002 MRK Pwr.... 1 Removed

19
Small-scale
Industrialisation
Small Industry
Rationale for Supporting Small-scale Enterprises
THE arguments advanced in the literature for promotion of small-
scale enterprises involve both certain desirable characteristics of such
enterprises and also a common belief that under normal market
conditions many such enterprises would not be able to survive in the
economy. A list of desirable characteristics of such enterprises include,
i n t e r a l i a , higher labour intensity and related positive income
distribution effects, their potential for balanced regional development
through greater decentralisation, their contribution to the promotion of
entrepreneurship, their flexibility in operation, and their ability to
export. If these positive characteristics are seen to be important and if
there is reason to believe that market failures inhibit the growth of small-
scale enterprises then it would be appropriate to frame policies that
attack these market imperfections.
It is believed that small-scale enterprises are hampered in their

growth because of imperfections in factor markets, in labour, capital
and land. Typically, the factor market most focussed on is the capital
market, distortions in which are seen to especially discriminate against
small-scale enterprises. Similarly, imperfections in the labour market
lead to factor price distortions causing larger than justifiable wage
differences between large and small enterprises. It can be argued,
1. This section draws liberally from Rakesh Mohan's paper "Small Scale Industry Policy in
India: A Critical Evaluation", Conference on Indian Economic Prospects: Advancing Policy
Reforms Centre for Research on Economic Development and Policy Reform, Stanford Uni-
versity. May 31-lune 1. WM
Small-scale Industrialisation 399
however, that the higher wages facing large firms can generally be
compensated by higher efficiency of the workforce so that the wage
cost difference per efficiency unit of labour is much less than the
observed difference in the prices of capital. Thus, it can be argued
that distortions in the capital market are much more important than
those in the labour market. Large firms are able to compensate the
higher wages through higher efficiency, but small firms are not able
to compensate for the high cost of capital through higher efficiency
of the capital used. Similarly in the land market small enterprises
could face greater regulatory hurdles in achieving appropriate access
to land.
The economic argument would then be that in the face of factor

market distortions special support policies for small-scale industries
would tackle the problems at their source. The best solution would be
to enact policies that remove the various factor market distortions that
are observed at their source. In practice, it is found that it is difficult
to remove such factor market distortions through direct interventions.
The result is that a whole plethora of other supportive policies for
small-scale enterprises are observed. India has differed from other
countries in its degreeof concern for supporting small-scale
enterprises. In fact, amongst developing countries, India was the first
to display special concern for small-scale enterprises, before it became
fashionable to do so. A basic focus of Indian government thinking has
been that employment generation is of paramount importance in a
labour surplus economy. Small enterprises manufacturing labour
intensive products make economical use of capital and absorb
abundant labour supply which characterises an under developed
economy. The belief has been that large enterprises are capital
intensive and reward only a small minority of labour which is skilled
and urban. Indian concern and support for small scale enterprises has
focussed excessively on small-scale industries as distinguished from
small-scale enterprises in general. This can perhaps be traced back to
Mahatma Gandhi's special concern for handicrafts and village-based
industries. In the nineteenth century, there was a widespread perception
in India that the import of mass-manufactured products had affected
millions of handloom textile workers and other craftspeople, and this
experience also contributed to the special concern for protecting SSIs.
All Industrial Policy Statements since Independence have provided

some special attention to the problem of small-scale industries.
400 Indian Economy: Performance and Policie.r
The basic structure of institutional promotion of small-scale

industries was put in place in the 1950s. This institutional structure had
aimed to provide for a development programme for small-scale
industries through the establishment of organisations for providing
technical assistance and industrial extension.
The basic idea then was promotion of small-scale enterprises

through positive technical and marketing support.
A policy of reserving items for the exclusive manufacture in the
small-scale sector began in 1967 when 47 items were reserved. This
number rose gradually to 180 by 1976. With the 1977 Industrial Policy
Statement a major expansion took place in the number of items
reserved for small-scale sector. A major shift in small-scale industry
policy took place with the promulgation of the Industrial Policy
Statement of 1977. It was then decided that the sole criterion for
reservation of products in the small scale sector would be merely its
ability to physically manufacture them. It was stated in the policy that
"whatever can be produced on a small scale must be so produced". The
regime for small-scale industry developed has remained virtually
unchanged after that.
The key elements of India's policy for the support of small-scale

industries have been small-scale industry reservations, fiscal
concessions by way of lower excise duties, preferential allocation of
and subsidisation of bank credit, extension of business services by the
government, and preferential procurement by the government. Thus,
small scale industry has been sought to be protected from the
competition of large companies both through reservations as well as
fiscal concessions. Extension of business services by the government
was considered necessary in the absence of equivalent services being
available in the private sector.
In his study Rakesh Mohan has argued that this support structure
may have reflected well the needs of the 1950s, 1960s and 1970s. The
argument is that these policies have now become obsolete and are now
likely to be harmful to the development of small-scale industries and of
industrial development in general. There has been vast growth of small
units over the years. Thus, the governmental structure for technical
support of small-scale industries has become both obsolete and
inadequate. There is now much greater availability of private sector
business and technological support service which should be fostered.
Second with the opening of the economy the reservation policy has
become counter productive. Third, the fiscal concessions can also be
operating so as to discourage growth into large units. Thus, it is argued
that a whole new approach for supporting small-scale industries has to
be adopted in India to serve the changing needs of the new open
economy.
Definition of Small-scale Industries

Most countries define small-scale industries or enterprises in terms
of employment levels. Usually small-scale industries are taken to be
those units which employ more than 5 but less than 50 or 100 workers.
India is among the few countries that has used investment ceilings to
define small-scale industries. Further, in India itself, different definitions
are used for different purposes. The Factories Act defines a factory as
one which employs 10 workers or more if the unit uses power, or 20
workers or more if it does not use power. All such units have to be
registered under the Factories Act and are subject to various labour laws
including the provision of medical insurance and some social security.
This is known as the registered sector. Within this definition, those units
which employ more than 50 workers (if using power) or more than 100
(if not using power) have to compulsorily register themselves with the
state governments in order to operate. The main source of data for
manufacturing is the Annual Survey of Industries (ASI). The coverage
of this survey is limited to those factories which are registered under
the Factories Act. The third definition is that used for giving fiscal
concessions. At present units which have less than Rs. 3 million turn
over are fully exempted from the excise taxes and there is a sliding scale
of concessions available for small-scale enterprises which have turnover
of upto Rs. 30 million.
In 1950, the investment limits was up to Rs. 0.5 million in fixed

assets employing less than 50/100 persons with or without power. From
1960 onwards, there are no conditions regarding employment but
investment limit has been raised to keep up with inflation and hence to
preserve the real value of investment limits. In 1966 Investment limit
was raised to 0.75 million in plant and machinery then 1 million in 1975,
2 million in 1980, 3.5 million in 1985, up to 6 million in 1991 and up
to 30 million in 1997. A curious development took place in 1999 when,
for the first time, a reversal in investment limit was put into effect by
lowering the investment limit to 10 million. The current definition is
therefore more restrictive in real terms relative to 1991.
The current status of the investment ceilings for small-scale

industries is provided in the following Statement.
402 Indian Economy: Performance and Policies
STATEMENT
Investment Ceilings for Small-scale Industry (December 1999)
Type of Small- Investment Limit Remarks

scale Industry
Small-scale Industry Rs. 10 million Historical cost of plant and
machinery
Ancillary Rs. 10 million At least 50 per cent of its
output should go to other
industrial undertakings
Export Oriented Rs. 2.5 million Obligation to export 30 per
cent of production
Tiny Enterprise Rs. 0.5 million No location limits
Service and
Business Enterprise Rs. 10 million No location limit
Women Enterprise Rs. 10 million 51 per cent equity holding
by women
Small Scale Reservation Policy

The policy of small-scale reservations was initiated in 1967 as a
promotional and protective measure for the small scale sector vis-a-vis
the large scale sector. Under this policy selected products are identified
for exclusive production in the small scale sector. The overwhelming
consideration for reservation is whether it is technically feasible to
produce that item in the small scale-sector, the manufacturing process
is of a simple nature i.e. is essentially labour intensive, and whether the
small scale units can meet the requirements of consumers both in terms
of quantity and quality. The rationale' for reservation was based on the
advantages of the small-scale sector like labour intensity and
adaptability to a semi-urban and rural environment. Another objective
was to make SSI products competitive with those of the large scale by
offsetting the disadvantage of mass scale production, economies of scale,
wider marketing network, better credit availability and publicity through
mass media and advertisements.
In April 1967 there were only 47 items in the reserved category

which increased to 504 by April 1978. In 1978 it was decided to recast
the reserved list by following codes adopted in the NIC and in this
process, the list of reserved items expanded from 504 to 804. The
number had increased to 873 in October 1984 and in 1989 after some
dereservation it came down to 836.
Throughout this whole period of reservation there has been little
analysis of the effects of this policy. The government has conducted
two small-scale industries censuses so far; one in 1972 and the other in
1987-88. The share of production in the reserved categories was 25 per
cent in total small-scale industry production in 1972 and 28 per cent in
1997-98. This small increase in the share was surprising given the large-
scale expansion of products under reservation that took place in 1977.
In both cases capacity utilisation in units producing reserved items was
47 to 48 per cent on average, whereas the average level of capacity
utilisation was over 50 per cent in units producing unreserved items. It
was also found in 1987-88 that a large number of reserved items were
not produced at all in any unit.
The second census of small scale industries provides persuasive

evidence of the misplaced importance given the policy of reservation.
Out of a total of 200 products leading in value of output produced by
the small scale sector, it was found that reserved products accounted
for only 21 per cent. Only 210,000 small scale units, less than half out
of a total of 5,82,000 units, manufactured the reserved products at all.
No less than 233 reserved items out of a total of 1,076 (when expanded
at a lower level of aggregation in the NIC code) were found not be
manufactured at all according to the census. Although further inquiries
have revealed that many of these products are found to be manufactured
by some units, the fact remains that their production is in negligible
quantities.
Conversely, very few of the reserved products attracted significant

levels of participation from small-scale units. As many as 90 products
were found to be manufactured by just one company each. The sum total
of the value of production of all small-scale companies in as many as
692 items was a low of Rs. 100 million or less. Just 68 reserved items
accounted for 81 per cent of the total value of production of reserved
products and 83 per cent of the units.
In recent years, with the opening of Indian trade almost 75 per cent
of all reserved items are now already importable with the removal of
quantitative restrictions (QRs) in the last few years. India is also
committed to remove the remaining QRs by April 2001. We, therefore,
now have a curious situation that the reserved items can be produced
by large foreign enterprises and imported into India whereas Indian large
enterprises are not allowed to produce the same items! Even this change
in the external environment has so far not persuaded the authorities to
change this policy of small-scale industry reservation.
404 Indian Economy: Performance and Polities
Reviewing the framework of Indian policies protecting and

supporting small-scale industries, Rakesh Mohan remarks, "That these
policies and programmes are thinly spread thereby leading to relative
ineffectiveness. Many of the policies are such that discourage growth
of small scale units into larger ones and thereby are likely to have a
stunting effect on manufacturing employment and output growth. Some
of these policies may have been useful in the earlier stage of Indian
industrialisation and in the context of a highly controlled and closed
economy. With all the changes in economic environment that have taken
place in the 1990s the indication is that future policies for the promotion
of small-scale industries must be more growth oriented and more general
rather than being sector oriented. It would be more useful if such
policies are designed to promote entrepreneurial entry, growth of
enterprises technology upgradation and labour productivity in a
pervasive manner regardless of specific sectors."
Spatial Distribution of SSEs

