126 Investment Strategies in Emerging Markets

5. Foreign Direct Investment in India

PL Beena, Laveesh Bhandari, Sumon Bhaumik,
Subir Gokarn and Anjali Tandon

INTRODUCTION
For the first four decades after achieving independence from British colonial
rule, the economic polices of the Indian government were characterised by
planning, control and regulation. There were periodic attempts at market-
oriented reform, usually following balance of payments pressures, which
induced policy responses that combined exchange rate depreciation and an
easing of restrictions on foreign capital inflows. However, the latter were
relatively narrow in scope and had little impact on actual inflows, which
remained small. Nevertheless, there were foreign shareholdings in many
companies, partly as a result of their pre-independence origins. Moreover, in
sectors upon which the government placed high priority, domestic firms were
allowed to enter into technology licensing arrangements, which often
involved an equity stake as well. But, there was a general sense of discomfort
with a foreign presence in industry, particularly in “non-essential” sectors
like consumer goods. This culminated in a series of major policy decisions in
the late 1970s that forced companies to restrict their foreign shareholdings to
a maximum of 40 per cent. Many companies did comply, but two prominent
ones who did not, Coca Cola and IBM, were asked to shut down their Indian
operations.
During the early 1980s, following a serious balance of payments crisis
and a large loan from the International Monetary Fund, the Indian
government relaxed its foreign investment policy. This engendered a number
of joint ventures in the automotive industry, involving both financial and
technical relationships between Indian and Japanese manufacturers. A few
years later, Japanese two-wheeler manufacturers entered the domestic
market, again through joint ventures with major Indian producers. Here
again, the ventures were followed by a series of arrangements between
component manufacturers in the two countries. Other key sectors, like the
computer industry, were also provided a more liberal trade and investment
environment.

126
 Foreign Direct Investment in India 127

The big opening up came in 1991, following yet another external crisis.
This time, the government went much further than before in introducing a
series of both domestic and external reforms that fundamentally changed the
business environment. One of the key components of this new policy was a
significant widening of the range of activities in which foreign firms could
enter as well as an easing of the conditions under which they came in.
This chapter first outlines the reform progress and the evolving pattern of
FDI over the past decade. We go on to report the key results from our FDI
survey.

REFORMS IN THE INDIAN ECONOMY

Prior to 1991, the government exercised a high degree of control over
industrial activity by regulating and promoting much of the economic
activity. The development strategy discouraged inputs from abroad in the
form of investment or imports, while the limited domestic resources were
spread out by licensing of manufacturing activity. The result was a domestic
industry that was highly protected – from abroad due to import controls and
high duties, and from domestic competition due to licensing and reservations.
Industrial policy was dominated by licensing constraints by virtue of
which strict entry barriers were maintained. Under the Industries
Development and Regulation Act (1951), it was mandatory for all companies
to get government approval to set up a new production unit or to expand their
activities. Approval was also required if the manufacturer wanted to change
the line of production. Moreover, when permission was granted, it was very
specific to product, capacity and location. The decision to award a license
involved many stages and became a highly bureaucratic process, with some
elements of state capture by incumbent domestic firms. This and other
policies led to a very high degree of bureaucratisation of the economy. Also
many sectors like textiles were reserved for the small scale sector, thereby
making it difficult for domestic firms belonging to these sectors to enjoy
economies of scale, and making these sectors unattractive to MNCs.
The government also controlled the exit option for a company.
Manufacturers were not allowed to close operations or to reduce their work
force without government approval. The intention was to try to avoid
unemployment, but it also promoted inefficiency in the industrial economy.
Indian trade policy before the 1990s focused on import substitution.
Restrictions on imports were imposed in different forms. In concurrence with
the objective of attaining self-reliance, import licensing was imposed to
exercise control over the importers. Further, imports were canalised, which
meant that certain commodities could be imported by only one agency, which
was generally a public sector company.
128 Investment Strategies in Emerging Markets

Import controls and high tariff rates led to high input costs, which made
Indian producers un-competitive in the world market. Further, certain items
were also subject to export controls with a view to ensure easy availability,
low domestic prices and for environmental reasons. As a result, domestic
industry operated in an isolated environment with limited exposure to the
international products and markets.
FDI policy put severe restrictions on foreign investment. Few foreign
companies were allowed to retain an equity share of more than 40 per cent,
and as a result many did not use their best technologies in India. The
economy was deprived of foreign capital and foreign technology and
internationally efficient scales and quality of production could not be
achieved.
Financial sector policy did not focus upon generating enough capital from
within and outside the country. The financial sector was highly regulated by
the state. The government had owned all the major banks since
nationalisation in 1969 and the early 1980s. It administered low interest rates
on borrowings and loans to small industries and agriculture; price controls
and credit rationing. Indeed, the basis of planning in India was a Harrod-
Domar growth paradigm which made the government focus on mobilisation
of savings for investment. The problem was that there was financial
repression because of price fixing and directed credit.
Raising equity from the market was also restricted. The government
decided both the amount of capital as well as price. Apart from interest rates,
initial public offerings and other equity issues required prior government
approval through its arm - the Controller of Capital Issues (CCI). Banks
could ignore market forces when taking functional and operational decisions,
and private sector participation was discouraged. Profitability of financial
institutions remained low owing to government control over interest rates and
absence of competitive forces.
In addition to industrial and trade policies, public sector policy
exclusively reserved certain sectors for the public sector. The public sector
was also present in almost all parts of the economy - petroleum, consumer
goods, tourism infrastructure and services, etc. Infrastructure industries such
as power, telecom, air transport, etc., were almost wholly public sector
controlled.
Reservation contributed to lack of competition, which reduced the
incentive to be efficient. Over-manning, poor management, obsolete
technology and insufficient research and development activities further
contributed to the decay of public sector undertakings. Most important of all,
non-commercial objectives and government muddling in day-to-day
operations made these companies extremely inefficient.
Small-scale industry policy gave protection from domestic as well as
international competition. This was done primarily by reservation of certain
product lines exclusively for small industries. The smaller firms benefited
 Foreign Direct Investment in India 129

