How To Compare The Performance Of Foreign And Domestic Firms In India

Transcription

1 Private Foreign Investment in India August 1999 Authors: Suma Athreye, Manchester School of Management, England Sandeep Kapur, Birkbeck College, University of London, England Address for correspondence Sandeep Kapur Department of Economics Telephone: Birkbeck College Fax Gresse Street London W1P 2LL UNITED KINGDOM Abstract Private foreign capital, whose presence in Indian industry was long regarded with concern and suspicion, is now touted as a panacea for India s economic problems. This paper compares the relative performance of domestic and foreign-controlled firms in India, and evaluates the contribution of foreign investment over the last five decades. We assess the impact of government policy towards foreign capital, and outline policy implications for the future. Keywords: India, foreign direct investment, MNCs, reform JEL classification: F21, F23, L6

2 Private Foreign Investment in India * August 1999 Abstract Private foreign capital, whose presence in Indian industry was long regarded with concern and suspicion, is now touted as a panacea for India s economic problems. This paper compares the relative performance of domestic and foreign-controlled firms in India, and evaluates the contribution of foreign investment over the last five decades. We assess the impact of government policy towards foreign capital, and outline policy implications 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; John Cantwell and Ron Smith for comments. 1

3 1 Introduction The 1990s have seen a marked increase in private capital flows to India, a trend that represents a clear break from the two decades before that. In the 1970s there was hardly any new foreign investment in India: indeed, some firms left the country. Inflows of private capital remained meagre in the 1980s: they averaged less than $0.2 billion per year from 1985 to In the 1990s, as part of wideranging liberalisation of the economy, fresh foreign investment was invited in a range of industries. Inflows to India rose steadily through the 1990s, exceeding $6 billion in The fresh inflows were primarily as portfolio capital in the early years (that is, diversified equity holdings not associated with managerial control), but increasingly, they have come as foreign direct investment (equity investment associated with managerial control). Though dampened by global financial crises after 1997, net direct investment flows to India remain positive. Table 1: Recent foreign investment in India, net inflows in $ billion Direct investment Portfolio investment Total Sources: see appendix Table 1 highlights the growth in inflows. To put these figures in perspective, note that 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 the flow to broad external sector aggregates, India s current account deficit, about $10 billion in the crisis year of , was financed primarily through commercial loans and external assistance: private investment flows were paltry. By , foreign investment inflows of $5 billion could finance a sizeable chunk of the $6.5 billion 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 sharply over this period. The historically low interest rates in the US encouraged global investment funds to diversify their portfolios by investing in emerging markets. International flows of direct investment, which had averaged $142 billion per year over , more than doubled to $350 billion in 1996, with the developing countries receiving $130 billion. Host country policies did influence the choice of location for this investment. China received the largest chunk: at $42bn, FDI 1

4 inflows accounted for as much as a quarter of its gross capital formation in Other developing countries, most notably those in the Pacific Basin, also received sizeable flows. Foreign direct investment flows to India were paltry in comparison: at $2.5bn in 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 why they remain low compared to other emerging markets? Some commentators believe that if only India could attract enough foreign capital it could, as China has, move on to a higher growth path. Official policy statements in India seems to endorse this belief: the progress of economic reforms is measured in terms of cumulative foreign capital inflows or, even more optimistically, in terms of approvals granted for foreign inflows. Reality has trailed behind official expectation over the period 1991 to 1996, actual inflows of foreign direct investment averaged no more than one-fifth of total approvals. The case for foreign capital is usually made as follows. Foreign investment can supplement domestic investible resources in a developing economy, enabling higher rates of growth. As a source of foreign exchange, it can relax potential balance of payments constraints on growth. Profit remittances on account of foreign equity are related to the performance of investment projects, unlike the inflexible repayment obligations of foreign debt: this risk-sharing feature makes foreign equity preferable to foreign debt. Foreign firms contribute to the technological base of the host economy, directly and through technological spillovers to other firms in the industry. Besides, in the right circumstances, the presence of foreign firms reduces market concentration and promotes a more competitive market structure. Critics of multinational firms have long argued against this rosy picture. They claim that multinationals monopolise resources, supplant domestic enterprise, introduce inappropriate products and technology, and aggravate the balance of payments problems through high remittances. They may also come to wield considerable political influence, distort the path of development, exacerbate income inequality, and exploit the weak environmental standards in developing countries (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 large extent, the answer depends on the nature of foreign direct investment (FDI) and its motivations. Some FDI is motivated by the high rates of return in a vibrant economy, and aims to benefit from better international organization of production and location. Crudely speaking, we could refer to such FDI as growth-led and efficiency-seeking. But even a stagnant economy may attract rent-seeking multinationals that have a comparative advantage, over domestic firms, in extracting monopoly rent in protected markets. The relative mix of these two 2