One of the aims of India's SSI policy was the dispersed development
of units in rural areas and in less developed 'backward' areas. There
has been only limited success in attaining this objective.
The SIDO figures suggest that 85 districts with more than 2,000
units in each account for 51 per cent of the total. More than 81 per cent
of SSEs are concentrated in 204 districts, and more than 50 per cent of
the districts do not have any significant number of small enterprises
(NCAER, 1993 3.7.6. p.81).
Rakesh Mohan argues, the objective of dispersal might be in conflict

with the dynamic growth of modern and efficient growth. There has been
important spatial concentration of SSEs in 'clusters' in particular product
lines. The external economies which these clusters generate in terms of
easy availability of raw materials, skilled labour, markets, etc. have been
known to have been instrumental in the growth of SSEs in many countries.
including Italy and Germany. India is proving no exception to this basic
economic impulse. It is appropriate that these trends might be more
emphatically encouraged in official policies and objectives. A closer look
needs to be taken at the methods for fostering development in 'backward
areas' through such methods as tax concessions and special allotment of
scarce materials.
Impact of SSI Reservation on Exports

According to Rakesh Mohan, the policy of small-scale industry
reservations has had a very deleterious effect on the growth of both
manufacturing employment and exports. An important feature of
industrialisation of the fast growing East Asian countries during the last
three decades or so has been high growth in manufactured exports
accompanied by high growth in manufacturing employment. The Indian
experience has been different. Our record of growth in manufacturing
employment has been poor and so has our export growth. The share of
exports in Indian GDP has barely reached 10 per cent now. Although
this is a significant improvement over the 3 per cent share of 1970 and
5 per cent in 1980, the Indian economy remains the least open among
major countries in Asia, including China. The volume of Indian exports
in 1970 was the third highest among the 10 Asian countries. Today it is
the second lowest. While Chinese exports grew from about US$ 18
billion in 1980 to about US $ 120 billion in 1994 Indian exports during
that period grew from US $ 8.6 billion to US $ 25 billion. Given that
the composition of exports of industrialising countries is largely labour
intensive, one of the reasons behind slow employment growth in
manufacturing in India is clearly related to the slow growth in exports.
It is possible that the damage caused by such policies was not very
high in the 1970s, when competition in exports of low technology
products was not as high as it is now. Furthermore, changing industry
structure and demand patterns in the developed world now place a much
higher premium on both product quality and service quality with the
inexorably rising incomes there. The average quality demanded for
products such as clothing, footwear, toys and sports equipment and the
like is getting higher and higher. Furthermore, the integration of
information technology in even these industries also requires greater
investment and greater labour sophistication. Such products are no longer
seen as free standing products but are increasingly becoming parts of long
value chains with the share of value added in plain manufacturing perhaps
falling. Higher quality requires high level designing upstream even for
simple products. Downstream marketing involves linkages with large
organisations which buy such products in bulk. Small enterprises
sandwiched between such high level organisations find it increasingly
difficult to operate and be competitive. Thus, apart from the loss that India
has suffered over the last 2-3 decades it is likely that the future scenario
will become even more difficult for Indian small enterprises to survive,
particularly in the reserved sector. Another issue of note is the prospective
dismantling of the Multi-Fibre Agreement. Paradoxically, although it may
have seemed that textile quotas were inhibiting Indian exports, it is likely
that we were actually protected through the MFA mechanism. This is
shown in Somnath Chatterjee and Rakesh Mohan (1993) who documented
406 Indian Economy; Performance and Policiej
the fact that Indian clothing exports went primarily to quota countries
and were almost absent in the markets of non-quota countries. Thus, the
removal of small-scale reservation is especially necessary in the items
affected by the removal of MFA.
Looking at the record of Indian exports in comparison with East

Asian countries, it is difficult to avoid the conclusion that Indian exports
have been heavily constrained by the policy of SSI product reservation.
The major conclusions of Rakesh Mohan's study are as below:
We may distinguish the 'small scale modern' sector—
consisting of units employing 6 or more workers and the 'tiny'
sector including household enterprises. In terms of
employment around 1990, the former accounted for roughly 20
per cent of all manufacturing employment, but nearly a half of
employment in the modern manufacturing sector. The tiny and
household sector is 2.5 to 3 times as large, depending on whether
or not we include secondary workers in the labour force. The
contribution of SSI in terms of value added is, of course, much
smaller—only a third as far as the modern manufacturing sub-
sector is concerned and no more than 40 per cent of all
manufacturing value added. The last point emphasises the
enormous difference in labour productivity between the
different sub-sectors of manufacturing.
As in other countries, the household sub-sector has declined

slowly over the last two or three decades. A more surprising
finding is that in spite of the vigorous policy of protecting the
small scale industry, this decline has not been fully
compensated for by the growth of non-household production in
the small-scale sector. The SIDO figures of high growth rates
of SSI's under their purview seem to be grossly
exaggerated.
In spite of the vast increase in the number of reserved items,

much of the growth in the SSI sector seems to have been in
product lines outside the reserved list. It is possible that the
policy of reservation might be merely protecting inefficient units
in stagnant industries.
A finding of some concern is the unequal distribution of units of
small and large sizes within the SSI sector. There seems to be an
increase in the concentration of output in larger units over the
last two decades. A comparison of the data from the
two SIDO censuses of 1972 and 1987-88 show a sharp fall in
the mean employment size but an increase in capital-intensity
of the SIDO units—which is consistent with a more skewed
distribution of enterprises, and increased contribution of the
more productive units.
The claim that there has been substantial dispersal of units to
backward and rural areas under the SSI policy might be
exaggerated. As far as the modern SSI's are concerned there
is considerable evidence of spatial concentration of SSE's in
`clusters' in specific product groups. We have already
emphasised in earlier chapters that there is a need for policies
of de-centralisation to come to terms with the economic logic
of external economies which 'clusters' provide.
All the evidence suggests that the Indian manufacturing sector

is likely to have been constrained by the various, anti-growth
policies promoting the small-scale sector, particularly that of
product reservation. Indian manufacturing employment growth has
been the lowest among large Asian countries over the past three or
four decades.
A particular casualty of SSI product reservations has been

growth in Indian manufacturing exports. A large number of
categories in which India exhibits comparative advantage have
been reserved for SSI. Consequently, Indian industry is unable to
upgrade quality on a continuous basis and is also not able to
diversify to higher technology and higher value added item, thereby
stunting export growth.
New Small Enterprise Policy

The document on the new small enterprise policy (NSEP) titled
`Policy Measures for Promoting and Strengthening Small, Tiny and
Village Enterprises' was tabled in the Parliament on August 6, 1991.
The NSEP is presented under the major heads of (a) small and tiny
enterprises, and (b) village industries. Since the emphasis on objectives
in the NSEP of these two groups is not the same, as also because the
measures proposed for them are substantially different, it is best to
examine the NSEP separately under these heads.
S m a l l a n d T i n y E n t e r p r i s e s
The primary objective of the NSEP as mentioned under the above
head, is to impart "more vitality and growth impetus". In as-much-as
408 Indian Economy: Performance and Policia
vitality is founded basically on cost-efficiency, and is prone to promote

growth. the NSEP may be said to have for this sub-sector, the objective
of increase in efficiency, and through it to promote growth of output,
employment and exports". In this context. a number of changes are
proposed, but four, according to Sandesara, are path-breaking.' They
are discussed in detail below.
First, the definition of a tiny unit is changed, and this change is

two-fold. It may be recalled that the Industrial Policy of May 1990 had
announced an increase in the investment limit of tiny units from
Rs. 2 lakh to Rs. 5 lakh. However, it had retained the location
requirement to villages and smaller towns (limit of 50,000 population).
The NSEP has done away with this requirement. The population of tiny
units will, thus, increase, as all units within the investment limit of
Rs. 5 lakh and located in bigger towns (population of 50,000 plus) will
now become a part of the tiny group.
The other definitional change is more basic. Earlier, 'industry'

meant, by and large, manufacturing industry. The NSEP has widened
the scope to include industry-related services and business enterprises
also. All such enterprises, irrespective of their location are now
recognised as small-scale industries, but their investment ceiling
corresponds to those of tiny enterprises. What we really have now, is,
thus, a tiny enterprise/business policy instead of a tiny industry
(manufacturing) policy as earlier. Thus, this change also increases the
number of enterprises in the small sector, more than in the tiny group.
This is to be welcomed for three reasons. First, service and business

activities are more labour-intensive than manufacturing activities. Thus,
state assistance to these a c t i v i t i e s will subserve the employment
objective. Second, of late, a number of large, high wage/salary paying
companies in the manufacturing sector have been getting considerable
auxiliary, servicing work done from outside—from smaller, low wage/
salary enterprises to reduce the costs of such services. Among such
activities are: cleaning, security, typing, transportation and distribution,
catering, etc. Partly because of this as also because of other
developments, over the years the tertiary sector has grown greatly in
relative terms, following the growth of the secondary sector. To illustrate,
the former's share in gross domestic product increased from 28 per cent
in 1950-51 to 39 per cent in 1989-90 and the latter's from 15 per cent
to 27 per cent, with a corresponding decline in the share of the primary
2. Sandesara, J.C. "Small Enterprise Policy: Implications and Prospects", in Uma Kapila (ed.),
Indian Economy Since Independence 2000-01 edition, Academic Foundation, New Delhi.
sector from 56 to 24 per cent over the same period. With its share of
nearly two-fifths, the tertiary sector has now become the largest, and
cannot be neglected by the state. Third, in the US, in the UK and in a
number of other countries, for the small sector, it has been really a small
business policy and not a small industry policy. It is, thus, in the fitness
of things that the NSEP includes non-manufacturing service enterprises.
The third major change relates to equity participation. The NSEP

provides for equity participation by other industrial units in the small
industrial units not exceeding 24 per cent of the total shareholding. This
provision should prove mutually beneficial both to large units and the
small units, especially ancillary units, and cement further the economic
bonds between the two sectors. Marketing is one of the most difficult
problem of small industry, and ancillarisation takes care of this problem
in varying measures. Large units are also known to take care of the
working capital and quality problems of small units, by giving them
advances and by making available their testing facilities. The provision
of equity participation not only relieves the small units of the burden
of full equity funding, but it also builds up the stakes of large units in
the survival and growth of small units.
The fourth special feature of the NSEP is the introduction of a new

legal form of organisation of business, namely, restricted or limited
partnership. In this form, the liability of at least one partner is unlimited,
whereas other partners have their liability limited to invested capital.
Following the example of the US and Japan, the A.R. Bhatt Committee
had recommended the introduction of this form of organisation in the
70s, but no follow-up action seems to have been initiated until the NSEP.
This is a welcome provision. It will attract equity capital especially from
friends and relatives of the entrepreneurs of small units, who may like
to help their kith and kin, but who fight shy because of unlimited
liability in the partnership firm (under which a large number of small
units are organised). On the other hand, small units short of funds but
wishing to avoid sharing of decision-making will welcome augmentation
of risk capital from such sleeping partners.
Village Industries
Although the objectives and policy measures for village industries
are presented separately for handlooms, handicrafts and other village
industries, there is a lot that is common for them in the NSEP as regards
both objectives and measures. To avoid repetition, it may therefore be
best to examine first the proposals of the NSEP for these industries
together and then draw attention to their special features individually.
A major objective for the group of village industries seems to be,

as the word village suggests, to promote rural industrialisation. The
other major objective is to promote employment, with a view especially
to help the weaker sections of society. Thus, here, employment is more
welfare-oriented than efficiency-oriented.
A number of measures are proposed to serve these objectives.

