Korean prosecutors indicted a former Samsung Electronics executive  for stealing the company’s technology to build a chip factory in China. Earlier this year, Dutch chip equipment maker, ASML, accused a former employee in China of stealing data related to its proprietary technology. So clearly, geopolitical and security preferences increasingly drive the geographic footprint of FDI.

Also read: India’s Mobile Phone Exports Driven by Assembly Rather Than Domestic Manufacturing: Raghuram Rajan

Can government initiatives reverse the dip?

Government initiatives have the potential to reverse the decline in FDI inflows. It has implemented favourable policies, such as relaxing sourcing requirements and allowing 100% FDI in sectors like commercial coal mining and contract manufacturing. Streamlining processes through measures like the National Single-Window System has improved approval and clearance procedures for investors. The expansion of flagship programmes like the Phased Manufacturing Programme and PLI scheme is also expected to attract more FDI in the medium term.

However, it’s important to note that the impact of these initiatives may take time to materialise, as some PLI schemes are still in the early stages, and only a few have been tendered out and notified.

Additionally, the reduction in FDI can be attributed to quantitative tightening by the US Federal Reserve and the European Central Bank, which has reduced the availability of investable resources for emerging markets. The Fed and the ECB are the two main sources of funds for the emerging markets.

One positive development is the increase in FDI from the UAE following the signing of the Comprehensive Economic Partnership agreement with India. The UAE has become India’s fourth-largest investor in FY23, with a threefold increase in investments from $1.03 billion in 2022 to $3.35 billion in 2023.

Overall, while government initiatives are trying to reverse the dip in FDI, it may take some time to realise their impact, due to geopolitical tension and global economic uncertainty.

Vaishali Basu Sharma is an analyst of strategic and economic affairs.