Improving the Investment Climate: Challenges for India

By
Michael F. Carter
Country Director, India
The World Bank Group
Jacaranda, India Habitat Centre, October 19, 2004

Good afternoon. I am happy to be able to join you at this OECD India Investment Roundtable.

India has made good progress in increasing incomes and improving living standards over the past decade. After the setback associated with the 1991 balance of payments crisis, economic growth picked up, the external position has strengthened remarkably, poverty has continued to decline, and many social indicators, particularly literacy, have continued to improve. The driving force behind these social and economic improvements was the ambitious reform program launched in 1991 to open and deregulate the economy. The reform program marked a new willingness to allow market forces the freedom to work. It included: industrial and trade liberalization; financial deregulation; improvements to supervisory and regulatory systems; and policies more conducive to privatization and foreign direct investment.

We should not underestimate these achievements. But neither should we take them for granted. Accelerating reforms to achieve broadly-based growth is essential if India is to attain its economic imperative of sustained high growth and poverty reduction. The Government of India’s Tenth Five Year Plan estimates that the Indian economy needs to grow at around 8% per annum over the next decade to create the required 100 million new jobs and reduce the poverty rate to 11%. This would require an increase in agricultural growth from the trend rate of about 3% per annum in the last decade to 4.5% per annum over the next 10 years. Industrial growth would need to increase from 6% p.a. in the last decade to 8% p.a. in the next decade. And services from 7.5% p.a. in the last decade to 9% p.a. over the next 10 years.

Fortunately, there is widespread agreement within India that much more needs to be done if the country is to achieve its economic potential. And that a vibrant private sector—with firms investing, creating jobs, and improving productivity–-is central to promoting growth and expanding opportunities for poor people. Sustained growth and higher employment over the next decade will require a step up in domestic investment, particularly private investment, coupled with improved productivity. This will have much to do with the quality of India’s investment climate, not only at the national and sub-national levels, but also in comparison with other investment destinations in Asia.

International comparisons indicate that India has intrinsic advantages, such as macroeconomic stability, a large and rapidly growing local market, a large and relatively low-cost labor force, a critical mass of well-educated workers, and abundant raw materials, that should allow it to attract and sustain higher levels of private investment, both domestic and foreign. Capitalizing on these national advantages, India’s private sector has registered some important achievements in the past decade and a half—for example, the development of exports of software and back office services and the emergence of a competitive automotive sector –driven largely by the reforms initiated in the early 1990s.

At the same time, the potential still to be tapped is clearly enormous. Private investment averaged around 15% of GDP in the 1990s—below the average for low income countries and below the level necessary to accelerate growth to a sustainable 8% a year. It was largely financed from domestic savings. FDI inflows to India have averaged only around US$ 5 billion annually over the past few years, as compared to US$ 40 billion annually to China. As a share of GDP, FDI in India stood at under 1% in 2002/03, compared with 4% in China and between 2% and 3% in many emerging market economies. Indian manufacturers have become more competitive over the past decade. However, the share of India’s manufacturing exports in world exports stood at 0.7% in 2000, against China’s share of 4%.

Two recently completed Investment Climate Surveys for India, conducted jointly by the World Bank and CII in 2000 and 2003, and also our cross-country reports on Doing Business, show that the private sector in India continues to be constrained by a number of bottlenecks. Let me focus on some of these critical investment climate bottlenecks.

According to the recent Investment Climate Survey for India, access to reliable power at reasonable cost is the single most significant constraint facing Indian businesses. Nationwide, the shortfall in 2002/03 was estimated at 11.4% for peak demand. On average, manufacturers in India face almost 17 significant power outages per month, versus 1 in Malaysia and less than 5 in China. Approximately 9% of the total value of output of firms is lost due to power breakdowns — compared to 2.6% in Malaysia and 2.0% in China. The frequency and average duration of outages is so great that generators are used as routinely as any standard industrial equipment in India. Some 61% of Indian manufacturing firms own generator sets, versus 20% in Malaysia, 27% in China and 17 % in Brazil. India’s blended real cost of power is 74% higher than Malaysia’s and 39% higher than China’s.

It must be noted that power sector bottlenecks appear to have eased somewhat over the past three years. For instance, the percentage of Indian firms owning generators declined from over 70% in 2000 to 61% in 2003. This reflects progress with sector reforms. The enactment of the Electricity Act in 2003 is definitely a step in the right direction. But much more needs to be done to make the enabling legal and structural environment work.

While the License Raj has been substantially reduced at the center, it survives at the level of states, along with a pervasive ‘Inspector Raj’ that imposes significant costs on businesses. According to the World Bank’s Doing Business Indicators, the median time to start a new business in India is 89 days, compared to 2 days in Australia, 5 days in the US, 18 days in the UK, 36 days in the Russian Federation and 41 days in China. In India, 14.2% of senior management time is spent in dealing with state government officials for various regulatory issues (versus 8.1% in China or 7.8% in Brazil). Indian manufacturers face, on average, 7.4 visits a year from government officials. Although this has decreased from 11.7 visits in 2000, the fact is that it still compares poorly with a country like Malaysia, where the average number of visits is just 2.8 per year. A key challenge for India is to streamline business entry and operation procedures, so as to reduce delays and opportunities for rent seeking. This may require re-engineering the entire gamut of business regulatory processes, at both the state and local levels, on the basis of clear principles of transparency, absence of discretion, and accountability.