Almost all the measures are of routine type, and relate to supply of raw
materials, sale of products, upgradation of production methods and
improvement in the quality of products, expansion of training facilities,
strengthening of the existing support organisations, etc.
The NSEP has broadened the definition of 'tiny' and 'women'

enterprises. It has also introduced a new form of legal organisation—
restricted partnership—to enable small units to raise equity from private
sources. It also permits limited equity participation by other industrial
enterprises. It also envisages greater role of non-government agencies
like co-operatives, industry associations, voluntary agencies and the like
in administering some assistance programme. It also speaks of
simplifying rules and procedures.
Performance of Small-scale Industries

The performance of small-scale industries sector in terms of critical
parameters like number of units (both registered and unregistered),
production, employment and export is given in the Table 19.1.
According to Economic Survey 2006-07, the micro and small
enterprises (MSEs) constitute an important segment of the Indian
economy, contributing around 39 per cent of the country's
manufacturing output and 34 per cent of its exports in 2004-05. It
provides employment to around 29.5 million people in the rural and
urban areas of the country (Table 19.1).
This sector has the second largest share of employment after

agriculture and spans a wide range, including small-scale, khadi, village
and coir industries, handlooms, handicrafts, sericulture, wool,
powerlooms, food processing, and other agro and rural industry
segments. It touches the lives of the weaker and unorganized sections
of the society with more than half of those employed being women,
minorities, and the marginalized. Fifty seven per cent of the MSE units
are owner-run enterprises with one person. They account for 32 per cent
of the workforce and 29 per cent of the value added in nonagricultural
private unincorporated enterprises. Infusion of appropriate technology,
design skills, modern marketing capacity building and easier access to
credit can make this segment an expanding base for self-sustaining
employment and wealth generation and also foster a culture of creative
and competitive industry. Agro-food processing, sericulture and other
village enterprises can check rural-urban migration by gainfully
employing people in villages. This will also take pressure off
agriculture. The MSE sector can open up a window of opportunities in
regions like the North East where large industries cannot be set up due
to infrastructure gap & environmental concerns.
TABLE - 19.1
Performance of Micro and Small-scale Enterprises
Year No. of units (lakh) Production (Rs. crore)
Employ-
ment Exports
Regd. Unregd. Total (at current (at constant (in (Rs.
prices) prices) lakh) crore)
2002-03 15.91 93.58 109.49 3,11,993 2,10,636 260.21 86,013
(4.1) (10.5) (7.7) (4.4) (20.7)
2003-04 16.97 96.98 113.95 3,57,733 2,28,730 271.42 97,644
(4.1) (14.7) (8.6) (4.3) (13.5)
2004-05 17.53 101.06 118.59 4,18,263 2,51,511 282,57 1,24,417
(4.1) (16.9) (10.0) (4.1) (27.4)
2005-06 18.71 104.71 123.42 4,76,201 2,77,668 294.91 N.A.
(4.1) (13.9) (10.4) (4.4)
Note : Figures in parentheses indicate percentage growth over previous years.

Source : Development Commissioner (SSI).
Several ministries/departments/institutions deal with activities

falling within the domain of the MSE sector, and have a variety of
schemes to support the MSEs. However, the benefits accrue to only a
small fraction of MSEs as only 13 per cent are registered. In the 11th
Plan we need to adopt a dual strategy to ensure that the unregistered
micro and small enterprises and units outside the cooperative fold are
encouraged to get themselves registered and are also able to benefit
from government schemes, pending registration. In fact, the provision
of voluntary filing of enterprise memoranda by micro and small
enterprises in the new Micro, Small and Medium Enterprises
Development Act, 2006 is a step in that direction and' should be
implemented energetically.
The Approach Paper to the 11th Plan states there is need to change
the approach from emphasis on loosely targeted subsidies to creating
an enabling environment. A cluster approach can help increase viability
by providing these units with infrastructure, information, credit, and
support services of better quality at lower costs, while also promoting
their capacity for effective management of their own collectives. The
11th Five Year Plan should restrict subsidies to those needed to create
a level playing field and to reflect the costs or benefits to others in the
society. It should incentivize innovation and creativity. It should remove
all entry barriers and mitigate business risks for start-ups, the latter,
inter-alia, through a large number of well-managed business incubators
in the identified thrust areas of manufacturing. It should provide
infrastructure and liberate MSEs from the inspector raj. Further, in order
to improve the competitiveness of these micro, small and medium
enterprises, schemes for establishment of mini tool rooms, setting up
design clinics, providing marketing support, sensitization to IPR
requirements and tools, adoption of lean manufacturing practices, wider
use of IT tools, etc., should be evolved on a PPP basis. Brand building
can be used as an effective strategy to promote their products in national
and international markets.
After due consultation with the stakeholders, 180 items reserved

for exclusive manufacture in micro & small enterprises have been de-
reserved on May 16, 2006 and 87 such items have been dereserved on
January 22, 2007.
The logic of reserving items for domestic production exclusively

in the small-scale sector, particularly when such products can be freely
imported from large-scale production units abroad and when such a
policy prevents the 'small' from growing and benefiting from the
economies of scale, has progressively come under serious questioning.
However the question that needs to be addressed is whether the
reservation in the small scale sector is based on any objective policy
parameter. The process of reservation of items for production
exclusively by the small-scale sector started in 1967 and reached its
peak in 1984 with 873 items reserved for small-scale. There has been
a gradual relaxation of the reservation policy over time, and the number
of items reserved for the small-scale sector was 239 on January 22,
2007.
4 14
Role of Foreign Capital*
Introduction
THE growth-augmenting role of external trade and foreign capital
flows has assumed critical importance in India in recent years. The
overall shift in the policy stance in India from export pessimism and
foreign exchange conservation to one that assigns an important role to
export of goods and services in the growth process has primarily been
guided by the perception that an open trade regime could offer a
dynamic vehicle for attaining higher economic growth.
Structural reforms and external financial liberalisation measures

introduced in the 1990s in India brought in their wake surges in capital
flows as well as episodes of volatility associated with the capital account
dictating the balance of payments outcome. Large capital inflows
enabled an easing of resource constraints and an acceleration of growth
in the mid-1990s. In the second half, the foreign exchange market
developments as well as the rapid transmission of international sell-offs
facilitated by cross border integration of equity markets via capital flows
have provoked a reassessment of the benefits and costs of employing
capital flows as a lever of growth. Throughout the 1990s, the role
assigned to foreign capital in India has been guided by the
considerations of financing a level of current account deficit that is
sustainable and consistent with the absorptive capacity of the economy
(Rangarajan, 1993; Tarapore, 1995; Reddy, 2000). In the aftermath of
South-East Asian crisis, however, the need for further strengthening the
capacity to withstand vulnerabilities has necessitated a shift in policy
that assigns greater weightage to stability (Reddy, 2000).
The experience of developing countries with harnessing capital

flows for growth over the last two decades has been mixed. The actual
* This chapter is extensively drawn from ch. VI of RBI Report on Currency and Finance, 2000-01,
Role of Foreign Capital 415
impact of capital flows on economic growth varies widely across
countries, depending on country-specific conditions and the nature of
policies for external capital. Accordingly, it becomes necessary to
empirically evaluate each country's experience in terms of the specific
role assigned to foreign capital in the process of development. This
includes an assessment, however subjective, of the negative externalities
associated with capital flows. Negative externalities could emanate both
during periods of surges and sudden reversals. Besides real appreciation
of the exchange rate, surges in capital flows could facilitate imprudent
lending and overheating associated with excessive capacity addition,
which may give rise to banking crises. Sudden reversals of capital flows,
particularly in cases of short-term banking flows and portfolio flows,
could trigger sudden collapse of asset prices and exchange rate and
thereby adversely affect growth.
This Chapter undertakes an empirical assessment of the contribution
of foreign capital to the growth process in India. Macroeconomic
analysis weighing the role of foreign capital vis-à-vis exports (of goods
and services) as a growth accelerator in a developing country context
is presented in Section I. Section II encapsulates the important features
of the role of foreign capital by drawing on the theoretical and empirical
literature on the subject. Different viewpoints on the role of alternative
forms of foreign capital and the changing importance of each form of
capital over time are also discussed. A brief overview of the Indian
policy framework for attracting foreign capital during the period of
planned development is set out in Section III, with specific empirical
findings presented in the context of the shifts in the policy regime.
Section IV suggests a realistic FDI Policy. This is followed by
concluding observations.
I
FOREIGN CAPITAL VERSUS EXPORT-LED GROWTH
The standard analysis of growth accounting in an open economy

encounters an apparent contradiction between 'export led growth' on
the one hand, and 'capital-flow induced growth' on the other, even
though in reality both strategies could be operationalised simultaneously
to strengthen the growth process. The apparent contradiction arises from
the macroeconomic identity [Y = C + I + G + (X - M)] which suggests
that while a surplus in the external goods and services account—
reflecting the result of an export-led growth strategy—could increase
416 Indian Economy: Pe rf ormance and Policies
GDP, that would tantamount to no role for net external financing as the
country must necessarily save more than it can invest, leading to net
capital outflows. The underlying assumption behind this assessment is
that an export-led growth strategy can stimulate growth only by
generating a surplus in the external goods and services account. The
actual external resource transfer process and the stages over which the
importance of each form of transfer changes can explain how a
developing country could simultaneously benefit from both export-led
and capital-flow-induced growth strategies.
In a developing country, the consumption level lags behind the