5 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 rentseeking FDI. Of course, from practical or regulatory points of view, it is not easy to distinguish ex-ante between the two types of FDI. Typically, a permissive regulatory environment may end up admitting both types, while a restrictive environment may exclude both. In the perverse case, the regulatory environment may create hurdles that rent-seeking FDI alone can jump over. One way to reduce this risk is to promoting a regulatory environment that makes it hard to generate monopoly rent, thus making investment less attractive for rent-seeking FDI. To assess the relevance of these arguments for the Indian case, we scrutinise the role private foreign capital has played in India over the last five decades. In particular, we compare the conduct and performance of foreign-controlled firms relative to domestic firms; unlike previous studies that have looked at this issue over short periods of time, we examine long-term trends in relative performance. Our study focuses on aggregate behaviour; this allows us to explore an issue ignored in previous studies, namely the macroeconomic linkage between policy towards foreign capital and its contribution to the Indian economy. Section 2 reviews the policy framework towards foreign capital in India, and Section 3 examines the long-term trends in foreign investment. Section 4 assesses the importance of foreign-controlled firms in Indian manufacturing, and their performance relative to domestic firms. Section 5 attempts to evaluate the contribution of foreign capital to the Indian economy. Section 6 outlines the policy 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 threequarters British-owned, concentrated mostly in extractive industries and trade, and managed by expatriate Europeans. The continued dominance of these colonial enterprises was an irritant to nationalist sentiments. Fledgling Indian business houses envisioned a future in which foreign interests would be curtailed, and Indian 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 to boycott foreign goods. Subsequently, the term became emblematic of nearly all forms of hostility to 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 the formation of the Swadeshi League. In 1953, the Federation of Indian Chambers of Commerce and Industry adopted the Swadeshi Resolution. Nationalists were only too conscious of the record of foreign investment in India: the East India Company, arguably the largest foreign direct investment enterprise in Indian history, had later formed the basis for imperial rule. 3

6 Early statements of government policy echoed these interests. The Industrial Policy Resolution of 1948, while conceding that participation of foreign capital and enterprise will be of value to the rapid industrialisation of the country, demanded that the conditions under which it may participate be carefully regulated in the national interest. As a rule, majority interest in ownership and effective control should always be in Indian hands, and called for a gradual replacement of foreign personnel. One Step Forward... However, the magnitude of the industrial challenge after Independence called for a more pragmatic approach. The government remained critical of the old foreign investment, but new investment was considered necessary, not only to supplement savings but also because in many cases, scientific, technical and industrial knowledge can best be secured through foreign capital. As early as 1949, a more conciliatory statement in the Parliament promised that existing foreign interests would be accorded national treatment ; new capital would be encouraged on terms that are mutually advantageous; although majority ownership by Indians was preferred, foreign control would be permitted for a limited period if it is found to be in the national interest; repatriation of capital and remittances of profits abroad allowed; in case of compulsory acquisition, fair compensation would be paid. Foreign firms were encouraged to invest in protected industries like fertilisers and machine tools. Extensive concessions and tax advantages were offered to attract multinational oil companies. Despite these overtures, inflows remained modest. Kidron (1965) notes that capital 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 their operations in India. The initial reticence of foreign capital was understandable. Domestic business houses, foreign capital, and the government were locked in what Kidron famously called an uneasy triangle. Individually, domestic industrialists sought foreign collaboration for access to foreign technology and brand names. At the collective level industry associations often dominated by the same industrialists sought to preserve the Indian market for themselves, and clamoured 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, the Commerce Minister declared in Government policy was non-discriminatory in intent but still vulnerable to nationalist sentiments. The ambivalence of domestic 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 situation dramatically. The Second Economic Plan, launched in 1957, chose the path of 4