from excise concessions and rebates that were determined on the basis of
annual turnover rather than investment in fixed capital. Financial aid was also
given in form of credit from government owned banks on softer terms. Small
firms also benefited from preferential government purchases and input
supplies.
To summarise the impact of pre-1990 policies, the Indian industrial
structure was weak, both financially and technologically. However, domestic
incumbents had been created who were entrenched and this had implications
for FDI and for the mode of entry in the 1990s. The major prevailing
problems were inefficiencies, high costs, poor management, non-
competitiveness, excessive reservation, import controls, lack of export
orientation and disincentives to the foreign investors.
Reforms launched in the early 1990s focused on addressing some of these
issues. Since manufacturers were highly dependent on domestic growth, a
more outward looking policy was adopted. Economic policies were
liberalised with a view to encouraging investment and accelerating economic
growth.
The new industrial policy announced in 1991 led to de-licensing of
industry, competition rather than protection as the desired policy
environment. The earlier requirement of approvals and licenses for any
investments and expansions were abolished for all except 18 industries.
Within a few years, only five sectors remained under the ambit of industrial
licensing.
De-licensing gave companies freedom to take decisions for investments,
expansions and plant locations. Bureaucratic practices involved in the
investment procedures were reduced significantly. Lowering of entry barriers
resulted in greater private sector participation.
Trade reforms addressed the anti-import bias by reducing tariffs,
quantitative restrictions and foreign exchange control. From being one of the
most protected domestic economies prior to the reforms, the Indian economy
has become similar to other developing countries. Trade reforms have
continued in a sustained manner throughout the 1990s and it is expected that
they will continue in the same manner.
The government also liberalised its policy towards FDI. Many constraints
that had historically been imposed on portfolio and direct investment were
removed. The approval process for technical and financial collaborations was
completely revamped. For many industries, the Reserve Bank of India (RBI)
would give an automatic approval.
Indian law does not differentiate between an Indian and foreign owned
company once it has been incorporated in India. The same procedures
govern Indian and foreign owned companies alike. Like Indian companies,
foreign owned companies also do not now require a license for production in
most manufacturing sectors.
130 Investment Strategies in Emerging Markets

Technology transfers were also made easier by removing many

mandatory approval requirements. Another measure to bring in FDI was
reduction of controls on technology and royalty payments. Restrictions on
foreign collaborations investment (both financial and technological) were by
and large removed.
India’s financial sector went through a wide variety of reforms during the
1990s (see Sarkar and Agarwal 1997), aimed at correcting the biases in the
lending policies of government owned banks and financial institutions. Under
new polices, the banks were free to decide lending and deposit rates. This
was accompanied by a significantly proposed reduction in pre-emption of
bank loans, both by the government and the priority sector. Both these gave
the banks freedom to opt for the most rewarding investments. Capital market
reforms coupled with the removal of restrictions on firms reduced entry
barriers for the private sector. As a result, today there are many private
operators in the sector - banks, financial institutions, NBFCs and insurance
companies have a significantly higher private representation.
The reforms in the public sector enterprises (PSEs) were intended to
be three pronged; privatisation, greater autonomy and reduction of the
monopoly power of the public sector. However, much has not been
accomplished. First, privatisation has not been very successful. Minor
proportions of a few companies' total equity was "dis-invested', only one
company out of a total of 242 public sector companies owned by the
government has been completely privatised. Second, though some attempts
were made at giving greater autonomy to PSEs this has largely been
unsuccessful (Bhandari and Goswami 2002).
Third, the public sector environment was highly un-competitive vis-à-vis
the rest of the world. Abolishing its monopoly was thought to be a solution
that would force public companies to adopt better management practices.
Sectors reserved exclusively for public sector were de-reserved (except for
some social and security sectors). This was a policy measure to bring in
private performers in competition with the PSEs. Compared to the first two,
these measures have been much more successful.
The policy reforms with respect to small-scale sector have not been as
significant. Small industries traditionally benefit from the preferential
treatment given by the government in many ways, including reservations and
tax concessions. Protective polices continue to shield small manufacturers
from competition from the medium and large ones. As a consequence, much
of the small sector depends on subsidies, concessions and reservations for its
survival.
India removed most quantitative restrictions from April 1st, 2001. Under
such circumstances, the small manufacturers face serious challenges from
international producers who have open access to the domestic market.
International companies that can benefit from large scale may therefore have
 Foreign Direct Investment in India 131

a major advantage over the domestic small manufacturers with fragmented

capacities.

