India Needs Course Correction to Lure Foreign Investment

By the Editors - May 9, 2012

Just because you can now go to Dunkin’ Donuts in New Delhi, with the first Starbucks soon to follow, doesn’t mean it’s morning for foreign investors in India. In fact, judging by some of the government’s recent moves, dawn has been postponed by a few years.

Wednesday, India’s Finance Secretary R.S. Gujral told Bloomberg News that if plans to amend India’s tax law go through, Vodafone Group Plc will face a retroactive tax bill of as much as $3.72 billion for its 2007 purchase of Hutchison Whampoa Ltd.’s Indian cellular operations. Changes to the law would override a decision issued this year by India’s Supreme Court releasing Vodafone from any tax obligation, and they might also expose companies such as Kraft (KFT) Foods Inc., AT&T Inc. and SABMiller Plc. to similar retroactive penalties and levies for previous transactions.

The government has also reportedly decided against lifting a 26 percent cap on foreign investment in the insurance business. And though single-brand niche retailers such as Dunkin’ Donuts and Starbucks can now own as much as 100 percent of their ventures (provided they source 30 percent of content locally), there is as yet no joy for multibrand retailers such as Wal-Mart Stores Inc., which remain locked out of the consumer market.

These misguided decisions have taken place against a background of a cooling economy and a deepening political paralysis. India grew by less than 7 percent last year, the slowest pace in three years, and it is saddled with a fiscal deficit and inflation rate that are the highest among the big developing economies, not to mention a swelling trade deficit driven by oil imports. Its fractious ruling coalition of frenemies can’t agree on whether to order a tall or a grande, let alone on what further reforms to adopt.

Faced with those circumstances, Finance Minister Pranab Mukherjee chose to make higher taxes on foreign investors a crucial part of his effort this fiscal year to close his country’s budget gap. But that’s exactly the wrong way to attract the capital that India needs: Its 12th Five Year Plan calls for $1 trillion in infrastructure investment over the next five years. Remarkably, in the face of widespread investor unease, some government ministers have argued that these tax changes “will not have any impact on foreign investment flow in the country.”

The prospect of a new rule on tax avoidance in Mukherjee’s budget spurred the outflow of hundreds of millions of dollars from India’s exchanges. Despite his subsequent decision to postpone the rule’s implementation until 2013, foreign portfolio investors have not been reassured. The proposed Vodafone provision, which could net India billions in retroactive revenue, sends investors exactly the wrong signal, not least because it overturns a seemingly settled court verdict. The government should drop the retroactive provisions of the law, and focus more on curbing the subsidies that eat up more than 2 percent of gross domestic product.

Secretary of State Hillary Clinton made the case for continued opening of the Indian economy in her just concluded trip. In fact, we give her major props for going into the lion’s den -- a visit with Mamata Banerjee, chief minister of West Bengal, leader of coalition member All India Trinamool Congress, one of Time magazine’s “100 Most Influential People” in 2012, and a reflexive opponent of economic liberalization. But given India’s fragmented polity and the sclerotic state of its national parties and their central leadership, don’t expect much, if any, change until national elections in 2014 -- and then hope that it’s for the better.

Read more opinion online from Bloomberg View.

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