7 industrialisation through import-substitution. The large increase in planned investment expenditure coincided with a severe foreign exchange crisis that forced a drastic reduction in imports, especially of consumer goods. These events created extremely lucrative opportunities for private investment in India. To exploit these opportunities, Indian business had to turn abroad for technology. For foreign capital, this was an excellent opportunity to jump the newly created tariff barriers. This coincidence of interests overwhelmed any misgivings that Indian industrialists might have had about foreign collaboration. The government, keen to achieve its Plan targets, encouraged private investment and, in particular, allowed foreign equity participation to meet the foreign exchange needs of investment projects. At the behest of the World Bank, the government dropped its insistence on majority Indian ownership. The Indian Investment Centre was set up in 1961 to expedite the approval of foreign collaborations. The government drew up a list of 26 industries where foreign collaboration was to be encouraged. Pharmaceutical drugs, aluminium, and heavy electricals were opened up to joint ventures. Foreign capital poured in during the 1960s. Its form and sectoral distribution was affected by the selectivity of government policy. Unlike the existing stock of foreign capital, fresh inflows concentrated on manufacturing, especially the technology-intensive industries. Collaboration was the preferred form of investment: joint-ventures with Indian business partners provided local intermediaries, who were better able to cope with the highly regulated industrial regime. 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 two famines and a humiliating devaluation of the Rupee, the political mood hardened and turned towards socialist idealism. Major commercial banks were nationalised, and the Monopolies and Restrictive Trade Practices Commission was set up in In such an environment, it no longer seemed politic to have an open-door policy to foreign capital. If anything, there was heightened concern about the foreign-exchange costs of repatriated profits and other remittances. The tenor of policy towards foreign capital changed. Foreign oil-majors were nationalised in the early 1970s. The government did not rule out new foreign capital it had set up the Foreign Investments Board in 1968, ostensibly to reduce average processing time for fresh applications but now wanted it on its own terms. The Foreign Exchange Regulation Act (FERA) of 1973 is singled out as evidence of the new hostility. It amended an earlier Act of 1947, and a crucial new clause aimed to limit the extent of foreign ownership at the enterprise level. It required that all firms dilute their foreign equity holdings to 40% if they wanted to 5

8 be treated as Indian companies. Most, though not all, firms chose to fall in line with this provision rather than risk the more stringent regulations imposed on the so-called FERA companies. However, the view that FERA was unambiguously hostile to foreign capital and intended to protect Indian industry from foreign dominance may be a little simplistic. The required dilution of foreign equity to 40% was not too onerous. While some multinational firms insist on majority ownership IBM and Coca-Cola left India in the late 1970s for many others, 40% was sufficient to retain managerial control. Moreover, exceptions in the Act allowed many technology-intensive, export-intensive, and core-sector firms to preserve majority foreign ownership, often as much as 74%. Most multinationals found it worthwhile to continued operating in India. Indeed, as we show later, many existing multinationals consolidated their positions in Indian market during the 1970s. Thus, FERA proved more hostile to new foreign investment than to existing foreign affiliates. FERA was only a part of the new regulatory regime. Limits on foreign equity holdings were now combined with restrictions on technology imports. Fresh lists were drawn up of industries where foreign collaboration was still considered necessary; others where only technical collaborations was permitted, with curtailed rates of royalty payment; and those where the domestic technological base was considered strong enough to obviate the need for imports of technology. To minimise the foreign exchange costs of technology acquisition, as far as possible technologies were to be acquired through licensing rather than financial collaboration. Intellectual property rights were severely curtailed by a revised Patents Act in 1970: product-patents were abolished in industries such as pharmaceuticals and chemicals; the duration of process-patents was shortened. Overall the technology policy, combined with selective licensing and progressive nationalisation of some industries, served to concentrate foreign direct investment in the manufacturing sector. Even within manufacturing, FDI was now predominantly in technology-intensive industries such as heavy chemicals, pharmaceuticals, and mechanical and electrical machinery. While this shift was broadly desirable, we argue later that the policy regime restricted access to foreign technology. Piece-meal reform In the 1980s, growing concern about stagnation and technological obsolescence in Indian industry drew attention to the restrictive licensing procedures. Poor quality and high costs in Indian manufacturing probably contributed to the poor export performance, a particular irritant in the wake of the second oil price shock. As a consequence, there was a softening of the regulatory regime. To encourage exports, firms that produced primarily for exports were granted exemptions from 6