FOREIGN DIRECT INVESTMENT

FDI Trends

As the restrictions on foreign investments were reduced or removed, there

was a sudden spurt in foreign net inflows. The number of approvals of
foreign technical collaborations registered a dramatic increase in the new
policy regime, and the number of foreign technology approvals went up. The
value of FDI approvals also increased significantly in the post-reform period.
1997, $15.8 billion of FDI was approved in contrast to US$ 0.3 billion
approved in 1991. Figure 5.1 highlights the increase in net FDI inflows after
1991. Net FDI inflows were only US$ 0.074 billion in 1991 increasing to
US$ 3.6 billion by 1997, though falling in later years (US$ 2.6 billion in
1998). After 1991, foreign investment followed a steep upward curve: from
1981 to 1990, FDI grew by 23 per cent annually; this increased to 44 per cent
annual growth during 1991 to 2001. Only US$ 0.1 billion of foreign capital
was invested in 1991, compared with US$ 4.28 billion in 2001 (World Bank
Development Indicators).
However, FDI still constitutes a very low share of total investment in
India. By 1998, this ratio was 2.5 per cent - much lower than that of most
other Asian countries. In many other post-reform economies, FDI has been
seen to increase substantially when there has been large-scale public sector
privatisation. In India this has not happened as yet; indeed domestic firms in
India have proved capable of absorbing large state owned firms that are being
privatised, for example BALCO and VSNL. But the share of FDI, as a
percentage of gross domestic investment (GDI) and GDP, has been growing.
While the share of FDI in GDI was only 0.2 per cent in 1990, it increased to
3.98 per cent by 2001, while FDI as a per cent of GDP increased from 0.05
per cent in 1990 to 0.90 per cent in 2001.
Although, inflows of foreign investments did gear up, they were not very
impressive in comparison with some other countries. (See for example
UNCTAD 2003) for a comparison of India with China). India's FDI share in
the developing world was only 0.4 per cent in 1991. A marginal improvement
was seen by 2001, when the share had increased to 1.7 per cent.

Distribution of FDI

In the absence of details of actual FDI inflows into different sectors, the
present sector-wise discussion depends on approval data only. The bulk of
132 Investment Strategies in Emerging Markets

the approvals from early 1990s to 2002, were directed towards infrastructure
and energy sectors. More approvals were made in non-manufacturing sectors. An
analysis of half-yearly figures from the SIA Database reveals increasing shares of the
metallurgy, power and fuel sectors in total number of approvals. Large falls were
observed in transport, industrial machinery and food processing. The services sector
including telecommunication increased its share during the initial years of 1992 to
1994. Its growth was limited by the domestic climate in the later years.
A ranking of cumulative investment approved during the period 1991 to
May 2002 reveals that USA was the largest investor in India with an
investment of Rs. 570 billion. Mauritius, UK, Japan, Korea (South),
Germany, Netherlands, Australia, France and Malaysia follow in that order.
USA had a smaller share of FDI into India after 1997. Mauritius ranked next
to USA in its cumulative investments since 1993. By 1997, the inflows from
this country accounted for almost 20 per cent of FDI inflows, probably
because of its status as a tax haven. Most of the approvals were in power,
fuel, telecom and transport sectors.

Ownership Classification

The more liberal environment resulted in greater equity participation from

abroad. Approvals for collaborations involving some amount of equity
increased both in number and percentage. Nearly 70 per cent of
collaborations were independent of any equity in 1991. Their share declined
in successive years. Further, most of the approvals were for majority stakes in
the host company. While there were only 4 per cent majority approvals in
1991, the share increased to almost 16 per cent by 1997. The most dramatic
change was witnessed by the subsidiary (wholly owned) segment, which had
carved a share of 17 per cent over seven years. Relatively greater investments
were approved for absolute ownership during 1995 to 1997, when power and
services sectors were opened up.
The reduction of rigidities in the investment procedures led to an increase in
the number of international collaborations. Initially, there was a spurt in the
number of joint ventures between international and Indian companies.
This was for two reasons. Firstly, approvals in many industries were
possible only if an Indian company was also involved as a promoter. Even in
cases where it was not necessary to have an Indian partner, the existence of one
greatly facilitated the initial approval process. Secondly, operating in the Indian
market was highly different from that in the other countries. Partnering with
an established Indian company benefited the new entity in setting up labour
relations as well as marketing. However both these factors have become less
important since the 1991 reforms.
The government no longer insists on Indian partnership for FDI in most
industrial sectors and operating in India is now more transparent. As a result,
 Investment Strategies in Emerging Markets 133

5 5
4.5 4.5
4 4
3.5 3.5

Billion US$
3 3
2.5 2.5
%

2 2
1.5 1.5
1 1
0.5 0.5
0 0
1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001
FDI, net inflows (% of GDI) FDI, net inflows (% of GDP)
FDI, net inflows (current billion US$)

Figure 5.1 Foreign direct investment in India

Source: World Development Indicators, CD-ROM, 2002, World Bank Little Data
Book, 2001 and www.worldbank.org

joint ventures in the form of technological collaborations also declined during

the period.
In the recent past, more ventures have been motivated by greater foreign
equity shares in the target firms. This is due to raising of the upper cap on the
equity limits. Further, more investment decisions were focussed on the
benefiting from the already built-in domestic distribution networks. This is
evident from a slight increase in the approvals for marketing of international
products in India.
Prior to the reforms, the government supported technology inflows by
means of technical collaborations between Indian and foreign companies, and
tended to restrict financial participation by foreign companies. The
restrictions on financial investments were dropped in the 1990s. For example,
new sectors were opened for automatic approvals up to 74 per cent of the
total equity. A combination of factors discussed above, as well as preference
for greater control, led to a situation where more foreign companies opted for
capital investment rather than purely technological alliances.
Until 1993 most collaborations tended to be purely technical in nature.
The situation reversed by 2002 when the share of financial approvals reached
82 per cent leaving behind purely technology transfer approvals at only 11
per cent.