consumption standards of advanced economies and the marginal
productivity of investment is higher. A deficit in the goods and services
account and the associated net capital inflows can not only enable the
economy to bridge its consumption gap but also help in achieving output
convergence with the advanced economies. An export-led growth
strategy could enhance the ability of a developing country to achieve
this goal faster by allowing higher levels of sustainable imports.
Sustainable capital inflows to finance the gap so created would be
growth enhancing. In small open economies, a surplus generated in the
trade (for goods and services) account could raise GDP. Residents would
increase their external financial assets, acquired in exchange of real
resources through the trade surplus. Financial assets, in turn, represent
command over future goods and services. An open capital account in
such economies helps in allowing freedom of portfolio adjustment and
consumption smoothing to each resident. Small open economies,
however, depend largely on external demand conditions for sustaining
the export-led growth. A slowdown in external demand conditions can
give rise to a large scale deceleration in domestic GDP growth in such
economies. For example, Singapore's external current account exhibited
large surplus in recent years (in excess of 20 per cent of GDP) indicating
the role of net exports in growth (IMF, 2001).
There are three possible types of resource transfers in the external

account, viz., 'real against real', 'financial against real' and 'financial
against financial'. Priority is generally assigned to 'real against real'
form of resource transfers in the initial years of development. As a
result, exports are regarded essentially as the means to pay for imports.
Since the demand for certain critical real resources may exceed what
could be made available domestically or what could be financed through
export earnings, a bridging role emerges for financial transfers in the
form of capital flows. With modest and gradually increasing recourse
to 'real against financial' form of transfer, a role for foreign capital is
envisaged. Only over time, 'financial against financial' form of
transfers—representing an open capital account—can occur. Even
though country-specific approaches to timing and sequencing often
widely differ, three phases for debt related capital flows could be
conceived. In the first phase, the country operates with a resource gap
that is financed by inflows of debt capital. During this phase, debt grows
faster than debt servicing. In the second phase, the country generates a
positive resource balance (in the goods and services account) in the
current account, but the debt servicing exceeds the positive resource
balance, giving rise to further addition to debt stock. In phase three,
the positive resource balance position becomes more than sufficient to
finance the debt servicing obligations. As a result, residents accumulate
external assets and the need for debt flows to finance the resource gap
disappears (Simonsen, 1985).
India could conceptualy be placed at present in phase-1 of this

cycle. An export-led growth strategy—that ensures export growth to
continuously exceed the interest rate on debt—would enable India to
raise its per capita GDP to the threshold level beyond which generation
of a surplus balance in the current account could enable the residents
to accumulate foreign assets. A possible threshold level of per capita
GDP for the developing countries in general could be about US $ 1,000.
Effective use of trade as an engine of growth could help India in
achieving a faster transition to the next phase of the cycle while at the
same time internalising the benefits of growth impulses associated with
a more open trade regime.
II
THE DEBATE ON THE ROLE OF FOREIGN CAPITAL
Theoretical and empirical research on the role of foreign capital in

the growth process have generally yielded conflicting results.
Conventionally, the two-gap approach justifies the role of foreign capital
for relaxing the two major constraints to growth—the saving constraint
or gap and the foreign-exchange constraint or gap.* (Chenery and Bruno,
1962; McKinnon, 1964). In the neo-classical framework, however,
capital neither explains differences in the levels and rates of growth
* Saving-investment gap i.e. resource gap between targeted or desired investment and locally
mobilised savings.
The second contribution, analogous to the first, is its contribution to fining the gap between
targeted foreign-exchange requirements and those derived from net export earnings plus net
public foreign aid. This is the so-called foreign-exchange or trade gap (Todaro 2004, p. 639).
across countries nor can large capital flows make any significant
difference to the growth rate that a country could achieve (Krugman,
1993). In the subsequent resurrection of the two-gap approach, the
emphasis was generally laid on the preconditions that could make
foreign capital more productive in developing countries. The important
preconditions comprised presence of surplus labour and excess productive
demand for foreign exchange. With the growing influence of the new
growth theories in the second half of the 1980s that recognised the effects
of positive externalities associated with capital accumulation on growth,
the role of foreign capital in the growth process assumed renewed
importance. In the endogenous growth framework, the sources of growth
attributed to capital flows comprise:
the spillovers associated with foreign capital in the form of

technology, skills, and introduction of new products;
the positive externalities in terms of higher efficiency of
domestic financial markets;
improved resource allocation and efficient financial
intermediation by domestic financial institutions (de Mello and
Thea, 1995; Bailliu, 2000).
The marginal productivity of capital in India was 58 times that of
the United States as obtained through the standard estimation of Cobb-
Douglas production functions (Lucas, 1990; Taylor, 1994). India,
however, could never attract enough foreign capital to take advantage
of the productivity differentials. Unlike the wide differences in estimated
productivity of capital, however, real interest rates—a measure of real
return received by the investors—turned out to be much less divergent
across countries in reality. Capital markets could be imperfect,
preventing capital flows from being driven by productivity differentials.
Incremental investment would be more productive in countries with
skilled workforce and well developed physical infrastructure. Thus, the
presence of internal growth supportive factors appear important, not
only for attracting higher private foreign capital but also for enhancing
the growth inducing effects of such foreign capital (Lucas, op.cit).
In the recent period, studying the growth augmenting role of various

forms of foreign capital has gained prominence over the general
analysis. The findings of these studies can be conveniently grouped
under the classification adopted in the analysis of the balance of
payments in India. This would also reflect the current ordering of capital
flows by type from the point of view of the policy stance (Reddy, 1998).
Foreign Direct Investment
Capital flows in the form of FDI have been widely believed to be
an important source of growth in recent years. Since the 1970s,
imperfections in goods and factor markets, presence of scale economies
and government restrictions on output, trade and entry have come to be
recognised as creating market structures where foreign capital in the
form of FDI contributes to growth (Kindleberger, 1969; Hymer, 1976).
It is eminently plausible that FDI flows might not have existed but for
the presence of these imperfections. The theories of international resource
allocation based upon the spatial distribution of factor endowments
suggest the importance of "locational advantages" as a key driver of FDI
flows while the theories of organisation point to the role of "ownership
advantage" and the advantage of "internalising intangible assets (like
technology, brand name and marketing skills)". Competitive policies of
nations to attract FDI often work towards reducing the cost of production
in a host country. Favourable tax treatment, protected domestic market
and low labour costs represent the primary pull factors for FDI. Sound
policies, strong and resilient financial systems and liberal exchange
control norms also help in creating the congenial environment for
augmented inflows under FDI.
Growth impulses originating from FDI are primarily ascribed to

superior technology and greater competition that generally accompany
FDI. Local firms of many developing host countries also do not invest
enough on R&D to offer and sustain competition with Transnational
Corporations (TNCs). Investment on R&D by TNCs in foreign affiliates
is, however, found to be low, accounting for as little as 1 per cent of
the total R&D investment even though TNCs are generally viewed as
R&D intensive (UNCTAD, 1999). Despite the usual concerns that
inappropriate technology is generally transferred to the foreign
affiliates, empirical assessments suggest that technology—both public
and private—that accompany FDI are complementary and inter-firm
collaboration helps in augmenting growth. In such cases also FDI may
augment growth in a country if its initial technology gap is higher and
openness to FDI is significant.
Whether FDI promotes competition or facilitates development of

oligopolistic structures depends upon whether FDI crowds-out or
crowds-in domestic investment. FDI can potentially displace domestic
producers by preempting their investment opportunities. It is possible,
however, that the adverse growth effect emanating from crowding-out
could be more than offset by the increase in productivity resulting from
advanced technology that often accompanies FDI.
420 Indian Economy Pe rf ormance and PoficieJ
Since trade is an important vehicle for growth, FDI could also

contribute to growth by promoting exports. For sustaining an export-
led growth strategy, it becomes important to attain dynamic shifts in
comparative advantage and FDI can play a major role in imparting the
desired dynamism on account of its global marketing network.
Portfolio Capital
Portfolio capital has emerged as the key channel for integrating
capital markets worldwide. For developing countries, the growth process
in the initial phase is often characterised by self-financed capital
investment, which is replaced gradually by bank-intermediated debt
finance and supplemented over time by both debt and equity from the
capital market. Portfolio capital flows can ease the constraint on growth
imposed by illiquid and small sized capital markets in the early and
intermediate stages of the growth process. Countries that reduced
barriers to portfolio flows exhibit significant improvements in the
functioning of their stock markets. Greater liquidity in the capital market
makes it possible to take up investment projects in developing countries
that require lumpy and long-term capital. Equity, unlike debt, allows a
permanent access to capital.
Surges in portfolio flows can, however, adversely affect growth.

Greater liquidity and opportunities for risk diversification may reduce
household saving and excess volatility in the stock market may hinder
investment. The problem of market imperfection and asymmetric
information amplifies the volatility resulting from sudden shifts in the
pattern of portfolio flows. Portfolio flows can hinder export promotion
by exerting upward pressures on the exchange rate and also sustain an
import-cum investment boom to overheat the economy. Unlike FDI, for
the portfolio flows there is no one-to-one relationship with real
investment. When portfolio activities are entirely concentrated in the
secondary market, there is no direct link with real investment in the
economy. At the macro level, portfolio flows finance the current account
gap when alternative forms of foreign capital prove inadequate.
Otherwise, it is only by enhancing the efficiency and liquidity of capital
markets that portfolio flows can propel growth.
External Aid
The role of external aid in enhancing growth has waned in recent
years. In several developing countries, including India, public and
publicly guaranteed capital flows have been supplanted by a growing
recourse to private capital flows. In some countries, the problem of
negative resource transfer associated with aid has emerged as an
additional balance of payments/growth constraint. Except for the poorest
countries and those with very limited access to commercial capital, a
general sense of aid fatigue has set in. Donors have also gradually de-
emphasised the role of aid in international economic relations resulting
in a significant decline in aid flows as percentage of GDP of the donors
since the 1960s.
External aid was initially equated with the need for resource transfer
to ease the financing constraint to growth. The major contradiction that
surfaced soon was that while the poorest countries had the greatest need
for external aid, their capacity to absorb foreign aid was highly
unsatisfactory. In the 1980s, structural reforms were seen as the key to
promote growth and the earlier project-linked aid strategy was
supplemented by non-project linked structural adjustment lending as an
additional instrument to augment growth. Lack of sound policy
environment in the aid receiving countries has operated as a major factor
in eroding aid effectiveness (World Bank, 1998). Despite the general
dissatisfaction with aid effectiveness, factors such as lower cost and
higher maturity of aid in relation to commercial loans has encouraged
many developing countries to maintain their access to aid flows.
An orderly transition from aid dependence to market access for

foreign capital is being pursued by several developing countries. A
number of countries have successfully accessed international markets
and raised adequate levels of private capital to meet the financing gap.
It is also being increasingly highlighted that 'more aid' policy should
give way to 'more trade', requiring a change in the policy stance of the
donors to liberalise their extant restrictions on exports from aid-
receivers so as to allow them to reap the benefits of their true
competitive advantage and in that process to reduce their dependence
on aid.
Commercial Debt Capital

Commercial debt capital includes a whole range of sources of
foreign capital where the overriding consideration is commercial, i.e.
risk adjusted rate of return. External commercial loans could include
bank loans, buyer's credit, supplier's credit, securitised instruments such
as Floating Rate Notes and Fixed Rate Bonds, and commercial
borrowings from the private sector window of multilateral financial
institutions.
It is generally believed that the potential of banking capital in

augmenting growth would be largely realised in a strong and resilient
domestic financial system with effective supervision and regulation.
Despite the diversification in the 1990s in favour of commercial
borrowings from the market, loans from banks continue to dominate the
commercial debt segment for the developing countries.
III
CAPITAL FLOWS AND GROWTH IN INDIA:

THE RECENT EXPERIENCE
Capital flows into India have been predominantly influenced by the

policy environment. Recognising the availability constraint and
reflecting the emphasis on self-reliance, planned levels of dependence
on foreign capital in successive Plans were deliberately held at modest
levels. Economy in the recourse to foreign capital was achieved through
import-substitution industrialisation in the initial years of planned
development. The possibility of exports replacing foreign capital was
generally not explored until the 1980s. It is only in the 1990s that
elements of an export-led growth strategy became clearly evident
alongside compositional shifts in the capital flows in favour of
commercial debt capital in the 1980s and in favour of non-debt flows
in the 1990s. The approach to liberalisation of restrictions on specific
capital account transactions, however, has all along been against any
`big-bang' (Box 20.1).
BOX — 20.1
Role of Capital Controls in Stabilising the Growth Process

The Indian Approach
India considers liberalisation of capital account as a process and not

as a single event. While relaxing capital controls, India makes a clear
distinction between inflows and outflows with asymmetrical treatment
between inflows (less restricted), outflows associated with inflows
(free) and other outflows (more restricted). Differential restrictions are
also applied to residents vis-a-vis non-residents and to individuals vis-a-
vis corporates and financial institutions. A combination of direct and
market-based instruments of control is used, meeting the requirements of
a prudent approach to management of the capital account. The
Contd. ...
...Contd. ...
control regime also aims at ensuring a well diversified capital account

including portfolio investments and at changing the composition of
capital flows in favour of non-debt liabilities and a higher share of
long-term debt in total debt liabilities. Thus, quantitative annual
ceilings on external commercial borrowings (ECB) along with maturity
and end use restrictions broadly shape the ECB policy. Foreign direct
investment (FDI) is encouraged through a progressively expanding
automatic route and a shrinking case-by-case route. Portfolio
investments are restricted to select players, particularly approved
institutional investors and the NRIs. Short-term capital gains are taxed
at a higher rate than longer-term capital gains. Indian companies are
also permitted to access international markets through GDRs/ADRs,
subject to specified guidelines. Capital outflows (FDI) in the form of
Indian joint ventures abroad are also permitted through both automatic
and case-by-case routes. The Committee on Capital Account
Convertibility (Chairman: Shri S.S. Tarapore) which submitted its
Report in 1997 highlighted the benefits of a more open capital account
but at the same time cautioned that capital account convertibility (CAC)
could cause tremendous pressures on the financial system. To ensure a
more stable transition to CAC, the Report recommended certain
signposts and preconditions of which the three crucial ones relate to
fiscal consolidation, mandated inflation target and strengthened
financial system. International developments, particularly the initiatives
to strengthen the international architecture for dealing with the
problems arising in the capital account of a country's balance of
payments, would also influence the timing and sequencing of CAC in
India.
A large part of the net capital flows to India in the capital account
is being offset by the debt servicing burden. As a consequence, net
resource transfers have fluctuated quite significantly in the 1990s,
turning negative in 1995-96.
Till the early 1980s, the capital account of the balance of payments
had essentially a financing function (Rangarajan, 1996). Nearly 80 per
cent of the financing requirement was met through external assistance,
Aid financed imports were both largely ineffectual in increasing the rate
of growth and were responsible for bloating the inefficient public sector
(Kamath, 1992). Due to the tied nature of bilateral aid, India had to
pay 20 to 30 per cent higher prices in relation to what it could have got
through international bidding (Riddell, 1987). The real resource transfer
associated with aid to India, therefore, was much lower. There were
occasions "when India accepted bilateral aid almost reluctantly and
without enthusiasm because of the combination of low priority of the
project and the inflated price of the goods". The Report of the High
Level Committee on Balance of Payments (1993) identified a number
of factors constraining effective aid utilisation in India and underscored
the need to initiate urgent action on both reducing the overhang of
unutilised aid and according priority to externally aided projects in
terms of plan allocations and budgetary provisions. Net resource transfer
under aid to India, however, turned negative in the second half of the
1990s.
In the 1980s, India increased its reliance on commercial loans as

external assistance increasingly fell short of the growing financing
needs. The significant pressures on the balance of payments as the
international oil prices more than doubled in 1979-80 and the world
trade volume growth decelerated sharply during 1980-1982, triggered
an expansion in India's portfolio of capital inflows to include IMF
facilities, greater reliance on the two deposit schemes for non-resident
Indians—the Non-Resident External Rupee Accounts (NRERA) (that
started in 1970) and Foreign Currency Non-Resident Account (FCNRA)
(that started in 1975)—and commercial borrowings on a modest scale.
A few select banks, all-India financial institutions, leading public sector
undertakings and certain private corporates were allowed to raise
commercial capital from the international market in the form of loans,
bonds and Euro notes.
The policy approach to ECB has undergone fundamental shifts since

then with the institution of reforms and external sector consolidation in
the 1990s. Ceilings are operated on commitment of ECB with sub-
ceilings for short-term debt. The ceiling on annual approvals has been
raised gradually. The focus of ECB policy continues to place emphasis
on low borrowing cost, lengthened maturity profile (liberal norms for
above 8 years of maturity), and end-use restrictions.
Given the projected need for financing infrastructure projects, 15

per cent of the total infrastructure financing may have to come from
foreign sources. Since the ratio of infrastructure investment to GDP is
projected to increase from 5.5 per cent in 1995-96 to about 8 per cent
by 2006, with a foreign financing of about 15 per cent, foreign capital
of about 1.2 per cent of GDP has to be earmarked only for the
infrastructure sector to achieve a GDP growth rate of about 8 per cent.
NRI deposits represent an important avenue to access foreign
capital. The policy framework for NRI deposits during 1990s has offered
increased options to the NRIs through different deposit schemes and
by modulation of rate of return, maturities and the application of Cash
Reserve Ratio (CRR). In the 1990s, FCNR(B) deposit rates have been
linked to LIBOR (London Inter-Bank Offer Rate) and short-term
deposits are discouraged. For NRERA, the interest rates are determined
by banks themselves. The Non-Resident (Non-Repatriable) Rupee
Deposit [NR(NR)RD] introduced in June 1992 is non-repatriable,
although interest earned is fully repatriable under the obligation of
current account convertibility subscribed to in 1994. In the 1990s, NRI
deposits remained an important source of foreign capital with the
outstanding balances under various schemes taken together rising from
about US $ 10 billion at the close of 1980s to US $ 23 billion at the
close of 2001. Capital flows from NRIs have occasionally taken the form
of large investments in specific bonds, i.e., the India Development Bond
(IDB) in 1991, the Resurgent India Bond (RIB) in 1998 and India
Millennium Deposits (IMD) in 2000.
The need for supplementing debt capital with non-debt capital with
a clear prioritisation in favour of the latter has characterised the
government policy framework for capital flows in the 1990s. The High-
Level Committee on Balance of Payments recommended the need for
achieving this compositional shift. A major shift in the policy stance
occurred in 1991-92 with the liberalisation of norms for foreign direct
and portfolio investment in India.
The liberalisation process started with automatic approval up to 51

per cent for investment in select areas. Subsequently, the areas covered
under the automatic route and the limits of investment were raised
gradually culminating in permission for 100 per cent participation in
certain areas (particularly oil refining, telecommunications, and
manufacturing activities in Special Economic Zones).
Foreign investment responded favourably to the liberalised policy

environment and the generalised improvement in macroeconomic
conditions. By 1993-94, FDI and portfolio flows taken together emerged
as the most important source of external finance and non-debt flows
exceeded net debt flows in the form of NRI deposits, external
commercial borrowings and external assistance. Since then, foreign
investment has remained as the most important form of external
financing for India.
It is difficult to assess the direct contribution of these flows,

particularly FDI, to the growth process. Anecdotal evidence suggests
that foreign-controlled firms often use third-party exports to meet their
export obligations (Athreye and Kapur, 2001). Another factor that
contributes to widening the technology gap in FDI in India is the
inappropriate Intellectual Property (IP) regime of India. Survey results
for 100 US multinationals indicate that about 44 per cent of the firms
highlighted the weak IP protection in India as a constraining factor for
transfer of new technology to Indian subsidiaries. For investment in
sectors like chemicals and pharmaceuticals, almost 80 per cent of the
firms viewed Indian IP regime as the key constraining factor for
technology transfer (Lee and Mansfield, 1996). It appears that the lure
of the large size of the domestic market continues to be one of the
primary factors causing FDI flows into India.
Spillover of positive externalities associated with FDI in the form

of transfer of technology is also highlighted as another factor that could
contribute to growth. The relationship between technology imports
(comprising import of capital goods and payments for royalty and
technical know-how fees) and domestic technology efforts in terms of
R&D expenditure does not exhibit any complementarity. Foreign
exchange spent on technology import as percentage of domestic
expenses on R&D rather increased significantly in the 1990s in relation
to 1980s, suggesting the use of transfer pricing mechanism to create a
gap between the visible and invisible patterns of resource transfer. The
share of imported raw materials in total raw materials used by FDI/
FCRC firms has, more or less, hovered around only 20 per cent. FDI
firms, however, outperformed the overall growth in industrial production
in the 1990s.
FDI Policy: A Historical Perspective

Over the last five decades, there have been significant changes in
approaches and policies relating to FDI in India in tune with the
developments in the industrial policies and also foreign exchange
situation, from time to time. There is a view in the literature that the
attitude and approach to FDI reflected the under current of balance of
payments crisis in the respective periods. Depending upon the thrust
and direction of the policies at different time period, one can identify
four distinct phases in the evolution of the policies:
i) first phase from 1950 to 1967-characterised by receptive
attitude or cautious welcome;
ii)second phase from 1967 to 1980- marked by restrictive and
selective policies;
iii) third phase from 1980 to 1990-gradual liberalisation;
and
iv) fourth phase from 1991 till date-paradigm shift to open
door policy (Jain, 1994, Subrahmanian, et al., 1996, and Kumar,
1998). Major features of FDI policies during the above four
phases are reviewed below. Exhibit 1 provides the major
features of FDI policies during the four phases.
First Phase 1950 1967 -
After independence, especially with the second Five-Year Plan,

