DESTINATION INDIA?
With its economy barrelling along at a healthy clip, India is full of buzz and optimism these days. So where is all the foreign direct investment?
By Justin Wood

In late January this year, Stefan Schulte received some good news – his company, Frankfurt-based Fraport, had won the concession to modernize, expand, and operate the main airport serving Delhi in India. The facility was dilapidated and desperately in need of investment, but with passenger traffic growing at 20% a year, the 30-year contract offered exciting growth opportunities for Fraport and its local partners in the project. Then came the bad news.

On learning of the decision, airport workers in Delhi and Mumbai – where a similar contract was also awarded – denounced the privatization and went on strike. For four days, air travellers in the two cities were treated to interminable delays, lost baggage, and the wretched stench of festering toilets and overflowing rubbish bins. The two airports, a national embarrassment to India on a good day, became a nightmare.

Airport workers and their unions took to the streets complaining bitterly of impending lay-offs and disappearing job security. Marxist politicians joined in, railing against the sale of state assets to foreign firms. A disgruntled rival bidder complicated matters by alleging the tender process was flawed and launched court proceedings.

“It wasn’t the best start,” concedes Schulte, who is CFO of the €2.1 bn-a-year (US$2.6 bn) German airport operator. “But the situation wasn’t as bad as it seemed. We explained to the workers that airports are jobs machines. We’ve agreed to make no lay-offs for three years, and to employ a minimum of 60% of existing staff thereafter.”

The saga illustrates one of the key conundrums characterizing India today. On the one hand, the country desperately needs foreign investment to upgrade its antiquated infrastructure and power the economy forward. But on the other hand, foreign firms frequently find India a tough place to do business. As a result, investment from abroad has been distinctly low.

In 2005, for example, foreign direct investment (FDI) inflows into India stood at US$6 bn. In China, the figure was ten times higher at US$60 bn. Even Singapore, a fraction of India’s size, attracted more than twice the FDI going into the sub-continent.

Given the stellar economic growth of India in recent years, is this situation likely to change? Could India be standing on the threshold of a giant inflow of FDI? Or will foreign investors continue to be lukewarm to India’s investment potential?

India rising

Few would deny that the Indian economy has a lot going for it. GDP has grown at close to 8% for the past three years and looks set to continue at the same pace. Inflation is well contained at under 5%. Stockmarkets are at record levels. And India’s world-famous IT services and business-process outsourcing industry is bounding ahead, growing by 28% in 2005 to notch up revenues of US$36 bn.

The country’s population is young – 36% are less than 15 years old while only 4% are older than 65. What’s more, the population is growing rapidly. By 2025, India will have added another 260m people to its current total of 1.1 bn.

People are getting wealthier too. At the end of 2005, India boasted 50.6m internet users, the fourth-highest total in the world, and 75m mobile phone subscribers, the sixth-biggest market globally.

The growth rate of vehicle sales is another measure pointing to the emergence of a middle class with real spending power. In 2001, manufacturers sold 3.6m motorbikes and 691,000 passenger cars. During 2005, sales figures almost doubled to 6.2m motorbikes and 1.1m cars.

Indeed, unlike many of its Asian neighbors, India stands out as being a consumption story rather than relying chiefly on investment and exports for its growth. McKinsey & Co, a management and strategy consultancy, calculates that India has around 42m households with annual income of more than US$4,000, which are the real drivers of the consumer goods market.

Of course, not everything is rosy. Alongside this wealthier middle class, McKinsey identifies a further 110m households as “struggling” and another 40m households as “destitute”. And with two-thirds of the country still working in agriculture, the economy remains heavily dependent on the monsoon for its progress. Elsewhere, the government is running a large deficit which, at 7.5% of GDP, must be brought down, warns the International Monetary Fund. Not an easy task with spending on social services and infrastructure projects all set to reach record levels.

All things considered, though, India is enjoying a positive patch in its development and has attracted much attention from business and the world’s media in recent years. And yet, despite the buzz and optimism, foreign investment is still little more than a trickle in relation to the size of the country.

Deregulation dividend

For Adil Zainulbhai, managing director in India of McKinsey, the picture is more promising than it seems. Yes, he says, FDI is still low, but it’s growing rapidly, having doubled in the last three years. What’s more, he predicts investment is poised to take off and will reach levels of around US$15 bn-a-year by 2009.

“If you look at China, it deregulated its economy in 1978 and it wasn’t until 1990 that FDI really started flowing in a major way,” he explains. In India, he adds, it was only in 1991 that Manmohan Singh, finance minister at the time and today the country’s prime minister, kick-started a similar liberalization of the economy. After years of socialism and a policy of self-sufficiency, India’s borders were gradually opened, government bureaucracy cut back and a new era of business-friendly government ushered in.

“India is following a similar pattern to China in that it really takes 12 to 15 years after deregulation for foreign investment to take hold,” says Zainulbhai. “Mindsets have to change, people have to start believing in the benefits of reform and that takes time.”

