Opening the sluice gates

A decision taken by the World Trade Organisation's dispute settlement body relating to the indigenous content of automobiles and allied matters has serious implications for India's balance of payments situation.

ON December 21, 2001, the World Trade Organisation's dispute settlement body (DSB) arrived at a decision of crucial significance for India. The decision came in response to a complaint filed by the European Union (E.U.) and supported by the United States and Japan on regulations relating to the manufacture of automobiles in India. The DSB ruled that any effort by India to set conditions relating to indigenous content of automobiles manufactured in India or conditions relating to balancing of foreign exchange flows on account of exports and imports by automobile manufacturers is violative of the Uruguay Round Agreement, especially the component relating to Trade Related Investment Measures (TRIMs).

Many of the conditions that the DSB has deemed violative had been withdrawn by India in April 2001, when as part of an agreement reached with the U.S. regarding all import-licensing conditions imposed on balance of payments grounds, India abolished the import licensing scheme for cars imported in the form of CKD/SKD (completely knocked-down/ semi-knocked-down) kits. The 'agreement' with the U.S. essentially involved succumbing to pressures to advance (from April 1, 2003 to April 1, 2001) the date on which import restrictions imposed for balance of payments reasons needed to be withdrawn.

In the automotive sector, the April decision amounted to quashing a Public Notice issued by the Ministry of Commerce in December 1997, which required any passenger car manufacturer importing CKD/SKD kits to sign a Memorandum of Understanding (MoU) with the government that required the manufacturer concerned to:

1. Establish actual production facilities for the manufacture of cars, and not for mere assembly;

2. Bring in through the foreign partner a minimum of foreign equity of $50 million within the first three years of the start of operations, if the firm is a joint venture that involves majority foreign equity ownership;

3. Ensure indigenisation (or local content) of components up to a minimum level of 50 per cent in the third year or earlier, from the date of first import of a consignment of CKD/SKD kits/components, and 70 per cent in the fifth year or earlier;

4. Ensure broad balancing of foreign exchange flows over the entire period of the MoU, in terms of balancing between the actual cif (cost, insurance, freight) value of imports of CKD/SKD kits/components and the fob (free on board) value of exports of cars and auto components over that period (subject to an initial two-year moratorium during which the firm need not fulfil that commitment, which then spills over into the subsequent years).

However, the fact that this understanding was reached with the U.S. and implemented even before the most recent DSB decision, does not reduce the significance of the decision. Since the earlier decision was 'voluntarily' arrived at by India, even if through a process of enforced compliance, it provided for the possibility that India could retract on its decision if and when required, not just in the automotive sector but also in other areas. The DSB has ruled that "the 'indigenisation' condition, as contained in Public Notice No. 60 and in the MoUs entered into thereunder, is in violation of Article III:4 of GATT 1994 as at the date of its establishment. This conclusion is consistent with the fact that the TRIMs Agreement Illustrative List identifies measures which require "the purchase or use by an enterprise of products of domestic origin or from any domestic source, whether specified in terms of particular products, in terms of volume or value of products, or in terms of a proportion of volume or value of its local production" as being inconsistent with Article III:4 of GATT 1994. In this instance, MoU signatory manufacturers are required to use a certain proportion of products of domestic origin in their local production. With the Panel having announced its decision, India would not be able to impose, in any manufacturing area, conditions of the kind specified in its December 1997 notification, so long as it remains a member of the WTO.

Inability to do so implies that the government does not have the capacity to ensure any link between the right to use foreign exchange, purchased from the domestic market, for imports and the obligation to earn foreign exchange to refurbish the pool of foreign exchange reserves available with the country. This inability to establish a link between the right to use foreign exchange and the obligation to earn it could lead to the profligate use of foreign exchange, especially by foreign companies investing in India.