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134 Investment Strategies in Emerging Markets

Table 5.1 Foreign ownership by level of control, India (in % of total FDI in
the year)

Year Non- Minority Majority Wholly- Average

equity Owned Equity
1991* 69.0 27.0 4.2 0.0 35.6
1992 55.0 31.0 13.0 2.0 41.1
1993 50.0 32.0 13.0 5.0 35.4
1994 44.0 34.0 17.0 6.0 47.4
1995 54.0 47.0 18.0 9.0 45.3
1996 33.0 34.0 20.0 13.0 49.7
1997# 30.0 29.0 27.0 17.0 65.8
All 43.5 32.7 16.2 7.7 47.5

Notes: Figures in column are percentage to column total. Non-equity collaborations

are primarily technical collaborations, which have no equity ownership by the
international collaborator. * Aug-Dec, # Jan-Aug.

Source: Rakesh Basant, 2000.

Mergers and Acquisitions

Mergers and acquisitions (M&A) activity grew at an unprecedented rate

during the 1990s, rising from US$ 35 million in 1992 to a peak of US$ 1.520
million in 1997, and staying in excess of US$ 1 billion between 1999 and
2001. Many such arrangements were worked out between Indian and foreign
firms and the bulk of these involved multi-national companies (MNCs),
though M&A activity between Indian companies was also quite significant.
Basant (2000) reports that between 1991 and 1997, 252 mergers and 145
acquisitions occurred. More than 85 per cent were between private Indian
firms, and almost 60 per cent of 145 acquisitions between 1991 and 1997
were by private Indian firms. Foreign private acquisitions accounted for 32.4
per cent. 221 out of 252 mergers (88 per cent) belonged to the Indian private
sector. Foreign private firms followed with a share of 7.5 per cent. Non
Resident Indian (NRI) mergers were only 0.4 per cent, while joint ventures
between Indian and foreign firms were a little higher at 1.6 per cent. 60.7 Per
cent of the acquiring firms were Indian private companies. In about 32 per
cent of the cases, the acquirer was a foreign company. NRIs acquired 4.1 per
cent Indian firms while joint ventures between Indian and foreign firms had a
share of only 1.4 per cent. Thus, merger and acquisition activity substantially
increased in India in recent years, though foreign investors participate only in
a minority of deals (although these may include some of the largest deals).
 Foreign Direct Investment in India 135

FDI SURVEY IN INDIA

With the help of data collected from 152 MNC affiliates established in India
in the last decade, the remainder of this chapter outlines the role of FDI in the
Indian economy. The data were collected by way of stratified random
sampling, to ensure that none of the sectors are over- or under-represented in
the sample, relative to the population, and that there is no selection bias of
any other kind. The majority of firms belong the manufacturing sectors,
including machines and equipment (26 per cent), intermediate goods (16 per
cent), and basic consumer goods (13 per cent). Information technology and
software firms account for 20 per cent, while business services account for 13
per cent (chapter 2). The machines and equipment sector has been over-
sampled, and the intermediate goods sector has been under-sampled.
However, there is no selection bias at the 2-digit level of ISIC classification.

Characteristics of MNC investing in India

Only a small fraction of the MNCs investing in India are large, the proportion
of MNC affiliates with 250 or more employees in the sample being 16 per
cent. On the other hand, small firms, those having between 10 and 50
employees, account for 42 per cent of the firms in the sample. The size of the
affiliates in India seems to be positively correlated with the overall size of the
MNCs. An overwhelming majority of them are small, about 76 per cent of
them having fewer than 10,000 employees worldwide (Table 5.2). Most of
the larger affiliates are concentrated in the infrastructure and machinery and
equipment sectors. Interestingly, however, the machinery and equipment
sector also accounts for a significant proportion of the very small firms. The
intermediate goods sector and the IT sector account for the bulk of the other
very small firms. A significant proportion of the MNC affiliates in India,
namely, 23 per cent, contribute to a significant proportion of the worldwide
turnover – greater than 5 per cent – of the parent MNCs (Table 5.2).
However, about 47 per cent of the affiliates constitute a small fraction of the
global turnover of the parent companies. Most of the firms contributing
significantly to the parents’ global output are in the IT and machinery and
equipment sectors
Most of the firms investing in India are from the USA and Western
Europe, together accounting for 78 per cent of the firms in the sample. MNCs
from Germany (11 per cent) and the UK (9 per cent) are the leading
European investors. This pattern of investment is consistent with India’s
trade patterns. Between 1990-1991 and 1998-1999, the EU accounted for 26
to 27 per cent of India’s exports, and 24 to 29 per cent of India’s imports. The
USA, on the other hand, accounted for 14 to 21 per cent of India’s exports
and 8 to 12 per cent of her imports.
136 Investment Strategies in Emerging Markets
Table 5.2 Characteristics of Investing MNC, India

(Unit) Categories
(000) (< 1) (1 - 10) (10 - 100) (>100)
Worldwide employment 38.3% 37.0% 19.8% 4.9%
(%) (0 - 0.1) (0.1 - 0.5) (0.5 - 2) (2 - 5) (5 - 20) (>20)
Local contribution to global
turnover 20.8% 26.7% 13.3% 15.8% 17.5% 5.8%
(% of turnover) (0 - 0.5) (0.5 - 1) (1 - 2) (2 - 4) (4 - 8) (8 - 15) (>15)
R&D expenditure 38.1% 12.4% 6.7% 16.2% 11.4% 3.8% 11.4%
Advertising expenditure 49.5% 10.7% 10.7% 3.9% 10.7% 9.7% 3.9%
(count) (None) (1) (2) (3) (4)
Emerging regions
experience 22.5% 34.9% 20.2% 10.1% 12.4%