But for companies doing business in India today, it’s clear that reforms have only gone so far. Take the oft-cited issue of excessive bureaucracy that grew almost into an art form during the years preceding 1991. Each year the World Bank produces an “Ease of Doing Business” survey of 155 countries and in 2006 India was ranked at 116 – two spots worse than Iraq. Of particular note, the report highlights the difficulties of handling licences, in trading across borders and in enforcing contracts – where India ranks 138th in the survey.

John MacLellan, financial director for Microsoft in Asia Pacific, agrees with the survey’s findings. “India is a tough place to do business,” he admits. “Working there has been a big learning experience.” MacLellan is based in Singapore but currently spends one week a month in India where Microsoft is investing heavily. In December 2005, Bill Gates, chairman of the US$39.8 bn-a-year software giant, announced his firm was investing US$1.7 bn in the country. In the process, it’s increasing its workforce there from 4,000 to 7,000 to take advantage of India’s large pool of highly educated, but relatively cheap, English-speaking workers.

Escaping the past?

MacLellan describes the legal and regulatory environment in India as “slow-moving and conservative”, with many roadblocks that need careful navigation. “India is highly protective of a large underclass of poorly-paid people which it doesn’t want to leave behind as the economy progresses,” explains MacLellan.

In other words, much of India is still steeped in its socialist, protectionist, and bureaucratic past. Its labor laws, for example, are particularly conservative. Companies employing more than 100 staff must first seek permission from the local state government before making any workers redundant. Frequently such permission is withheld, a fact that, perversely, dissuades businesses from growing above a certain size and protects the employed at the expense of the jobless.

Equally, India’s borders remain relatively closed. For goods coming into the country, import duties are still high, although they are coming down – in the year to March 2005, the average tariff rate in India fell 5% to 17% and the government is aiming to reach 9% by 2009 to match ASEAN levels. Similarly, there are caps on foreign investment in certain sectors, such as financial services, media, and retail. Once again, though, halting progress is being made: in 2005, for example, the limit on foreign ownership in telecommunications companies was raised from 49% to 74%.

Companies looking to India’s political leadership to speed up the pace of reform toward a more open economy with less red tape will be disappointed. A coalition government called the United Progressive Alliance is currently in power, led by the left-of-center Indian National Congress. And although the party has expressed a commitment to be more pro-business, it relies on the support of a group of mainly communist parties known as the Left Front, which acts as a significant brake on change.

Indeed, the very nature of India’s political system means that progress on all manner of fronts occurs only slowly. Observers often point out that, while China has a highly centralized power structure that lets the government push through legislation and big-ticket projects at will, India must contend with the constraints and vagaries of democracy and coalition politics. What’s more, India’s 28 states and seven union territories all enjoy a high degree of autonomy, meaning that not only do local rules differ widely across the country but so too does progress in reform.

Observers say that states such as Kerala, Gujarat, and Tamil Nadu are at the forefront of cutting bureaucracy and introducing investor-friendly policies, while the likes of Bihar, Orissa, and Jharkhand have dragged their feet. That said, even the laggards now seem to recognize the need for change. Indeed, McKinsey’s Zainulbhai reckons a healthy competition is starting to emerge as states vie for interest from foreign firms.

Steely resolve

Tae-Hyun Jeong can certainly attest to those observations. As deputy managing director of POSCO India, he has spent the past year in Orissa trying to set up the biggest FDI project in India’s history. In June last year, POSCO, a 6.5 trn won-a-year (US$6.9 bn) Korean steel maker, signed a memorandum of understanding with the state government of Orissa to invest US$12 bn over a number of years in a massive integrated steel works, complete with iron ore mines, a new port and a workers’ township.

In the course of getting the project off the ground, Jeong has encountered all manner of issues. For example, securing the 4,000 acres needed for the steel and mining facilities has been tortuous because it requires relocating and rehabilitating 500 families. As a result, POSCO has already reduced its land needs to help push the project forward.

Marxist politicians have jumped on the bandwagon, questioning why the state is supplying land for foreign investment but not for local tribesmen, and campaigning against a contract that lets a foreign firm extract Indian natural resources. Environmentalists have joined the fray too, as have unions at a nearby port with concerns about the impact of POSCO’s proposed new shipping facilities on their own livelihoods.

Needless to say, Jeong has spent a good part of his time building community relations and explaining the benefits of the project – not least the creation of 48,000 jobs in the region. POSCO has hired a renowned local body, the Tata Institute of Social Sciences, to help formulate its approach to corporate social responsibility in India. It has outlined plans to build training facilities for local workers, and all senior managers at the company are on courses to learn Oriya, the language of the region. In April, the company even flew 17 local journalists to Korea to meet POSCO’s most senior managers and to see its existing steel mills.

While Jeong acknowledges that the investment has had its ups and downs, he feels the authorities have been supportive. “The central government has been very transparent and friendly toward us,” says Jeong. “I believe their attitude will attract a lot more companies.”