India's development strategy focused on import substituting
industrialisation. At that point of time, the availability of capital,
technology, skills, entrepreneurship, etc., was very limited. Hence, the
attitude towards FDI was increasingly receptive (Kumar, 1998). During
this period, FDI was sought on mutually advantageous terms, though
the majority local ownership was preferred. As foreign investment was
considered necessary, foreign investors were assured of non -
discriminatory treatment on par with domestic enterprises. There were
no restrictions on the remittances of profits and dividends. Foreign
investors were assured of fair compensation in the event of acquisition.
However, it was provided that, as a rule, the major interest in ownership
and effective control would always be in Indian hands. With the foreign
exchange crisis in 1957-58, FDI policies were further liberalised and
offered a host of incentives and concessions. During this phase, market
seeking FDIs have been specially encouraged by the locational
advantage in production as there was protection to local manufacture
in the domestic market. Thus, during this phase, the country had given
cautious welcome to the foreign capital.
Second Phase 1967 1980 -
By the middle of sixties, there was considerable investment in

various industries. Besides, India's scientific and technological
knowledge and infrastructure were developing and manpower was
getting more skilled and constraints on local supply of capital and
entrepreneurship have begun to ease somewhat. On the other hand,
outflow on account of servicing of FDI and technology imports from
the earlier period has begun to rise in the form of dividends, profits,
royalties, and technical fees, etc. These factors forced the government
to adopt a more restrictive attitude towards FDI (Kumar, 1998). Major
features of the policies followed during the phase are:
i)restrictions were imposed on proposals of FDIs without

technology transfer and those seeking more than 40 per cent
foreign ownership;
ii)the government listed industries in which FDI was not
considered desirable in view of local capabilities;
iii) foreign collaborations required exclusive use of
Indian consultancy services wherever available;
iv) the renewals of foreign collaboration agreements
were restricted;
v)from 1973 onwards the further activities of foreign companies
along with those of local large industrial houses were
restricted to a select group of core or high priority industries. The
enactment of Foreign Exchange Regulation Act (FERA), 1973
became the key to guiding and controlling FDI inflows. The
phase of tight regulation and selective policy was
implemented by an administrative system based on
discretionary power.
Third Phase 1980 1990-
There was a gradual liberalisation of FDI policies in the eighties

due to the deterioration of foreign exchange position in the wake of
second oil crisis and India's failure to boost her manufactured exports.
Hence, eighties witnessed a gradual but discernible sign of easing of
restrictions on foreign investment inflows with the liberalisation of
industrial and trade policies. Policies were framed to attract more FDIs
and foreign licensing collaborations. During this phase policies were
specially designed to encourage higher foreign equity holding in export-
oriented units and investments from Oil Exporting Developing countries.
Approval systems were streamlined. A degree of flexibility was
introduced in the policy concerning foreign ownership, and exceptions
from the general ceiling of 40 per cent on foreign equity were allowed
on the merit of individual investment proposals. The rules and
procedures concerning payments of royalties and lump sum technical
fees were relaxed and withholding taxes were reduced. The approvals
for opening liaison offices by foreign companies in India were
liberalised. New procedures were introduced enabling direct application
by a foreign investor even before choosing an Indian partner. A fast
channel was set up in 1988 for expediting clearances of FDI proposals
from major investing countries, viz. Japan, Germany, the US and the
UK. Thus, the third phase witnessed a concrete move towards
liberalisation of FDI policies.
Fourth Phase 1991 Onwards

-
There has been a paradigm shift in the policies on FDI right from
the early nineties with the adoption of the Industrial Policy Statement
of July 1991. One of the objectives of Industrial Policy Statement was
that "foreign investment and technology collaboration will be welcomed
to obtain higher technology, to increase exports and to expand the
production base". The Industrial Policy Statement of 1991 has followed
an 'open-door' policy on foreign investment and technology transfer.
The policy since then has been aimed at encouraging foreign investment
particularly in the core and infrastructure sectors. During the fourth
phase, favourable policy environment consisting of the liberalisation
policies on foreign investment, foreign technology collaboration, foreign
trade and foreign exchange, have been exerting positive influence on
foreign firms' decisions on investment and business operations in the
country.
During this period, the FERA, 1973 has been amended and
restrictions placed on foreign companies by the FERA have been lifted.
In 1999, FERA has been replaced with Foreign Exchange Management
Act. Government has permitted, except for a small negative list, access
to the automatic route for FDI. Hence, foreign investors only need to
inform the RBI within 30 days of bringing in their investment.
Companies with more than 40 per cent of foreign equity are now treated
on par with fully Indian owned companies. New sectors such as mining,
banking, telecommunications, highways, construction, airports, hotel
and tourism, courier service and management have been thrown open
for FDI. Even the defence industry sector is opened upto 100 per cent
for Indian private sector participation with 26 per cent FDI, subject to
licensing. (FDI is not permitted in the following industrial sectors:
i) arms and ammunition, ii) atomic energy, iii) railway transport, iv)
coal and lignite, and v) mining of iron, manganese, chrome, gypsum,
sulphur, gold, diamonds, copper and zinc). The liberal policies have
been accompanied by active courting of foreign investors at the highest
level. The international trade policy regime has been considerably
liberalised too with removal of quantitative restrictions lowering of peak
tariffs to 30 per cent and sharp pruning of negative list for imports. The
rupee was made convertible on current account and gradually to capital
account.
EXHIBIT — 20.1
Major Features of FDI Policies during the Four Phases
Phase I Phase II Phase III Phase IV

1950-67
 1967-80
 1980-90
 1991  L
Non- Restrictio Higher Onwards iberal
Receptive Attitude or Restrictive Gradual
Cautious discrimi
Welcome n on
Attitude foreign
Liberalisation policies
natory FDI equity in Open Door relating to
treatme without export-oriented technology
nt to technolo units allowed. collaborati
FDI. gy on, foreign
 trade and
Proced
ure foreign
 for remittance exchange.
No  of royalty and n E
restricti Above technical fees ncouragin
ons on 40% stake liberalised g
remitta not FDI in core and
nce of allowed. infrastructure
profits industries.
and n
dividen  Fast
channel FERA replaced
ds. Allowed
for FDI with FEMA
only in
priority clearanc Procedures
area. e. transparent
  Liberal
Owners FDI approach for
hip and controlle NRI investments
control d by
with FERA FDI need not
Indians. be accompanied
by technology
* F
DI

through
Discretion
Mergers
ary power
and
in
Acquistion
sanctioni
ng the
s.
projects.  F
DI in
services
and
financial
sector-
banks.
NBFCs.
insurance.
Now FDI is permitted under the following four forms of
investments: i) through financial collaboration, ii) through joint ventures
and technical collaborations, iii) through capital markets via Global
Depository Receipts (GDRs) (Euro issues), and iv) through private
placements or preferential allotments.
Transparency and openness have been the most significant features
of FDI policies in the fourth phase. The degree of openness is reflected
in (i) the sectors open to FDI, (ii) higher level of foreign equity
participation, and (iii) transparency in approval procedures. One striking
aspect of the present liberalisation policy is that unlike the previous
phases, it is not necessary that FDI is accompanied by foreign
technology agreements. There is a liberal approach towards investment
by non-resident Indian (NRIs): NRIs and overseas corporate bodies can
invest up to 100 per cent in high priority industries. Another distinctive
feature of the policy is the simplification of procedures.
Thus, the ongoing measures taken since 1991 are focused towards
a virtual elimination of the both direct and indirect barriers to foreign
direct investment [indirect barriers in the form of investor protection,
differences in accounting standards, legal and regulatory structure]. In
short, the evolution of FDI policies in India are characterised by
receptive attitude till the mid-sixties to a policy of restrictions and
controls till 1980 and then to gradual liberalisation till 1990 and finally
to a policy of full-fledged liberalisation since 1991.
Trends in FDI—In the 1990s

TABLE — 20.1
FDI-Amount Approved, Actual Inflows and
Per cent of Capital Formation
(Rs. Crore)
Year
Amount Actual Inflow % of Inflow % of
Approval Inflow Approval GCF
1991 534 351 65.8 0.2

1992 3888 675 17.4 0.4
1993 8859 1787 20.2 1.0
1994 14187 3289 23.2 1.4
1995 32072 6820 21.3 2.2
1996 36147 10389 28.7 3.4
1997 54891 16425 29.9 4.7
1998 30814 13340 43.3 3.6
1999 28367 16868 59.5 3.8
2000 37039 19342 52.2
2000* 32631 13810 42.3
2001* 23266 16127 69.3
Note * : January-October, GCF: Gross capital formation.

Source : Economic Survey 2001-02, Government of India.
From a closer look at the data, one can identify two distinct phases
in the growth of FDI during the nineties. The four year period from 199.4
to 1997 is characterised by high growth of approvals and lower inflows

and realisation rate. During this period, there was a significant rise in
the number of projects and amount approved for FDI—the average
annual growth of FDI amount approved was 63 per cent. However,
inflows as a per cent of amount approved was lower: 26 per cent during
1994-97.
Phase I: 1994 to 1997—High growth of approval and low growth

of inflow and realisation rate.
Phase II: 1998 to 2001—Low growth of approvals and high growth
of inflow and realisation rate.
On the other hand, during the next four year period from 1998 to
2001 (till October) there was a slow down in both number and amount
of approvals but growth of inflows and realisation rate was higher. During
this low growth phase, the yearly average number of approvals declined
to 1,998 from 2,205 during the high growth phase. Further, the average
annual growth of amount approved during this period was lower at 12
per cent as against 63 per cent during the previous phase. Though there
was a lower growth of approvals during this period, the actual inflow has
been higher in terms of absolute amount and realisation rate. Average
amount of inflow during this period was Rs.16,419 crore as against Rs.
9,231 crore during 1994 to 1997. Actual inflows as a per cent of amount
approved rose from 26 per cent to 56 per cent.
Since inflows in a particular year need not be entirely related to

the approvals given in that year, it is possible to infer that higher inflows
during the second phase may be on account of lag involved in the
realisation of projects for which approvals were given in the earlier
phase. If that is the case, it can also be inferred that lower approvals
during the second phase may lead to lower inflows in the coming years.
The reasons for the reduction in the number of approvals can be traced
to: i) the effect of restrictions on India following nuclear tests,
ii) political uncertainty, and iii) very slow progress in second generation
reforms, particularly relating to real sector and privatisation of public
enterprise.
Changes in Sectoral Composition

In tune with the government's priorities with respect to FDI, sectoral
composition of FDI has undergone significant changes during the last
two decades. Till 1990, the government policy was to channel FDI
inflow in technology-intensive branches of manufacturing. Thus, more
than four-fifth of FDI stock in 1990 was in the manufacturing industries.
The share of petroleum and power and service sectors were only
marginal. However, with the changes in the FDI policies in the 'nineties,
the share of manufacturing has been more than halved to 40.1 per cent.
Within the manufacturing industries, FDI is shifting away from heavy
capital goods industries to light industries. With the opening up of the
infrastructure industries, on the other hand, the share of petroleum and
power sector rose substantially to 30.6 per cent in 1999 from just 0.1
per cent of FDI stock in 1990. Similarly, the share of service sector
rose to 27.8 per cent from just 5.2 per cent, respectively, during the
above period.
Three high priority industries, namely, power, telecommunication

and oil refinery accounted for nearly half of the total amount of FDI
approvals during 1991 to 1999. Among the different industries, power
and telecommunication accounted for the highest share (17.5 per cent
each) of FDI approvals during the 'nineties. They are closely followed
by oil refinery, which accounted for 13.1 per cent of FDI approvals.
Transportation industry and financial sector were the other two
prominent sectors accounting for larger share of FDI approvals. Thus,
what is noticeable in the 'nineties is the rise of FDI inflows in the
priority infrastructure sectors like power, telecommunication, oil
refinery, transportation, finance and banking. Perhaps, this is on
account of the opening up of these industries for FDI in recent times.
Changes in the Sources of FDI
Over the years, there has been diversification of sources of FDI.

