The recently published Annual Report of Reserve Bank of India profiles the trends of foreign direct investment (FDI) flows into India. These offer some insights about the allocation of such investments these last few years. How and where capital resources are distributed in an economy is instructive for many reasons. Amongst other things, it tells us which sectors are more profitable or yield relatively higher returns to capital. Illustratively, the allocations of investments across the tradeable and non-tradeable segments shed light upon the relative attractiveness of these two aggregates. In turn, if non-tradeable goods’ prices are higher relative to those of tradeables, an internal appreciation of the real exchange rate, it carries significance for macroeconomic policies. At the balance of payments level, there are potential implications about future foreign currency earnings or liabilities from current investments. The most important is the employment link: to the extent the tradeable sector, typically manufacturing-exports, is demonstrably capable of large-scale absorption of surplus, unskilled labour, where FDI tends to flow indicates prospects for mass-scale job creation.
The accompanying chart shows the distribution of FDI flows between manufacturing and services for last six years; since an average 10% of such investments have flown into construction and real estate activities, these are shown separately. The services component is the sum of FDI into financial, communication, business, computer, restaurants & hotels, retail & wholesale trade, transportation, trading, education, research & development, miscellaneous and electricity and other energy generation, distribution & transmission, services. Including construction and real estate, which are non-tradeable in nature, the broad distinction is to be made between manufacturing and the rest.
Overall, FDI flows have grown robustly over these years, an average 25% annually from 2010 onwards. FDI grew exceptionally strongly in some years, e.g., 60%, 54% and 46%, respectively, in FY12, FY15 and FY16. On average, manufacturing shares in FDI flows are 35.5% while services incl-construction (non-tradeable) is 63.3%. In the just-concluded financial year, manufacturing shares in FDI flows dropped sharply, 16 percentage points from a 40.5% peak in FY14 peak to 23.5% currently. Whether this is a one-off drop or not remains to be seen; so far, the structural allocation patterns between manufacturing and the rest appear relatively unaltered.
From the standpoint of job creation and shifting unskilled workers from farms to factories, and the Make-in-India goal to be realised through increasing manufacturing shares in GDP to 25% by 2022, these FDI flow patterns are not a favourable portend.
One reason for the drop in FDI flows into manufacturing to $8.3 billion in FY16 from $9.6 billion the previous year may be the persistent and rising excess capacity in the Indian manufacturing sector. The slack here has been rising, with utilisation rates down nearly 8 percentage points from an average 80% in FY12. Average use of production capacities is stagnant at 72% in past two years. Investors may see little merit therefore in ploughing resources for fresh capacity creation in falling demand conditions.
Globally, too, excess supply characterises several manufacturing sub-sectors. This brings in the point of attracting investments relocating from China into India, an area of policy thrust these last two years. Despite the climbs up the ‘ease of doing business’ ladder, is it the low-demand external environment that is inhibiting translation of reform gains into actual,
realised investments? Policies may have to be reworked to explore other sources of job-creation in that case. Especially as, historically, FDI into Indian manufacturing has been motivated by a combination of domestic and external demand, if not just the former.
It can also be that gains from a reformed business environment are yet insufficient for Indian manufacturing to emerge as an attractive destination for FDI relocating from China. Looking to the migration of such units to countries like Vietnam, it is hard to dismiss the argument that production costs in India are relatively higher. Or that efficiency gains from reforms so far have been inadequate in bridging the production cost gap vis-à-vis competing nations. More, deeper reforms may then be the need.
The long-term tilt of FDI flows into non-tradeable (services) sectors that still holds reaffirms that returns to investments are relatively higher in this segment. Investors have responded with alacrity here to the lifting of some caps and other liberalisations in insurance, defence, retail trade, etc, while the vibrancy of Indian e-commerce has added further impetus.
The FDI-allocation features have some important macroeconomic implications. For one, the preference for services as its favoured destination means a longer road to achieving a sustainable current account balance. Why? Because revenues from most services, which are non-tradeable by nature, are generated in domestic currency; likewise for construction and real estate activities, which fetch rupee revenues. But foreigners’ claims upon income earned on many of these investments (royalties, etc.) generate future foreign currency outflows and, thus, contribute to widening the current account gap. FDI-associated liabilities have been on the rise since 2009 while earnings from services exports and private transfers are simultaneously decelerating due to structural shifts in the nature of demand and poorer economic conditions abroad.
So, even as the buoyancy of FDI inflows is celebrated, one has to be mindful of some macroeconomic consequences. If much of the current investments create repayment liabilities in subsequent periods, macro imbalances will aggravate unless of course, offset by matching rise in foreign currency receipts from other sources. A context in which the importance of export-oriented FDI cannot be emphasised enough. Minus such countervailing impacts, macroeconomic stability will continue to hinge upon the price of oil.
The author is a New Delhi-based economist