9 the usual FERA restrictions on foreign equity ownership. In an attempt to modernise manufacturing industry, restrictions on technology transfers and royalty payments were relaxed and, where attempts to acquire technology through licensing had failed, foreign equity participation was permitted again. This early softening did not reflect any serious change of heart. Despite the official claims of simplified procedures and cleared bottlenecks, foreign investment projects were still very vulnerable to bureaucratic discretion: there is little evidence that policy was any more informed about the needs of Indian industry or the nature of the technology market. There was only a slight increase in foreign inflows, and the most part, Indian industry came to rely on foreign debt capital 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 the consequent expulsion of Indian expatriate labour from the Middle-East, foreign exchange remittances fell. As the balance of payments position deteriorated, a panicked withdrawal of funds deposited in India by non-resident-indians exacerbated the problem. The real possibility that India might default on its external obligations led to a downgrading of India s credit rating. The government turned 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. Industrial licensing was abolished in all but a handful of industries. Foreign direct investment was invited in a wide range of industries, including consumer goods. The government dropped its insistence that foreign equity participation provide specific benefits in terms of technology transfer or export earnings. The limit on foreign equity participation was raised to 51% for most industries, and even 100% in some cases. Foreign investment was especially sought in the infrastructure sectors previously monopolised by state enterprises: power generation, highway and port construction, telecommunications, oil and natural gas exploration, etc. The services sector, where foreign capital had been gradually eliminated as a matter of deliberate policy, was reopened to foreign investors: they were invited to invest in financial services, retail banking, and recently, in life and general insurance. Restrictions on the use of international brand names were removed. Reforms in the technology policy have provided greater recognition of intellectual property rights. This liberalisation coincided with growing interest in emerging markets, especially among the global pension funds. In a major break from the past, foreign institutional investors (FIIs) were allowed to make portfolio investments in Indian companies, subject to overall limits on ownership within each firm. Foreign funds 7

10 surged in, initially in the form of portfolio capital, but increasingly in direct investment projects. In , foreign direct investment inflows exceeded $3.2bn. Despite the exceptional political instability after 1995, successive governments have continued to court foreign capital even though the liberal stance has not always been consistent. In a sense, the attitude towards foreign capital seems to have turned a full circle. In a pattern reminiscent of the early 1950s, domestic business interests have increasingly lobbied the government for continued protection against foreign capital. In the last five decades, policy towards private foreign capital has moved closely with exigencies of India s external payments position, and with changing official perceptions of the role of foreign capital in alleviating or exacerbating that position. The early liberalisation of the late 1950s was in part motivated by a balance of payments crisis. The restrictive regime of the 1970s, and FERA in particular, was influenced by the belief that excessive remittances of foreign enterprises were worsening a precarious balance of payments position. The gradual liberalisation of the 1980s and the major reforms of the 1990s were, to different degrees, responses to external payments difficulties. Even when the private capital inflow was not large by itself, it was expected that a more liberal regime towards foreign investment would enable other flows, including those from the multilateral lending agencies. The changing policy environment affected the extent of foreign capital in Indian industry and its contribution to the economy. 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 at Rs 5.8 billion ($1.2 billion at 1948 exchange rates). By 1995, the most recent year for 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 over this period. Table 2: Stock of private foreign capital in the Indian corporate sector Long-term investment (Rs billion), of which 1 Direct investment (% share in total) 2 Portfolio investment (% share in total) (89) na 0.5 (9.0) 7.4 (44.8) 0.9 (5.7) 9.3 (42.1) 1.2 (5.5) 3 Foreign debt na (49.5) (52.4) 17.4 (13.0) 4.6 (3.4) 38.4 (7.2) 14.8 (2.8) 94.2 (9.5) (22.9) (90) (67.6) This is private long-term capital in firms, excluding banks. The procedure for classifying equity capital as direct investment and portfolio investment changed in 1992, hence relative shares are not comparable after that year. For a discussion of this and all data sources, see the appendix. 8