126
 Investment Strategies in Emerging Markets 137

Much of the European investment is concentrated in the intermediate

goods and machinery and equipment sectors. The majority of the North
American firms, almost all of which are from the USA, on the other hand,
have invested in the IT and financial services sectors. Much of the investment
of Japanese and East Asian firms have been concentrated in the “old
economy” machinery and equipment sector and in the “new economy” IT
sector.
In light of the fact that economic reforms in India began in earnest as late
as 1991, it is hardly surprising that not many MNCs invested in India until
1994, i.e., during the first four years of economic liberalization, and
investment into India picked up only after 1994. Indeed, only 25 per cent of
the firms in the sample invested in India prior to 1995. This is consistent with
the slow yet steady liberalization of FDI regulations and the capital account
of the balance of payment in India since 1991. Most of the early entrants into
India were in the intermediate goods, machinery and equipment and IT
sectors. These three sectors, along with financial services, continued to
account for most of the post-1995 MNC investment in India.
Most of the MNCs investing in India do not have R&D intensive
products; parents of about half the firms in the sample invest less than 1 per
cent of their global sales in R&D activities (Table 5.2). The MNCs with
R&D intensive products have invested largely in the IT and pharmaceutical
sectors.
The MNCs parents of about 60 per cent of the firms in the sample spend
more than 1 per cent of their global sales on advertisement, while only about
13 per cent of the parents spend more than 8 per cent (Table 5.2). Given that
high advertisement related expenditure is associated with consumer goods
products, this is consistent with the pattern of MNC investment in India, with
the majority of investment in the intermediate goods, IT and machine and
equipment sectors.
About 57 per cent of the MNCs in the sample either did not have any
emerging market experience before entering India, or their experience was
limited to one of the four major regions with developing countries/emerging
markets, namely, Asia (other than Japan), Eastern and Central Europe, Latin
America and Africa (Table 5.1). The proportion of MNCs investing in India
without significant emerging market experience – about 76 per cent – is
especially striking for the financial services sector. However, two-thirds of
the MNCs investing in the pharmaceutical sector had significant operational
experience in all four regions.

Entry Strategies

Most of the MNCs enter into India either with greenfield projects or with
joint ventures with local firms. Indeed, greenfield and JVs account for 83 per
cent of entries captured in the sample. MNCs investing in the basic consumer
126
138 Investment Strategies in Emerging Markets

goods sector prefer greenfield to JV, as do those investing in the

pharmaceutical sector. MNCs investing in the machines and equipment
sector, however, prefer JV to greenfield. Entry mode for these three sectors is
entirely consistent with the hypothesis that MNCs with high proprietary
“technology” would prefer to enter an emerging market on their own. There
is, however, no discernible pattern for the other sectors.

Primary
Basic consumer goods
Intermediate goods
Machinery & equipment
Infrastructure & construction
Trade, tourism & recreation
Financial & business services
Information technology (IT)
Pharmaceuticals

0 10 20 30 40 50 60 70 80

At present At the time of entry

Figure 5.2 Proportion of output exported in India

Nearly 60 per cent of the output of the IT sector is exported (Figure 5.2),
while another quarter of it is “produced” for either the parent MNC or other
affiliates of the parent MNC. This is consistent with India’s reputation as an
IT hub catering to the rest of the world. MNCs in all other sectors sell 60 per
cent or more of their output in the local market, confirming the popular
wisdom that the size of the Indian domestic market plays a significant role in
attracting FDI.
On average, MNCs that entered India by way of JVs cater more to the
local market, while MNCs with greenfield entries cater more to overseas
markets. About a third of the JVs in the sample sell more than half their
output in the local market, and about 37 per cent of them sell 10 per cent or
less. The corresponding numbers for greenfield projects are 20 per cent and
50 per cent. This is consistent with the literature which argues that MNCs
aiming to cater to the local market are more likely to tie up with local
partners to help mitigate costs associated with understanding markets and
developing business contacts and distribution networks. MNCs with focus on
the global market, on the other hand, are more likely to retain complete
control to ensure that the quality of the products meets global standards, and
that the contractual agreements with global buyers are met.
 Foreign Direct Investment in India 139