Until 1990, European countries have been the major sources of FDI
inflows in India. They accounted for nearly two-third of total stock of
FDI in 1990. However, their share drastically declined to around one-
fifth during the 'nineties. Among the European countries, the decline
was significantly high in case of the UK from 48.8 per cent in 1990 to
just 7.6 per cent during the 'nineties. The share of European countries,
America and Japan taken together accounted for nearly 90 per cent of
total stock of FDI in 1990, however, it has declined to 46.6 per cent
during the 'nineties. The decline in the share of the above group is
essentially due to the rise in the inflows from other countries. What is
more striking is the fact that after USA, Mauritius is the second largest
source of FDI in India. Because of lower taxes in Mauritius, they are
able to attract foreign capital from different parts of the world, which
is in turn invested in countries like India.
Country-wise, the number of approvals of FM during the nineties

shows that USA accounts for nearly one-fifth of total approvals. Four
countries, namely, USA, Germany, United Kingdom and Japan, together
share around half of the approvals. Around 95 per cent of foreign
collaboration approvals from Mauritius and NRIs are financial in nature.
However, in case of Japan and Italy, technical collaborations are more
than financial collaborations.
Pattern of FDI by Type of Approvals

There are two major routes, namely, Government-through Foreign
Investment Promotion Board (FIPB) and Secretariat for Industrial
Assistance (SIA)-and the Reserve Bank, through which FDI approvals
are given. An analysis of institution-wise approval of the amount of
inflows reveals that the share of Government through FIPB/SIA has been
on the decline and it formed around three-fifth of the approvals in 2001 '
02. The share of RBI's automatic approval, on the other handy has
increased to 19.4 per cent in 2000-01 from 13.3 per cent in 1992-93.
NRI direct investments constituted around one-third of total FDI inflows
in 1995-96. However, of late, their share has declined and it formed only
to 2.9 per cent in 2000-01 as NRI investments are increasingly taking
place in the form of acquisitions of shares of domestic companies. The
share of acquisition of shares by Non-residents rose significantly from
0.5 per cent in 1995-96 to 15.5 per cent in 2000-01 (Table 20.2).
T AB L E - 20.2
Share of Different Approval Sources in Actual Flow of FDI
(Per Cent)
Sources of Approval 1992-93 1995-96 1998-99 2000-01

1. Government 70.5 58.3 74.0 62.2
(FIPB/SIA)
2. Reserve Bank 13.3 7.9 7.3 19.4
(automatic route)
3. NRIs (40% and 16.2 33.3 2.5 2.9
100% scheme)
4. Acquisition of
Shares by
Non-Residents* 0.0 0.5 16.2 15.5
Total 100.0 100.0 100.0 100.00
Note: 'I` : Acquisition of shares of Indian companies by non-residents under Section 5 of

FEMA, 1999.
Source : Economic Survey 2001-02, Ministry of Finance, Government of India, New Delhi.
Comparative Performance of India and China

While discussing about FDI in India, often a comparison is made with
China, as it is the major recipient of FDI among the developing countries.
According to the World Investment Report 2001, India's inward FDI in
2000 stood at US$ 2.3 billion as against US$ 40.8 billion in China, nearly
18 fold higher than India. Further, the accumulated stock of FDI in India
was US$ 19.0 billion in 2000 as against US$ 346.7 billion in China, nearly
18 fold higher than India. India compares very poorly with China in terms
of inflow of FDI during the last two decades. During the 'nineties from
1991 to 2000, China accounted for 27.0 per cent of total flow of FDI
to developing countries as against India's share at 1.0 per cent.
As a result of higher FDI inflows, in China the number of foreign-

invested firms constituted 16 per cent of all companies in 1998, which
contributed 24.7 per cent of total industrial output, 17.6 per cent of
total assets and 18.8 per cent of total revenue. Further, FDI inflows in
India as per cent of her gross fixed capital formation and GDP was
very much lower than that of China. In 1999, FDI inflows in India as
per cent of gross fixed capital formation was just 2.4 per cent as
against 11.3 per cent in case of China (Table 20.3). Similarly, FDI
inflows in India as per cent of GDP was as low as 3.6 per cent as
against 30.9 per cent in case of China (Table 20.4). These facts
indicate that India is relatively slow in restructuring growth and
orienting policies to encourage FDI. The comparison shows that there
is considerable scope for attracting more FDI in India as the country
has the potential to absorb it.
TABLE - 20.3
Inward FDI Flows as Per cent of

Gross Fixed Capital Formation in India and China
(Per Cent)
Country 1986-1995 1997 1998 1999
India 0.6 3.80 2.9 2.4
China 6.4 14.6 12.9 11.3
Developing Countries minus China 4.7 10.9 11.7 13.8
World 4.0 7.5 10.9 16.3
Source: UNCTAD, 2001.

TABLE — 20.4
Inward FDI Flows as Per Cent of

Gross Domestic Product in India and China
(Per Cent)
Country 1985 1990 1995 1999

India 0.5 0.6 1.7 3.6
China 3.4 7.0 19.6 30.9
Developing Countries minus China 14.1 13.4 15.6 28.0
World 7.8 9.2 10.3 17.3
Source: UNCTAD, 2001.
Here it is worthwhile to examine why China is able to get more

FDI than India despite her many relative advantages like prevalent
English fluency, top-notch engineers, a well developed IT industry and
low wages. One significant factor cited for the difference is the
contrasting discretion in adopting policies of openness by the respective
governments. Chinese governments pragmatic reform and policy of
openness is exemplified through their Prime Ministers famous remark,
"...it doesn't matter if a cat is black or white, so long as it catches mice".
However, India's openness policy is applied to relatively restricted
sectors, mainly social overhead projects such as roads, ports,
telecommunication, electricity, etc., where capital requirement is very
large with low profitability.
Another factor is the differences in the structure of local

governments and their authority. In China, local governments play an
important role in attracting FDI because they have a great deal of
autonomy in issuing permits as well as offering various administrative
services. Since China is still a highly planned economy, the Central
governments openness policy tends to be executed easily and efficiently
throughout the economy. In contrast, in India under democratic setup, the
sovereignty of the local governments is well guaranteed, and hence, some
of the local governments are still passive with regard to attracting FDI.
Another inhibiting factor in India is the uncertainty of policy

decisions which obscures predictable future profits and establishment
of well-guided management plans. Factors like lack of well-established
investment procedures, unpredictable costs for factory construction and
operation and corrupt bureaucracy aggravates the level of uncertainty
in the eyes of potential foreign investors. The India-China comparison
shows that a government's firm determination to pursue a policy of
openness and capability to ensure efficient coordinated implementation
systems can outweigh the inherent advantages of another government
(Kim, 2002).
Another major reasons for China's success is that they are able to
attract more investment from their own people who are doing business
in America, Hong Kong, Macao and in other countries. Further, the level
of infrastructure in China is better than India. On the policy front, in
case of India, the initial reform measures were mostly in the area of
financial sector. Only recently reform measure were contemplated for
the real sector. In fact, for attracting FDI, real sector reforms are
essential as the investment essentially takes place in sectors like
manufacturing, infrastructure and services.
Impact of FDI
Impact of FDI can be felt on a number of areas and it varies
depending upon the nature of the projects and the degree of integration
with the rest of the economy.
Impact of FDI: Performance of

FDI-Companies in India
The Reserve Bank's regular surveys on "Foreign Collaboration
in Indian Industry", provide valuable information on the status of
industries which are having foreign collaboration. The latest survey (the
sixth in the series) pertains to the period 1986-87 to 1993-94 and it
covered 1,108 companies in the private sector (132 subsidiaries, 572
minority capital participation companies and 404 purely technical
collaboration companies). Major relevant findings of the survey are:
(i)There was significant concentration of foreign capital in the

manufacturing sectors like chemicals and chemical products,
machinery and machine tools, electrical machinery and
apparatus and transport equipment.
(ii) As compared with the previous survey period (1981-86),
there has been an improvement in the profitability of the companies
during 1986-87 to 1993-94, especially in case of companies with
minority capital participation and pure technical
collaborations.
(iii) Production of the surveyed companies rose at an
average annual rate of 20.3 per cent; the leading contributors
to production were chemicals and chemical products, transport
438 Indian Economy: Pe rformance and Policies
equipment, machinery and machine tools and the diversified

groups.
(iv) During the survey period (1986-87 to 1993-94), on
an average, exports accounted for 63.3 per cent of imports by
the companies; trade deficit was more pronounced in the case of
pure technical collaboration companies.
(v) Import intensity of production increased during the

survey period; value of imports formed 11.6 per cent of total
production of technical collaboration companies, 11.5 per cent of
minority capital participation companies and 8.6 per cent in case
of subsidiaries.
(vi) Dividend remittances were high in case of chemicals
and chemical products, followed by machinery and machine tools
(Reserve Bank, 1999).
IV
TOWARDS A REALISTIC FDI POLICY'
If history is any guide, foreign investment in infrastructure is

potentially probleMatic. Latin America witnessed a wave of foreign
infrastructure investment from the US in the 1930s, only to leave with
the bitter experience of nationalisations in a couple of decades. It bears
repetition that infrastructure is inherently capital-intensive with long
gestation lags, and low (but stable) returns over a long period. Market
failures are ubiquitous in these industries, with considerable network
economies necessarily inviting wide and deep state intervention. In a
world consisting of politically independent nations with a growing
number of democracies, the pricing of infrastructure is bound to be a
political decision. Foreign firms with short pay-back periods invariably
find it hard to stay . on, as it conflicts with the goals of developing
economies caught in an increasingly uncertain world economy.
There are also perhaps some India specific factors for the relatively
small foreign capital inflow. It seems worth reiterating that India is still
largely an agrarian economy, with land productivity being a third of
China's, where the average disposable income after meeting food and
clothing (wage goods) requirement is still relatively small. Price-
1 This section is drawn extensively from R. Nagaraj (2006). "Foreign Direct Investment in
India: Trends and Issues", in R Nagaraj Aspects of India's Economic Growth and Reforms,
ch. 12, Academic Foundation, New Delhi.
income-ratio of most consumer goods that foreign firms usually sell is
high by domestic standards, accentuated perhaps by cultural factors and
regional heterogeneity of markets (Financial Times, April 25, 2002).
In infrastructure industries, the rupee cost of electricity supply by
foreign firms seems high. Given India's fairly diversified industrial
capability, and low labour costs, foreign firms may not have a cost
advantage over the domestic producers—especially with the currency
depreciating in nominal terms. This is perhaps best illustrated, again,
by the Enron's DPC. With imported capital goods and fuel, and high
operating cost due to international norms of costing, Enron's cost of
production was found to be higher than the comparable new plants using
domestic capital equipment (Morris, 1996).
At the same time, Hyundai's large investment with consciously