11 The growth rate of foreign liabilities varied across time and investment categories. Foreign direct investment (i.e., foreign equity holdings associated with foreign control of enterprises) grew steadily at first, its stock rising from Rs 2.6 billion in 1948 to Rs 7.4 billion by Its rate of growth fell in the 1970s, picked up in the 1980s, but the surge came after 1992: the stock of direct investment rose from Rs 38 billion in 1992 to Rs 94 billion by In contrast, foreign portfolio investment was restricted a matter of deliberate policy for most of this period. The total stock of portfolio capital was less than Rs 15 billion in With liberalization these portfolio holdings rose to Rs. 200 billion by 1995, though recent financial crises have seen net outflows on this account. But, most strikingly, the largest single component of private foreign capital after 1980 has been long-term corporate debt: when foreign equity inflows were restrained during 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. (Of course, the rupee value of debt is slightly exaggerated by currency devaluation in ) Thus the commonly held view that the Indian economy was cut off from foreign capital is not quite true more accurately, the corporate sector was deprived of foreign equity participation. Foreign Direct Investment Table 3 summarises the changing industrial distribution of foreign direct investment. 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. In absolute terms, the stock of foreign direct capital in manufacturing rose from Rs 0.7 billion in 1948 to over Rs. 79 billion by Within manufacturing, the capital goods sector was the predominant recipient of FDI: engineering and heavy chemicals account for two-thirds of all foreign direct capital. The primary and services sectors now account for less than 10% each of all foreign direct capital. Foreign holdings in plantations and mining fell steadily after Independence. The share of oil-refining rose as the oil-multinationals entered in the early 1950s, but then fell when they were nationalised in the 1970s. The energy 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 the success of a selective regime. To a large extent, the government managed to direct foreign capital to technology-intensive, manufacturing sectors: this was consistent with the needs of an industrializing economy. 9

12 Table 3: Changing distribution of foreign direct capital stock in India, percentages Industry/Sector Plantations Mining Petroleum Total primary sector Food & beverages, tobacco Textiles Transport equipment Machinery & machine tools Metals and metal products Electrical goods Chemicals & pharmaceuticals Miscellaneous Total manufacturing Trading Construction, utilities, transport Total services Total FDI (current Rs. Million) and 1995 figures use the modified definition of FDI. See appendix. The historical dominance of British firms has shown remarkable persistence in post-imperial India. Three-quarters of all foreign capital was British in This share declined to 40% by 1992, but since then has been eroded to 25% by disproportionately large inflows from other countries. The share of US firms has risen; Germany, Japan, and Switzerland have a significant presence, too. The industrial distribution of foreign capital differs according to the nationality of investors. Multinationals from the US, Germany, and Japan have gravitated to technology-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 UK USA Germany Japan Switzerland Others 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 some controversy. Existing estimates see Kumar (1994) for an excellent survey are 10

13 based on a variety of methods, data, and working assumptions, so provide a poor guide 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 is constructed from a sequence of surveys of Finances of Medium and Large Public Limited 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 are predominantly domestically-owned so our estimates probably exaggerate the foreign presence. Moreover, if excluded sectors grow faster (or slower) than the firms 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 of foreign firms also affect our estimates. Despite these limitations, the data has the merit of being internally consistent and covers a reasonable period of time. Earlier versions 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 share of assets that are foreign-owned, or as the asset- or market-shares of foreigncontrolled firms. The identification of foreign-controlled firms is not free from ambiguity. Managerial control of listed companies is exercised through ownership of sufficiently large blocks of voting stock. Majority ownership enables control in most circumstances, but minority ownership may be sufficient if other shareholdings are fragmented, i.e. dispersed among a large number of small shareholders. Many studies, Kumar (1994) for instance, classify a firm as foreigncontrolled if at least 25% of its shares are held abroad. The International Monetary Fund uses a lower threshold: its Balance of Payments guidelines treat a firm as a foreign direct investment enterprise if 10% of its voting stock is held abroad by a single 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 each firm 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 was held by a single foreign investor, or if 40% of the equity was held in any one foreign country. Effective 1992, the RBI adopted the IMF guidelines for identifying foreign direct investment enterprises. Thus, over time, changes in the identified country of control may just reflect changes in the classification rules for foreign investment. Our results must be interpreted with this caveat. 2 These surveys are described in the Appendix. 11

