Why has private investment been so weak? The answer: Modinomics understands return, but is cavalier about risk. On the face of it, Modinomics is a strategy specifically designed to encourage investment, indeed to convince the whole world to “Make in India”. Yet, global investors have been reluctant to beat a path to India’s doorstep and even domestic firms have been investment-shy, especially in manufacturing. So, at the start of a fresh term, the question to ask is: What has gone wrong? Why is foreign direct investment (FDI) declining and overall investment stagnant?
This situation must frustrate the government because for the past 10 years, measure after measure has been rolled out to encourage investment. The country’s infrastructure has been transformed. The corporate tax rate has been cut. Generous production subsidies have been made available. Tariffs have been imposed to provide protection to domestic producers. Bank balance sheets have been cleaned to enable them to hand out long-term loans. These have involved considerable work and great public expense. But so far, the private sector’s response has been tepid.
Why? Look again at the measures. Many are designed to reduce costs, some to increase revenues, and others to enhance after-tax profits. But all share a common goal: Increasing the returns to investment.
Of course, firms care about returns. But they are also extremely sensitive to risk. In many cases, risks can be contained, using techniques such as reversibility and scalability. For example, portfolio investors have the option of taking money out quickly, which encourages them to invest in the first place. That explains why foreign portfolio inflows have been healthy even when FDI inflows have not.
Service firms typically manage risk by employing scalability. If someone wants to sell IT services, for example, all that is needed are a few talented people, some computers and decent connectivity. If the plan works out, the firm can be scaled up gradually.
But manufacturing is very different. Investments are large, indivisible, and difficult to reverse. That means that managers need to carefully consider the risks of any investment before approving any significant project.
In Narendra Modi’s first term, measures were taken to address such investment risk. There was a concerted effort to restore macro stability by introducing an inflation targeting regime and cutting the fiscal deficit. The government also tried to reduce risks for banks by providing them with legal recourse via the IBC in case the loans went wrong.
But during the second term, the idea of risk mitigation eluded Modinomics. Some of the measures taken increased investor risk. We highlighted some of these problems earlier in Foreign Affairs. From an investor’s perspective, risks emanate from three types of state action that favour competitors, are directly coercive, or jeopardise the supply chain. Consider each.
The first is what could be termed “national champions risk”. On numerous occasions, the government has abruptly changed the policy framework when it saw the opportunity to promote a national champion. The attraction of such an approach is obvious: If it is successful, an Indian firm will invest, become large and successful, and enter the global fray. But this strategy has a drawback — it deters all the other domestic firms from entering the same manufacturing space or even a different space, out of fear that once their irreversible investment is made, the policy framework will be changed to their disadvantage.
Examples of this risk are numerous: It has materialised in online and physical retail, airports, cement, ports, telecoms, and media. Our invocation of “2A stigmatised capitalism”— the privileged status enjoyed by the Reliance and Adani Groups — is not a cute slogan, but the lived reality or feared anticipation of many firms, domestic and foreign.
The second risk stems from direct and coercive state action, such as aggressive tax collection. Admittedly, such policies can benefit the government, with reportedly around 40 per cent of income tax (corporate and individual) revenue accruing from additional tax demands. But if ED or tax authorities raid selectively, while regulatory agencies render arbitrary verdicts, or actions verge on extortion as in the electoral bonds saga, risk perception deteriorates sharply. As a result, lakhs of crores of investment can be destroyed. And even the apparent revenue benefits may prove elusive over the long-term, since historically most additional tax demands are ultimately overturned in the courts.
In particularly prominent cases, Cairn/Vedanta and Vodafone invoked bilateral investment treaties to challenge the government’s retrospective imposition of taxes. The government dithered when international arbitration upheld their claims. Even when the government eventually withdrew the tax, it was done tardily (after seven years) and more out of duress than conviction. Further, it allowed all its bilateral investment treaties to lapse, viewing them as a problem rather than as a means to reassure investors.
Finally, there is supply chain risk. Today, virtually no manufacturing product is made solely from domestic materials. For India to become internationally competitive — and convince the world to “Make in India” — manufacturing firms need to be assured that they will have access to raw materials and inputs from anywhere in the world. But every time a tariff is increased or a product ban imposed, or even when such measures are floated by the government, firms worry about their access to low-cost supplies.
How can the government reassure investors against these risks? Some actions are conceptually simple. For example, Vietnam has sought to mitigate supply chain risks by signing FTAs with all the major trading powers, thereby assuring investors that they can count on having access to supplies, both now and in the future. But more generally, reducing risk requires persistent action and, above all, inaction or restraint. Like reputation, a good risk environment is easily damaged but painstakingly difficult to build and sustain.
In some ways, this risk-return perspective also points to some deeper flaws in the Modinomics attempt to “do a China”. For a start, the Chinese model was never merely about increasing returns by providing subsidies and infrastructure. It was also about reassuring investors that the state was right behind them, working to minimise their risk. Indeed, it is precisely because China has recently abandoned that second element of its long-standing strategy that its growth has slowed and confidence has collapsed.
Moreover, to always be like China is one thing but to become like China is a different matter. In India, the government works on the soil of democratic and administrative procedure, long baked into the system. Even a centralised India can never become China.
So, there is bad news and good news. The bad news is that reversing India’s reputation as a high-risk destination will not be easy. The good news is that China’s problems have forced investors to revisit their calculations, rendering them willing to take on more Indian risk than in the past. But not too much more. Not if they continue to worry that the Damocles’ sword of expropriation via tax and ED raids hangs over them; not if their old investments can be jeopardised at the behest of their government-favoured competitors; and not if the liberalising policies of yesterday can become history today.
Policy actions can raise returns. But reducing risks demands much more. Modinomics has not been equal to that. Felman is Principal, JH Consulting and Subramanian is Senior Fellow, Peterson Institute for International Economics and former CEA, Government of India