Importance and Sources of Resources

Brands are viewed by a significant proportion of the MNCs in India as the

most important resource necessary for success. Most of these firms belong to
the primary, basic consumer goods, financial services and pharmaceutical
sectors. With the exception of distribution networks (for pharmaceutical
sector), equity (for primary and infrastructure sectors) and technology (for
the primary and machinery and equipment sectors), no other resource is as
important to the MNC affiliates in the sample. However, if one takes into
account the three most important resources necessary for success, as chosen
by the firms’ management, managerial and marketing capabilities also
emerge as important resources. It should be noted that aside from equity and
technology, most of the resources deemed important by the MNC affiliates
are intangible. Ceteris paribus, this suggests that in India the potential gains
from a tie up with a local firm can be significant.
In keeping with the literature on agency and transactions cost, a majority
of the MNCs that entered India by acquisition, rate brand as the most
important resource necessary for success, while a third of the MNCs entering
by way of a JV, accord a similar status to business networks. If, as before,
one takes into consideration the three most important resources contributing
to a firm’s success, managerial capability emerges as another resource
important to the acquiring firms. Technology is deemed important for success
by a majority of the firms, irrespective, of their choice of mode of entry.
The eight resources deemed most important for success by the MNC
affiliates are brand, business network, distribution network, equity,
machinery and equipment, managerial capability, marketing capability and
technological know-how. Importantly, most of these are intangible resources.
The MNC parents contribute 80 per cent of brand value, 85 per cent of equity
and 73 per cent of technological know-how, on average (Figure 5.3). At the
same time, 70 per cent of the business networks, nearly half of the
managerial capability, about two-fifths of the distribution networks and
almost all of marketing capability is sourced locally.
In other words, the MNCs provide most of the tangible resources and
source most of the intangible resources from India. This is consistent with the
fact that JVs constitute a significant proportion of the firms in the sample.
Further, given that distribution networks and marketing capabilities are two
of the key intangible resources sources that are sourced locally, it can be
hypothesised that most of the MNCs aim to sell their products in the Indian
market.
Brand, equity and technological know-how are the resources that are
deemed important for success by a majority of the MNCs in the sample. Of
these, technological know-how is important to firms of all sizes, the measure
of size being the number of people employed by the local affiliate. Brand, on
140 Investment Strategies in Emerging Markets

the other hand, is more important for larger affiliates while equity is more
important for the smaller affiliates.

Technological know-how
Marketing capability
Managerial capability
Machinery and equipment
Equity
Distribution network
Business network
Brand
0% 20% 40% 60% 80% 100%

Local firm MNC Local market Foreign market Other

Figure 5.3: Source of key resources in India

FACTOR MARKETS AND INSTITUTIONAL

ENVIRONMENTS IN INDIA
The MNCs in the sample feel that there has been a noticeable improvement
in the quality of labour available locally across the board (Figure 5.4). The
average quality of labour registered a 0.40-point improvement, on a 5-point
scale, for executive management, professionals, operations management and
skilled non-managerial labour. MNCs investing in the primary, intermediate
goods and IT sectors experienced the most significant improvements in
labour quality.
The perception about the across the board improvement in the quality of
labour available locally is also invariant with the mode of entry of the MNCs.
Interestingly, however, the MNCs that are in JV with local firms experienced
the least improvement in labour quality. This may be a manifestation of the
agency costs associated with local partnership.
The MNCs in the sample experienced a noticeable improvement in a
variety of local resources – IT, professional services, real estate, machinery
and equipment and raw materials, but the perceived quality/reliability of
utilities still lag the quality/reliability of other inputs. The most significant
improvement was experienced, not surprisingly, with respect to IT: a 0.91-
point increase on a 5-point scale. MNCs that invested in the primary,
intermediate goods, financial services, IT and pharmaceutical sectors
experienced the greatest improvement in quality of local resources, while
 Foreign Direct Investment in India 141

those that invested in the infrastructure sector experienced the least

improvement in quality.
The perception about the institutional environment in India, however, too
is not as optimistic (Figure 5.5). Respondents felt that there was virtually no
improvement in the legal-institutional framework relevant to business during
the 1990s. The only perceptible improvements were with respect to
procurement of business licenses, real estate and visa and work permits. The
MNCs that invested in the pharmaceutical and machinery and equipment
sectors experienced the greatest upturn in the business-related institutional
environment.
The MNCs that entered India by acquisition had the worst experience
with respect to the country’s institutional environment. They felt that the
legal-institutional environment in India deteriorated during the 1990s. MNCs
that entered India by all other modes, including JV, however, experienced an
improvement in the legal-institutional environment. While the experience of
the JVs highlight the importance of local partnership in emerging markets,
the experience of the MNCs that entered by way of greenfield is perhaps a
reflection of a selection bias – these MNCs entered on their own because they
were capable of functioning successfully under the Indian legal-institutional
set up.
MNCs from North America reported the greatest improvement in the
legal-institutional environment; the experience of MNCs from Europe and
East Asia (including Japan) was not as good. Both the North American and
European MNCs reported the greatest improvement with respect to business
licenses and visa and work permits. The East Asian MNCs, in addition, felt
that there was an improvement in the support of the central government’s
institutions and policies for FDI, as well as in the legal-institutional
framework associated with procurement of real estate.
MNCs investing in all sectors were favourably impressed with the
direction and pace of change in the quality of range of products produced in
India (Figure 5.6). With some exceptions – intermediate goods and financial
services sectors – the perception was that the pace of change in the quality of
management was far less muted. In other words, there is prima facie evidence
that the spillover effect of FDI in India has largely been in the form of better
quality of products, rather than in the form of improved managerial abilities.
Interestingly, while the MNCs in the sample felt that the productivity of local
labour improved, on average, those investing in the IT sector experienced a
decline in labour productivity. This is consistent with the views about the
impact of en masse migration of high quality IT professions to North
America and Europe, and the inability of the local educational system to
rapidly replenish the stock of such professionals.
The MNCs that entered by way of JVs perceive the greatest improvement
by far in range and quality of products, as also in managerial and marketing
capabilities of local firms, the level of technology used and labour
142 Investment Strategies in Emerging Markets

productivity. This suggests that JVs contribute most to FDI-related spillovers

in India.