14 We estimate foreign shares in Indian manufacturing as the share of foreigncontrolled firms in gross sales; one could equally well measure their share in assets or, indeed, any size-related variable, but this does not seem to affect the overall pattern. Figure 1 shows that foreign-controlled firms accounted for between a third and a quarter of gross sales in Indian manufacturing over period 1970 to The foreign share rose slightly from 1970 to 1976 and since then has declined. We believe that the sharper decline after 1991 is an artefact of the data: foreign firms seem under-identified or under-represented in recent surveys. More detailed results reported in Athreye and Kapur (1999) show that foreign shares 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 the largest share: in , 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 of this data (see, for instance, Kumar s (1994) estimates for ). Others, with alternative assumptions, produce different estimates. Ganesh (1997) identifies foreign-control with majority foreign ownership (i.e., foreign ownership in excess of 50%). Among the largest 1000 listed firms in 1995, he found that only 72 firms are foreign-controlled by this (tighter) criterion, and together control only 9% of total sales. Ganesh concludes, on this evidence, that foreign presence in Indian manufacturing has been exaggerated. Identifying foreign control by the criterion of majority ownership is probably inappropriate in the Indian context. Under the Foreign Exchange Regulation Act (1973), many multinationals operating in India were forced to dilute foreign shareholdings to 40%. In most cases, the foreign parent could maintain complete control over their Indian affiliates even with this minority shareholding. Typically, the required dilution was achieved through fresh equity issues. Control of share allocations ensured that domestic shareholdings were fragmented. For instance, 89 thousand individuals together made up the 47% domestic shareholding in Hindustan Lever, while its parent, Unilever, retained 51% (figures for 1980). State-controlled financial institutions, which often had significant equity holdings in Indian business houses, did not invest in foreign affiliates -- this removed a possible channel of countervailing power. Even when the government enforced the complete Indianization of managerial cadres in India, many minority foreignowned affiliates found non-equity forms of control over their local management. When foreign exchange was a scarce commodity, control over loans from the foreign 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 12

15 multinationals continued to turn adversity into opportunity : in exchange for expanded exports or increased production in priority industries, the government allowed more than a hundred foreign enterprises to retain majority-holdings in their Indian affiliates. The required equity dilutions allowed them to raise fresh capital at a time when access to capital markets was severely restrained by the government. Even though a few multinationals notably Coca-Cola and IBM left India in the late 1970s, most chose to stay. Indeed, many foreign-controlled firms managed to consolidate their position in the Indian market. Overall, FERA allowed incumbent foreign firms to preserve their market shares in India, and sometimes to thrive too, even as it deterred new foreign investment. The gradual decline in foreign market shares, especially in the 1980s, is better explained by the restrictions placed on foreign firms by the overall regulatory framework. Greater selectivity in industrial licensing restrained the growth of many multinationals. Many multinationals were unable to compete against wellorganised domestic industrial lobbies. Restrictions on monopoly power (the Monopolies and Restrictive Trade Practices Act) and a diminution of intellectual property rights (the Patents Act) eroded many of the rent-seeking advantages that foreign firms had enjoyed in India. Encarnation (1989) argues that India acquired financial autonomy from foreign enterprises at an early stage by mobilising domestic and foreign capital, and then managed to unbundle technology acquisition from equity participation. As a result, domestic enterprises gradually acquired control over product markets that were previously dominated by multinationals. Foreign multinationals were also displaced by the growth of stateowned 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 quite dislodged from India. Many preserved their foothold in India, and were well placed 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 of their conduct and performance? Kumar (1994) examines the discriminating characteristics of domestic and foreign-controlled firms, using data for , and with careful attention to the underlying statistical issues. He found that as a proportion of sales, foreign-controlled firms spent less on R&D (presumably because they rely on technology imports) than domestic firms, but expenditure on advertising was broadly similar for the two groups of firms. However, foreigncontrolled firms were significantly more profitable in their operations, a result corroborated by other studies. Kumar (1990) concluded that the profitability of foreign-controlled firms was protected by entry-barriers: in knowledge- and skillintensive industries, their technological strength, access to global marketing 13