As for the local government in Orissa, Jeong points out that this is the first time the state has ever handled a project of this size. Needless to say, there have been teething problems, but once again Jeong says the mood has been generally helpful and positive.

And the situation looks set to improve. Orissa and many other states are trying to streamline the investment process by setting up fast-track approvals for certain types of projects. In Maharashtra, for example, the local government is promising “single-window clearance” within one month from the state machinery for all investments bigger than 5 bn rupees (US$100m) or which create 1,000 new jobs.

Trains, planes, and automobiles

The central government is pitching in too. Last year, the prime minister set up an Investment Commission to look at how India could boost its FDI performance. Early this year, the commission reported back. To sustain an annual growth rate of 8% over the next five years, said the report, India needs investment of US$1.5 trn, of which more than US$70 bn should be FDI. To lure that investment, the report continued, India needs to simplify regulations and reduce the transaction costs of doing business. Of even greater importance, the country needs to improve its infrastructure.

“Inadequate infrastructure is now our greatest challenge,” agrees Amit Chandra, managing director of DSP Merrill Lynch, an investment bank in Mumbai. “However, this problem could be turned into our biggest opportunity if we are able to create a sensible framework for attracting investment.”

The country’s ports, for example, are operating at full stretch – the average capacity utilization for India’s 13 biggest ports is running at 97%. Airports are equally bogged down, as is India’s network of mostly single-lane highways. A report released this year from the government’s Planning Commission sheds light on the poor state of the railways: between 1992 and 2002, China invested US$85 bn and expanded its rail network by 24%, while India invested just US$17.3 bn and grew its network by only 1%.

Here too the government is taking action. The contracts to upgrade Mumbai and Delhi airports are good examples and illustrate how the government is opting for public/private partnerships to help shoulder the cost. Much-needed new airports are also under construction in Bangalore and Hyderabad. Roads are being improved – a “Golden Quadrilateral” of new highways linking Delhi, Mumbai, Chennai, and Kolkata should be completed by the end of 2006, albeit three years behind schedule. A program of “two-laning” and “four-laning” many existing highways is also under way. And deals to expand India’s drastically underdeveloped network of power stations are being negotiated.

It’s not a moment too soon, reckons Albert Kappeler. As the South Asia regional president of 7.4 bn Swiss franc-a-year (US$5.8 bn) Swiss chemicals giant Ciba Specialty Chemicals, Kappeler is overseeing a push to make India a global supply source for his firm. This year the firm has announced investment of US$40m to expand its two manufacturing plants in Goa and Gujarat.

Up until now, India has failed to develop a vibrant manufacturing sector in direct contrast to China, and one of the main reasons, believes Kappeler, is its sub-par infrastructure. Nonetheless, he adds: “I have a feeling that things are improving. With decent infrastructure India has every chance of becoming a major global supply center in the way that China has.”

A policy launched in 2000 allowing the creation of special economic zones (SEZs), which offer tax breaks and incentives and where companies can bring goods in and out without excise duties, should also boost foreign interest in India as a manufacturing hub. So far, just 14 SEZs have been built, attracting 183 bn rupees in investment, but another 61 such sites have been approved and are under construction.

People power

Another issue making foreign investors think twice about India revolves around recruiting and retaining staff. While India has no shortage of people, finding enough educated engineers and experienced managers is sometimes not easy.

It’s a serious issue for Ciba’s Kappeler. “We often find that, because of management shortages in the big cities, we have to bring in expatriates,” he says. But with good schools, hospitals, and other facilities in short supply, that can be tricky, he adds. “In my experience, it’s easier to place older managers whose children have grown up, or younger ones who haven’t had them yet.”

Russell Freeman has staffing issues of a different kind. As CFO of Texas-based Perot Systems, a US$2 bn-a-year IT services firm, Freeman is overseeing a big push by his firm into the sub-continent to take advantage of the “global labor arbitrage” in wage levels between India and America.

As of today, almost a third of the company’s 17,000 staff are based in India, working at centers in Bangalore, Noida, and Chennai. Perot Systems has been in India since 1996, and in 2005 it held one of its four annual board meetings there as a sign of its commitment. Around 25% of the company’s capital expenditure is going into India currently, the firm is due to announce new offices in a fourth city soon, and last year it reorganized many of its key US consulting practices so that they are now run by managers based in India.

Nonetheless, despite the heavy commitment to India, Freeman recognizes serious shortages of the software engineers, science graduates, and MBAs needed to man his operations. “Demand for labor in India is tough and it’s really driving wage inflation,” he says, particularly as more and more Western firms shift their back offices and their research and development activities offshore.

Labor rates in his industry in India are still only a quarter of what they are in the US, and with wage inflation of between 12% and 15% a year “you realize that the arbitrage has many more years to run,” he notes. Nonetheless, he adds: “I think everyone in our industry is struggling with how long wage inflation will continue.”

In the end, though, Freeman remains confident that India will overcome its problems and continue to draw foreign investment in ever greater numbers. For Fraport’s Schulte and his team manning Delhi airport, the more that come, the better.