CONSIDER, for example, the automotive sector itself. If a manufacturer is required to meet minimum investment and local content requirements, entry would be largely restricted to those who expect to achieve production volumes that warrant meeting those requirements. The industry would then consist of a few relatively large manufacturers catering to all segments of the market. If those requirements need not be met and local assembly can be ensured with imported CKD/SKD kits, we would have a large number of producers entering the market with a multiplicity of models, all of which will be characterised by high import intensity. Since the government cannot impose any foreign exchange balancing requirements on these producers, the foreign exchange outgo would have to be met from the common pool of foreign exchange available with the country.

This scenario can be replicated in a wide variety of areas, starting from pharmaceuticals where bulk drugs can be imported to make formulations or just be converted to capsules, to computers where all or most components can be imported for domestic assembly. This would imply that as foreign brands increasingly occupy the market for capital, intermediate and consumer goods, the import intensity of domestic manufacturing can rise substantially. The foreign exchange outgo involved could then result in balance of payments problems.

Advocates of reform, who defend policies of the kind imposed by the WTO, argue that this should not be a problem because the restructuring of industry that would occur with the implementation of such policies would result in an increase in India's exports and an expansion in foreign exchange revenues. More specifically, it is argued, the liberalisation of regulations with regard to the operation of foreign capital would result in foreign investors choosing India as a site for world market production. That is, foreign producers locating in India would exploit its benefits as a site for production to target world rather than domestic markets, so that we have a nexus between foreign investment and exports.

UNFORTUNATELY, the evidence on exports and with foreign investments as they have occurred till now goes contrary to that judgment. Barring a period of two to three years in the 1990s, India's exports have languished and currently grow at just 2-3 per cent a year in dollar terms. Further, an examination of the 'sources' of foreign direct investment (FDI) inflow is revealing. To start with, not all of this is investment in greenfield projects. In the wake of liberalisation of ceilings on foreign shareholding, from the 40 per cent level required for national treatment under the Foreign Exchange Regulation Act (FERA), a number of companies already in operation in the country raised the foreign stake in their paid up capital through issue of new shares to the foreign investor. Many of those issues have occurred at prices way below the prevailing market values of the shares concerned, implying that the foreign stake has increased substantially based on a relatively small inflow of foreign capital.

Thus, during the first nine months (January-September) of 2001, the country witnessed a 40 per cent increase in actual FDI inflows, which touched $3,623.7 million as compared with $2,584.9 million in the corresponding period of the previous year. However, one reason for this sharp increase was the decision of a large number of international firms to buy back shares issued to domestic shareholders in their Indian subsidiaries, which too is considered as FDI and requires the approval of the Foreign Investment Promotion Board (FIPB). During the period, around 30 foreign companies decided to raise their stake in their Indian subsidiaries to 100 per cent and delist the companies from the stock market. The outlay for this made by these companies is estimated at $2 billion, or 55 per cent of the total FDI inflow during the period concerned. Since there would have been other companies that would have raised their stake without having bought out all shares held by those other than the foreign investor, the actual inflow on this count would amount to a substantial chunk of total FDI inflows.

Secondly, there has been a large number of cases of foreign firms acquiring wholly Indian ones, epitomised by the purchase of soft drinks giant Parle Exports by Coca-Cola. Data relating to inflows on account of acquisition of shares of Indian companies by non-residents under Section 29 of FERA is available from January 1996. The evidence shows that the share of FDI inflows on this account has been substantial in recent years, accounting for 23 per cent of the total in 1999-2000 and 15.5 per cent in 2000-2001.

The fact that FDI inflows do not always reflect investments in greenfield projects is not without significance. Both foreign firms set up during the years when FERA limited foreign shareholding to 40 per cent, and Indian companies established during the import substitution phase of Indian industrialisation, were created with the domestic market as their primary targets. In the case of foreign firms, quantitative restrictions and high tariffs forced those that could earlier service the Indian market with exports from the parent or third-country subsidiaries to jump tariff barriers and set up capacity within the domestic tariff area in defence of existing markets. On the other hand, the large market 'opened up' to domestic entrepreneurs by protection, which was expanding as a result of state investment and expenditure, provided a major stimulus for the creation of new indigenous firms by Indian industrialists to cater to the local market. Such protection also ensured that profit margins on domestic sales exceeded that on exports, encouraging firms to focus on production for the home market. The government itself did little to counter this tendency, generated in part by its own actions.