16 networks and brand names gave them a clear edge over domestic firms. He found that degree of seller concentration did not seem to affect profitability but there was market segmentation: foreign-controlled firms competed on the high value end of the market while domestic firms concentrated on the low-value end. We use the RBI data to compare the conduct and performance of foreigncontrolled and domestic firms over the period 1970 to For each variable under scrutiny, we compare the (weighted) average for foreign-controlled firms with that for domestic firms. Figure 2 confirms earlier findings that foreigncontrolled firms have persistently higher profit margins, whether measured as share 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 for foreign-controlled firms (see figure 3), but domestic firms relied more heavily on selling commissions (figure 4). Of course, different industrial sectors differ in the advertising intensity: the overall difference in marketing strategies might reflect the differences in industrial concentration of foreign-controlled and domestic firms. Figure 5 shows that domestic firms have increased their expenditure on technology imports, especially in recent years, and have overtaken foreign firms in this respect. Unfortunately, we do not have comparable data for R&D expenditure, but these were typically quite small for all manufacturing firms in India. 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? Has the presence of multinational corporations helped or hampered growth in Indian industry? There is no easy consensus on these issues. Those who advocate a more liberal regime claim that FDI will provide the much-needed investible resources and foreign exchange for reviving Indian industry, improve the crumbling infrastructure, and allow India to modernise its technological base. Moreover, greater competition in Indian manufacturing will benefit the Indian consumer. On the other hand, critics of foreign capital point to the poor record of multinational corporations in India, their excessive profitability, the adverse impact of profit remittances on India s balance of payments, and limited technology transfer, and their domination of the Indian manufacturing sector. We scrutinise the available evidence to assess the validity of the rival claims, but it helps to begin on a conceptual note. Does foreign investment contribute to growth? Casual empiricism does not offer any simple lessons. Countries like China have experienced large FDI inflows and high growth in recent years, while Korea grew rapidly without significant 14

17 levels of foreign capital. Many Latin American countries have periods of slow growth despite openness to foreign capital, while much of sub-saharan Africa has experienced low growth and poor investment flows. Moreover, even if we did find some positive correlation between FDI and growth, the issue of causality remains unresolved. Does foreign capital increase the growth rate, or does the prospect of higher growth attract investment flows? Anecdotal evidence apart, cross-country econometric evidence does not offer stronger conclusions: de Mello (1997), surveying the evidence, concludes that the relationship between FDI and growth depends on country-specific factors. In theory, foreign direct investment inflows affect economic growth through increased investment in the economy. The relation between the FDI and domestic investment is best explained through the following macroeconomic identity. Total investment 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, as foreign equity and foreign debt inflows. Other things being the same, an increase in FDI increases foreign savings, and so increases investment in the economy. However, quite plausibly, increases in FDI inflows may coincide with a reduction in debt inflows (so that total foreign savings remain constant) or be accompanied by a fall in domestic savings (if there is a consumption boom): in each case domestic investment does not rise. The effect on balance of payments can be analysed by rewriting the above identity as foreign savings = imports - exports In general, if an increase in FDI increases available foreign savings, it allows the host country to import more or to accommodate a decline in exports. Thus, at least in 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 in the short run. Note that the effect on the balance of payments is the flip side of the effect on domestic savings and investment: FDI can conceivably increase domestic investment, or provide additional balance of payments financing for an existing current account deficit, but cannot do both at the same time. In general, an FDI-financed, short-run, ability to import more could equally well support a consumption boom or an investment boom. If it is the latter, it would 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 foreign exchange reserves. Large, rapid inflows then present problems for the management of money supply: sterlization of flows is not always effective. 15

18 allowing for some profit repatriation on account of successful investment, the host economy would still benefit. However, the long-term outcome is not always so favourable. Singh and Weisse (1998) note that rapid inflows to Mexico in the early 1990s fueled a consumption boom, accompanied by large current account deficits. 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 rather than investment booms. Patnaik (1997) notes that a significant fraction of recent inflows to India have been short-term flows of portfolio capital, whose direction is easily reversed with changes in market perceptions. A sudden reversal of flows has catastrophic effects on investment, output, and the balance of payments, as evident from the experience of Mexico, and more recently, East Asia. Instability in capital flows would then result in increased volatility in economy-wide growth rates. In view of this, it may be over-optimistic to rely on FDI to increase investment and growth in India, especially in the short-run. India has had a relatively high savings rate, and it is quite possible that FDI may merely substitute for domestic savings. Savings and Investment Theoretical possibilities apart, does FDI increase aggregate investment in an economy? Fry s (1995) econometric analysis of FDI flows over to 16 large developing countries, including India, cautions against any simple generalizations. Correcting for a host of country-specific factors, he finds that FDI inflows seem to have a negative effect on domestic investment. Other studies, for instance Dhar and Roy (1996), confirm this finding. It could well be that FDI crowds out domestically-financed investment. Alternatively, it could be that FDI inflows rise in recessionary environments -- note the fire-sale FDI in wake of the recent South Korean crisis. Fry s related finding, that FDI flows do not have any significant positive impact on contemperaneous growth rates, is hardly surprising. FDI inflows may have a more positive contribution in the long-run, and more so for some countries than others. Fry finds that domestic investment and growth are 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 Pacific Basin countries, domestic investment rises by the full extent of the FDI inflow, with generally beneficial effects on growth. Outside the Pacific Basin, FDI appears to substitute for other kinds of foreign flows: FDI inflows were accompanied by lower investment, lower savings and slower growth. In other words, FDI could even be immiserising. It is argued that these diverse experiences are related to the overall economic regime of the host country, and that countries with a favourable environment for 16