Quality and range of products

Management capabilities
Marketing capabilities
Technology
Labour productivity

0 0.5 1 1.5 2 2.5 3 3.5 4

At present At the time of entry

Figure 5.4: Perceptions about the local industry in India

TRANSFER OF TECHNOLOGY AND KNOW-HOW

A negligible proportion of the firms spend a significant fraction of their
turnover on training (Figure 5.7). Indeed, only about 6 per cent of the MNCs
in the sample spend more than 8 per cent of their turnover on training, while
a meagre 12 per cent spend more than 4 per cent. Even in the IT sector, only
17 per cent of the MNCs that invested in India spent more than 4 per cent of
their turnover on training. By contrast, three quarters of the MNCs spend less
than 2 per cent of their turnover on employee training. In other words,
abstracting from the relative contribution of different entry modes to
spillovers, the absolute level of knowledge and know-how spillover from FDI
is not significant in India.
Even MNC affiliates whose parent firms have R&D intensive products do
not spend a noticeable proportion of their turnover on training.
Only 15 per cent of such MNC affiliates spend more than 4 per cent of
their turnover on training. This suggests that by and large MNCs use India as
a manufacturing base for low-end generic or downstream products. This is
consistent with the experience of the IT industry, which has not moved
significantly up the value-addition ladder.
Although firms across the board offer little or no training to their
employees, there is a weak relationship between training and performance of
the MNCs in India. The firms that were most dissatisfied with their own
performance are also the ones that offered noticeably less training to their
employees, as compared to the other firms.
 Foreign Direct Investment in India 143

Primary
Basic consumer goods
Intermediate goods
Machinery & equipment
Infrastructure & construction
Trade, tourism & recreation
Financial & business services
Information technology (IT)
Pharmaceuticals

0% 20% 40% 60% 80% 100%

0 - 0.5% 0.5 - 2% 2 - 4% 4 - 8% 8 - 15% > 15%

Figure 5.5: Proportion of revenue spent on training by local affiliate in India

Primary
Basic consumer goods
Intermediate goods
Machinery & equipment
Infrastructure & construction
Trade, tourism & recreation
Financial & business services
Information technology (IT)
Pharmaceuticals
Total

0% 20% 40% 60% 80% 100%

Not satisfied Somewhat satisfied Largely satisfied

Figure 5.6: Performance of MNC affiliates relative to expectations in India

PERFORMANCE OF MNC AFFILIATES

Overall, most MNCs were satisfied with their own performance, relative to
their initial expectations (Figure 5.8). However, the aggregate numbers mask
a significant amount of heterogeneity across firms. MNCs in the sample that
144 Investment Strategies in Emerging Markets

entered India by way of greenfield projects were by and large happy with
their performance; the measure of experience being an index that accords
equal weights to the MNCs’ experience with respect to labour productivity,
revenue growth and profit growth. About 40 per cent of them feel that all or
nearly all their expectations have been satisfied. In comparison, MNCs that
entered by way of JV were less successful; only 28 per cent of them feel that
all or nearly all their expectations have been satisfied. Overall, only 16 per
cent of the MNCs report that their expectations have been largely or entirely
unmet.
A significant proportion (nearly 40 per cent) of the early entrants, i.e.,
those that entered India prior to 1995, have had their expectations with
respect to performance met. By contrast, only 29 per cent of the late entrants,
i.e., those that entered after 1998, were satisfied. This may be a reflection of
the change in the a priori expectations of the MNCs about investment in
India over time.
The largest number of well-performing firms is in the machinery and
equipment and, not surprisingly, IT sectors. A large proportion of the MNCs
in the financial services and pharmaceutical sectors, about 35 and 44 per cent
respectively, are also satisfied with their performance. The machinery and
equipment and the intermediate goods sectors account for most of the under-
achieving MNC affiliates in the sample.
MNCs in the sample are more likely to have been satisfied with their
performance if they are very export oriented than if they are focused on the
domestic market. About 52 per cent of highly export oriented MNCs are very
satisfied with their performance. By contrast, only about 33 per cent of the
MNCs with domestic market focus feel that all or nearly all their expectations
have been fulfilled.
As seen before, all MNCs experienced an improvement in the quality of
local labour during the 1990s. However, the MNCs that were least satisfied
with their performance experienced the most significant improvement in the
quality of non-managerial skilled labour and, at the same time, the steepest
decline in the quality of executive management (Table 5.3). This possibly
suggests that “failure” of MNCs in India is closely associated with
management problems, as opposed to problems with the non-managerial
labour force.
MNCs that are dissatisfied with their performance in India experienced
noticeably less improvement in the reliability of utilities, compared to other
MNCs. However, on average, satisfaction with performance and experience
with local resources have a non-monotonic relationship. Indeed, while MNCs
that are completely or almost entirely dissatisfied and those that are by and
large satisfied with their own performance experienced similar (average)
levels of improvement in the quality of the local resources – 0.44 points on a
5-point scale – the middle of the road MNCs have distinctly better experience
with the quality of the same resources. The latter experienced an average
 Foreign Direct Investment in India 145

improvement of 0.58 points on the aforementioned 5-point scale. This

surprising result might be a reflection of the high a priori expectations of the
“successful” MNCs about the rate of improvement in the quality of the local
resources.
The degree of satisfaction of the MNCs with their own performance has
an unambiguous negative relationship with the perceived change in the
quality of the local industries to which the MNCs belong. This is possibly a
reflection of the more realistic a priori expectations of the “successful”
MNCs about the quality/extent of local competition they were likely to face,
and hence the extent to which they would be able to extract rent using their
proprietary products and brands.
Firms across the performance spectrum witnessed improvement in the
legal institutional environment pertaining to procurement of business
licenses, real estate and visa and work permits. In addition, a large number of
the MNCs perceived an improvement in the FDI-related policies of the
central and state governments. Firms who were entirely or almost entirely
satisfied with their own performance did not perceive any significant
improvement in the governments’ policies. Indeed, the firms at the two ends
of the performance spectrum felt that the state governments’ policies actually
became less investor friendly over time, albeit marginally.