The inward-orientation of such firms was not merely because protection made the domestic market the target for these investors. Foreign firms, which either invested in domestic capacity or licensed their technologies to domestic firms, were not keen to encourage competition from capacity created in India in international markets being serviced by the parent firm or its third-country subsidiaries. Firms in India were virtually straitjacketed into servicing the large Indian market. The net result was that even when the world market for manufactures was expanding quite rapidly in the 1950s and 1960s, both foreign and domestic firms from India were conspicuous by their absence in the international markets.

Given the evolution of these firms, it should be expected that any increase in the equity stake of the foreign investors in existing joint ventures or purchase of a share of equity by them in domestic firms does not automatically change the orientation of the firm. This implies that if FDI inflows in the wake of liberalisation are directed at enhancing foreign equity in 'rupee companies' registered in India but controlled by foreigners or into the acquisition of Indian companies occupying a prominent place in the Indian market, the aim of the investor is to benefit from the profits being earned by such firms in the Indian market. As a result, in such cases FDI inflows need not be accompanied by any substantial increase in exports, whether such investment leads to the modernisation of domestic capacity or not. This fact counters the presumption of many advocates of reform who argue that in the context of globalisation FDI flows reflect the need of large international firms to seek out the best locations for world market production, resulting in a nexus between FDI and exports.

Finally, in recent years there has been an increase in FDI inflows into infrastructural areas such as power and telecommunications. This has been encouraged by the promise of high returns in these areas, which in some cases has been ensured by a state-guaranteed rate of return in foreign exchange terms. The logic on the basis of which such guarantees were provided to the 'fast-track' power projects was that adequate capital to invest in such areas was not available domestically. What was ignored was the difficulties that would arise when the foreign exchange costs of such investments had to be serviced. Most infrastructural projects produce 'non-tradable' services, or services that cannot be exported. Hence, if financed with foreign investment, such projects will not be able to earn the foreign exchange needed to service their external costs, which makes them adverse from a balance of payments point of view.

The net result of all this has been that studies of a varying sample of foreign direct investment companies (FDICs) by the Reserve Bank of India (RBI) shows that these firms have been characterised by a net outflow of foreign exchange in recent years. Net per-firm foreign exchange flows, which amounted to an inflow of Rs.44 lakhs in 1990-91 and Rs.219 lakhs in 1993-94, turned into an outflow of Rs.69 lakhs in 1994-95. That outflow had risen to Rs.1.2 crores by 1996-97. Even in 1990-91, firms in sectors such as Engineering and Chemicals, which were the ones receiving further investments in the subsequent years of liberalisation of FDI regulations, were registering large outflows. It was only because of the inflows into firms in traditional sectors such as Tea, Textiles and Leather, that the aggregate figure turned out to be positive. The evidence is clear that FDI of the kind that India has been receiving in the wake of liberalisation is a factor contributing to a foreign exchange drain rather than to an enhancement of India's foreign exchange earning capacity.

Seen in this light, the Panel's decision that binds the government's hands when it comes to making firms using foreign exchange earn the requisite amount of dollars allows for the possibility that foreign exchange expenditures of the manufacturing sector would far outstrip foreign exchange revenues. This could result in a build-up of foreign debt or a growing reliance on volatile portfolio flows, both of which increase India's balance of payments vulnerability and make it prone to crises of the kind that now routinely plague developing countries in Asia, Africa and Latin America. This makes nonsense of the official view that the DSB's decision relating to automobile production in India is of little relevance today.