19 investment do better with FDI than countries with distorted financial or trading systems. Of course, the ingredients of a favourable environment are not easy to specify, ex-ante. Balasubramanyam, et al (1996) claim that countries with a liberalised trade environment grow better with FDI than countries with distorted trading systems. Balance of payments Fry (1995) finds that foreign direct investment inflows tend to worsen the current account 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 export propensity, the extent to which they rely on imported inputs, including technology imports, and on the volume of profit-repatriation. Of course, there are indirect effects too. Multinationals can conceivably increase the export-propensity of domestic firms through spillover effects. Further, if domestic production by multinationals substitutes for previously imported goods, FDI can reduce the total import bill. Unfortunately, these indirect effects are harder to measure in firmlevel data. The relative export propensity of foreign and domestic firms has been a controversial issue. Figure 6, based on the RBI data, reveals that exports as share of 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 export behaviour of foreign-controlled and domestic firms for did not differ significantly. Some studies, typically not as robust as Kumar s, conclude that multinationals export more. Lall and Mohammad (1985) found that industries with high foreign shares (as measured by the share of dividend paid abroad) tended to be more export-intensive. Majumdar and Chhiber (1998) find that, among foreigncontrolled firms, there is positive correlation between the level of foreign equity ownership and export performance, but only when foreign affiliates have majority control. They conclude that majority ownership is essential for effective foreign control, and the latter essential for export performance. Such findings, even when true, have to be interpreted cautiously. In the post-fera regime, firms that exported a significant part of their output were allowed foreign shareholdings above the usual 40%. In other words, greater foreign shareholdings could be a reward for good export-performance, rather than its cause. Besides, anecdotal 17

20 evidence that foreign-controlled firms often used third-party exports to meet their export obligations makes it hard to formulate simple policy conclusions. 4 Of course, export behaviour is only a part of the picture when considering the overall impact on balance of payments. Comparing earnings and expenditures in foreign exchange the latter includes imports of raw materials, royalty payments, technical fees, and dividend remittances -- Chandra (1977, 1993) estimated that the net foreign exchange contribution of foreign-controlled firms was negative through the 1960s and 1970s. While this is a reasonable (and frequent) criticism of multinationals, we find both domestic and foreign-controlled firms in India did badly by this criterion. Figure 7 suggests that the net foreign exchange contribution of foreign-controlled firms and domestic firms was broadly similar and, 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-fera period, majority foreign-owned subsidiaries exported more than they imported. Besides, it helps to get a sense of the absolute sums involved. Our calculations based on RBI (1993) show that total outgoings of foreign-owned firms (technical fees, royalties, and dividends) averaged $120 million per year through the 1980s. While this was not insubstantial, even moderately successful export performance could 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 remained low, at around 5%, for most of this period. Nayyar (1978) had arrived at similar estimates for an earlier period. The high profitability in the sheltered domestic markets probably blunted the incentive to export, both for domestic and foreigncontrolled firms. As a high-cost economy, India was an unlikely export base for multinationals: regardless of the government s motives, the major motivation of foreign 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 US firms in the computer software industry, a sector in which India has substantial skills at low cost. Technology: policy and reality Host country governments often encourage foreign investment in the hope of improving the productivity of domestic firms. Foreign direct investment potentially brings new technologies to the host economy. Technology inflows can also 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 giant Phillips, met its export obligations by exporting marine products (mostly shrimp). 18