CONCLUDING COMMENTS
India has come a long way since 1991 in so far as quantum of FDI inflow is
concerned. But it is still a mere USD 4 billion per year, and seems to have
stagnated at that level. FDI inflow in 2002 was just 3.2 per cent higher than
FDI inflows in 2001. The popular wisdom is that MNCs are discouraged
from investing in India by bureaucratic hurdles and uncertainty about the
sincerity of the government(s) about economic reforms.
However, to date, there has been very little discussion about two
important issues, namely, the experience of MNCs that have invested in India
and the relationship between their performance and experience with the
operating environment, and the extent of spillovers in the form of transfer of
technology and know-how. The importance of the former is that the
satisfaction of expectations of the MNCs that are already operational within
India is, for obvious reasons, an important pre-condition for growth in FDI
inflow. Transfer of technology and know-how, on the other hand, is at least
as likely to have an impact on India’s future growth as the quantum of FDI
inflow. Indeed, to the extent that India’s future growth will depend on the
global competitiveness of its firms, the importance of such spillovers can be
paramount.
146 Investment Strategies in Emerging Markets

Table 5.3 Assessment of the Indian business environment and FDI

performance

Somewhat Largely
Performance Not satisfied satisfied satisfied
At At At
Initial present Initial present Initial present

Labour market
Executive manager 3.32 3.81 3.37 3.82 3.81 4.16
Professionals 3.68 3.19 4.07 4.38 4.23 4.58
Operations management 3.68 4.24 3.71 4.12 3.98 4.37
Skilled non-managerial
labour 3.68 4.38 4.07 4.35 4.14 4.48
Local inputs
Utilities 3.45 3.76 3.39 3.69 3.88 3.91
IT and Telecommunications 3.32 3.82 2.98 4.07 3.37 4.40
Competent professionals 3.91 4.36 3.85 4.40 4.19 4.62
Real Estate 3.68 3.95 3.76 4.16 4.09 4.34
Machinery and equipment 3.55 4.14 3.59 4.16 3.98 4.38
Raw materials and
components 3.53 4.05 3.33 3.90 3.61 4.10
Local industry
Quality and range of
products 2.18 2.86 2.29 2.75 2.74 3.00
Management capabilities 2.86 3.41 2.93 3.25 3.00 3.05
Marketing capabilities 2.64 3.36 3.39 3.45 3.16 3.38
Level of technology 2.23 2.86 2.39 2.84 2.60 2.89
Labour productivity 2.77 3.50 3.15 3.27 3.00 3.08
Institutional environment
Business licenses 3.55 3.20 3.02 2.55 2.72 2.49
Procurement of real estate 3.05 2.81 2.80 2.42 2.88 2.65
Visa and work permits 2.73 2.67 2.98 2.54 2.84 2.70
Environmental regulations 3.27 3.35 2.76 2.70 2.86 2.89
General legal framework 2.86 2.77 3.05 2.86 2.74 2.83
Predictability and stability of
rules 3.00 3.18 3.39 3.27 3.05 3.08
Central government 3.00 2.68 3.19 2.78 2.74 2.70
State government 3.00 3.05 3.26 3.00 2.63 2.70

126
 Investment Strategies in Emerging Markets 147

Data obtained from the 160 MNC affiliates in India directly address both
these issues. MNCs that have invested in India are, by and large, satisfied
with their own performance, the measure of experience being an index that
incorporates into itself the MNCs’ experience with respect to labour
productivity, revenue growth and profit growth. Indeed, the majority of the
firms in both old economy sectors like machines and machine tools and new
economy sectors like IT feel that their expectations with respect to these
parameters of performance were largely met. Importantly, neither the central
nor the state and local governments were viewed as obstacles to carrying on
business in India.
However, there is little room for complacence. Firms whose expectations
with respect to performance have not been met experienced a noticeable
decline in the quality of executive management in India, and were largely
dissatisfied with the extent of improvement in the reliability of utilities.
Further, late entrants into India were found to be less satisfied with their own
performance, on average, than the early entrants, perhaps reflecting the fact
that the growth of labour productivity, revenue growth and profit growth of
MNCs did not keep pace with the ex ante expectations about the rapidly
growing Indian economy.
But the optimism on this front has to be tempered by two observations,
namely, that most of the firms investing in India have small R&D budgets,
relative to their turnover, and most of them do not provide significant training
to the employees in their Indian affiliates. This casts doubt on both the extent
of transfer of cutting edge technology to India, and the extent of spillovers by
way of enhancement of skills of the labour force.
As with the overall economic reforms programme, India’s performance
with respect to FDI remains a mixed bag. A stagnation of the quantum of FDI
inflow coexists with the perception that quality of labour and other inputs, as
well as the legal-institutional environment relevant to the MNCs, have
improved noticeably during the 1990s. The average MNC remains satisfied
with growth in labour productivity, revenue and profits, and remains willing
to transfer technological resources to the Indian affiliate. At the same time,
however, supply of key resources like power remain unreliable, and the
extent of spillover effects in terms of both quality of technology and know-
how remain uncertain. The appropriate mood, perhaps, is one of cautious
optimism.

126