Restrictions on the hiring and firing of workers are identified as another key challenge of doing business in India. Employment in India’s registered firms (those with more than 100 employees) is highly protected, making labor rationalization difficult, and discouraging the hiring of labor in the organized sector. This is especially burdensome for exporters who have to compete with producers in other exporting countries. The World Bank-CII Surveys found that the typical Indian firm reported excess labor of 17% in 2000 and that the labor laws and regulations were the main reason why it could not adjust to the preferred level. These numbers improved sharply to 11% in 2003, reflecting improvements in labor market flexibility in some states. Going forward, key priorities for the central government include the repeal of legislation blocking layoffs in registered firms, and legislation to ease constraints on the hiring of contract labor. But state governments, too, can facilitate labor rationalization, even within the current legal framework.

Problems in accessing financing are often cited as another major impediment to the performance of small and medium sized businesses in India. Only 54 % of small businesses in India have active bank credit lines against Brazil’s 75 %. Addressing this problem requires improving the efficiency of SME credit markets through reforms in the legal framework for loan recovery and bankruptcy and improving credit information. At the same time, banks and other financial institutions need to focus on building the necessary capacity for better credit appraisal and risk management.

Industrial policy continue to present obstacles to doing business in India. Some of the key industrial policy reforms required include: eliminating preferences, product reservations and investment ceilings for small-scale producers, all of which have the unintended consequence of preventing smaller firms from growing, reaping economies of scale, and competing on world markets, easing constraints on FDI, and revamping bankruptcy legislation. Trade policy reforms also need to be accelerated. In particular, the government needs to move aggressively to reduce import tariffs to a single rate (say, 10%) over the next three to four years and phase out remaining tariff exemptions, specific tariffs and anti-dumping duties.

One of the biggest barriers to competitiveness is the lack of a unified VAT regime across states. Successive studies have conclusively demonstrated the high degree of un-competitiveness arising out of non-VATable state level indirect taxes and levies, and the need to implement a unified VAT regime as quickly as possible. There was a high likelihood of VAT being introduced in at least the major states in April 2004. This remains an urgent priority for state governments.

All these issues, and more, will need to be addressed to achieve the GoI’s ambitious investment, growth, job creation and poverty reduction targets. It should be noted, of course, that the investment climate varies considerably across the states, and not all of these problems are equally severe in all states.

The World Bank-CII Surveys indicate significant inter-state variations in the investment climate, and also on how investors perceive the investment climate across states. In the 2003 Survey, as in the previous one, respondents were asked to rate all states other than their own for their general investment climate. The outcome was a rating pattern where the six states that attracted almost all the FDI were rated to have a better investment climate by the majority of respondents. These ‘better climate’ states are Maharasthra, Delhi, Gujarat, Andhra Pradesh, Karnataka, Punjab, Tamil Nadu and Haryana. The first three states are also the only ones to have registered growth in per capita incomes greater than 6.5 %. Although these rankings are broadly consistent with the earlier rankings in 2000, there are some important changes. While there has been a decline in the scores of Gujarat and Tamil Nadu, Delhi has moved up the rankings.

Differences in the quality, availability and cost of infrastructure are critical in explaining the differences in investor perception of the investment climate across states. Our analysis indicates that the main reason why the ‘better climate’ states have been rated thus, and more important, why these states attract almost all FDI to India, is to be found in their better physical infrastructure—and particularly, power supply.

The measures I have just outlined for improving India’s investment climate constitute a formidable reform agenda. Fortunately, considerable thinking has already gone into the details of how many aspects of the business environment can be improved.

While some of the challenges I have highlighted would require reforms by the central government, many represent areas for state-level action—for example, doing away with the Inspector Raj, implementation of the VAT, and power sector reforms.

The political economy of implementing these reforms presents a daunting challenge for policymakers. In many cases, reforms could challenge the interests of privileged groups, and involve painful adjustments. But the long-term benefits far outweigh the short-term costs, and delay will only increase the costs further. Our calculations suggest that, if each Indian state could attain the best practice in India in terms of investment climate, the economy would grow about 2 percentage points faster. The gains would be particularly large in states that have poorer investment climates. But even in states that have better investment climates, there is significant room for improvement. And if India could achieve Chinese or Thai levels in distinct investment climate areas where it lags behind those countries, its overall growth acceleration and success with poverty reduction would be even more dramatic.

The role of central government and state governments in all of this is of course vital. But the private sector can also play a critical role in partnering with Government to help India realize its investment and growth potential.

Thank you.