built-in high domestic content secured through economies of scale has
succeeded in producing a small car that seems competitive both in price
and quality. Reportedly, Hyundai proposes to use its Indian plant as a
global hub for its small car (The Economic Times, January 2, 2003).
Thus, the key to increasing FDI inflow seems to lie in industries (and
products) with relatively high technology that have large economies of
scale, with substantial domestic content.
However, the foregoing reasoning still does not explain why foreign
investment does not come to use cheap labour and skills for export of
labour-intensive manufactures—as it has happened in China. We are
inclined to believe that the foreign investment policy lacks a clear focus.
Unlike China, India has not invested in export infrastructure. In fact, as
is widely accepted now, the share of infrastructure in fixed capital
formation has declined sharply for nearly one and half decade now
(Nagaraj, 1997). Further, what is needed is perhaps not large investment
but suitable inducement to international marketers—trading houses and
retail chains—to set up purchase offices and testing facilities to tap the
potential of the domestic manufacturers. It is widely acknowledged that
China's export success largely lies in marrying its low cost
manufacturing capability in Town and Village Enterprises (TVEs) with
Hong Kong's highly developed trading houses and other long-
established commercial organisations catering to international trade.
While it is out of question for India to replicate the locational and
historical advantage of Hong Kong for China, investment in export
infrastructure in strategic locations and carefully tailored incentives to
international trading houses (and retailers) merit a serious consideration.
Similarly, such investments are perhaps equally necessary to tap the
growing potential for using India's labour cost advantage for doing back
office jobs—business processes outsourcing—for international firms
(The Economist, May 5, 2001).
Realistically, what is it that India expects from foreign investment,
and how to secure it? In principle, openness to foreign investment
should be strategic, not passive (or unilateral). History does not seem
to support such an uncritical international integration as a proven route
to growth and efficiency. If the recent experience is any guide, foreign
capital is far from a major provider of external savings for rapid
industrialisation of any large economy. It can only supplement the
domestic resources, wherever they necessarily come bundled with
technology, and access to international production and distribution
networks. The terms of foreign investment will depend on the relative
bargaining power of the foreign firm vis a vis domestic firms, backed
- -
by the state. Indian advantages are the availability of skilled workforce,

cheap labour, and the size of the domestic market, which it should
leverage as most successful countries have done. A telling instance of
it is perhaps Korea's big leap in semiconductor and telecom equipment
manufacturing in the recent years, as it seems to have tied liberalisation
of domestic market to sharing of production technology.
If this view has any value, then how should we go about inviting
FDI that is consistent with the economy's long-term interests? Foreign
investment should be allowed mainly in manufacturing to acquire
technology, and to establish international trading channels for promoting
labour-intensive exports.
V
SUMMARY AND CONCLUSION
Ending its long held restrictive foreign investment policy in 1991,

India sought to compete with the successful Asian economies to get a
greater share of the world's FDI. Cumulative approved foreign
investment since then is about $67bn, but the realised amount is about
a third of it—the ratio roughly comparable to China's. While the foreign
investment inflow represents a substantial jump over the 1980s, it is
modest compared to many rapidly growing Asian economies, and
minuscule compared to China. While the bulk of the approved FDI is
for infrastructure, the realised investment is largely in manufacture of
consumer durable goods and the automotive industry seeking India's
seemingly large and growing domestic market. Foreign investment in
telecom and software industries has also been significant. Approved FDI
has largely gone to a few developed states—similar to its concentration
in the southern coastal provinces in China. A sizable part of the foreign
investment seems to represent a gradual increase in foreign firms' equity
holding (hence managerial control) in the existing firms, and acquisition
of industrial assets (and brand names).
China's ability to attract a phenomenal amount of foreign investment

is a puzzle for many. About 40-50 per cent of China's FDI represents
its domestic saving recycled as foreign investment via Hong Kong to
take advantage of economic incentives—popularly called the "round
tripping". Another 25 per cent or so, seems to represent investment in
real estate by overseas Chinese that is potentially problematic, as such
investments could easily give rise to property bubbles. Thus the quantum
of foreign investment from the advanced economies that could improve
domestic production capability is perhaps not very different from that
in India, in relation to its domestic output. Contrary to the popular
belief, China's foreign investment regime is said to be more restrictive
than India's. Therefore, what India should be concerned about is not so
much the absolute quantum of the inflow, but how effectively it uses its
external openness to augment the domestic capability, and access foreign
markets for its labour-intensive manufactures.
As the 1990s experience shows, quite contrary to the popular

perception, the size of India's domestic market is relatively small, given
the low levels of per capita income. After meeting the needs of food
and clothing (wage goods), income left for spending on products that
most foreign firms offer seems small; their price-income ratio too high
for Indian consumers. Therefore, many of them seem to be making
efforts to indigenise production to reduce costs and secure economies
of scale. In this process, many foreign firms are discovering the potential
of low cost of manufacturing for exports.
Much of the approved FDI in infrastructure did not fructify, as the

rupee cost of electricity supply by foreign firms is too much high for
Indian consumers. This seems true for two reasons: one, prices of goods
like electricity are widely subsidised, and cannot be increased without
inviting public opposition; second, India produces much of these
services at lower cost using domestic raw material and capital
equipment.
Foreign investment in consumer goods industries has increased
domestic competition, resulting in greater choice and quality
improvement. While FDI inflow displaced some domestic firms (and
brand names), the bulk of them have—at least yet—largely been able
to withstand the competition by making large capital investment, and
in expanding distribution networks.
What should be done to increase foreign investment? It is popularly
believed that a more liberal policy regime, industrial labour market
reforms, and infrastructure investment are needed. While infrastructure
improvement surely merits a close attention, one is not so sure if the
extent of the reforms and the quantum of foreign investment inflow are
positively related. Moreover, there is little evidence that greater FDI
inflow ensures faster output and export growth. Such simplistic
associations, usually based on cross-country analysis, seem to have
support neither in principle nor in comparative experience.
What is needed is a strategic view of foreign investment as a means

of enhancing domestic production and technological capability, and so
also to access the external market for labour-intensive manufactures—
as China has precisely done. It seems valuable to reiterate what
K.N. Raj, a perceptive observer of comparative economic development,
noted early in China's liberalisation drive, "It is certainly not without
good reason that China has chosen to be hospitable even to
multinationals with worldwide ramifications like IBM, evidently in the
expectation of securing the know-how for building up semi-conductor
industry of its own. Those who do not realise the implications of all
this for India are living in a dream world of their own...." (Raj, 1985).
Such interventions need selectivity, and strategic intent.

Comparative experience seems to clearly favour such a policy stance.
21.
Services in the
Indian Growth Process*
THE phenomenal expansion of services world-wide led to services being

regarded as an engine of the growth and even as a necessary concomitant
of economic growth. Development economics suggests that development
is a three-stage process. The dominance of the services sector in the
growth process is usually associated with the third stage of growth.
During the 1980s and 1990s, services accounted for a share of about
70 per cent of GDP in industrialised countries and about 50 per cent in
developing countries.
In India growth of services picked up in the 1980s, and accelerated

in the 1990s, when it averaged 7.5 per cent per annum, thus providing
an impetus to industry and agriculture, which grew on average by 5.8
per cent and 3.1 per cent respectively. Growth in the services sector has
also been less cyclical and more stable than the growth of industry and
agriculture (in the sense of having the smallest coefficient of variation).
TABLE — 21.1
Sectoral Growth Rates
Average growth (In per cent per annum)
1951-1980 1981-1990 1991-2000
Agriculture 2.1 4.4 3.1
Industry 5.3 6.8 5.8
Services 4.5 6.6 7.5
GDP 3.5 5.8 5.8
Source : Gordon and Gupta, 2003.

* This chapter is drawn liberally from RBI Report on Currency and Finance 2000-01 ch. 3,
pp. III 38-45, Lima Kapila (2006). Indian Economy Since Independence, (17th edition), Ch.
28. and Jim Gordon and Poonam Gupta's paper Understanding India's Services
Revolution (2003).
A notable feature of the structural transformation of the services

sector has been the growth of skill intensive and high value added
sectors, i.e., software, communication and financial services. The rapid
growth of services can be attributed, inter alia, to the advent of
information technology (IT) and the knowledge economy. This has
enhanced the growth of the high productivity segment of the services
sector as well as a variety of service activities involving low
productivity activities catering to a large mass of people. The
phenomenal growth of low skilled service activities has occurred due
to reduced opportunities in the manufacturing sector, particularly in the
unorganised sectors.
Some of the activities in the services sector are multidimensional,

being part of industry as well as services, such as information
technology and construction. Service statistics in most countries
including India provide information on value-addition of various
activities of business services, hotels, trade, financial services, etc. For
an empirical analysis, sub-sectors including trade, transport and
communication, financing, insurance, real estate and business services
can be categorised as producer services with hotels and restaurants and
other services as consumer services. Government services comprise
public administration and defence services. During 1999-2000, producer
services accounted for about 70 per cent of the total services followed
by consumer services (17 per cent) and government services (13 per
cent). The high share of producer services reflects the strong inter-
linkages between services and goods producing sectors of the economy.
The emergence of services as the most dynamic sector in the Indian

economy has in many ways been a revolution. The most visible and well-
known dimension of the takeoff in services has been in software and
IT-enabled services (including call centers, design, and business process
outsourcing). However, growth in services in India has been much more
broad-based than IT. In fact, although IT exports have had a profound
impact on the balance of payments, the sector remains a small
component of GDP. As of 2001, business services (which includes IT)
contributed only about 1 per cent to GDP, or 1/50 to the size of total
services output (Table 21.1).
Rapid growth of the service sector is not unique to India. The

existing literature shows that as an economy matures the share of
services in output increases consistently. To begin with, the increase
occurs along with an increase in the share of industry. Thereafter, the
service share grows more rapidly, accompanied by a stagnant or
Services in the Indian Growth Process 445
declining share of the industrial sector. Cross-country experience
suggests that the first stage occurs until the country reaches lower
middle income status, while the second stage commences once it
becomes an upper middle income country.
Consistent with the trend observed in other countries, India's growth

experience has been characterised by a decline in the share of agriculture
in GDP and an increase in the shares of industry and services. Between
1951 and 2000, the share of agriculture in GDP fell from 58 to 25 per
cent, while the share of industry and the share of services increased from
15 to 27 per cent, and from 27 to 48 per cent, respectively. In the 1990s,
however, the share of services in India's GDP climbed by about 8
percentage points, as compared to a cumulative increase of 13
percentage points during 1951-1990. The share of the industrial sector,
on the other hand, has been stagnant since the 1990s. As a result, the
sectoral composition of output in India has come to resemble that of a
middle income country, even though its per capita income remains that
of a low income country.
Growth and Sectoral Shares, Cross Country

Evidence and Indian Experience
The evolution of sectoral shares in output, consumption and
employment as economies grow has been studied by economists for well
over fifty years. During the 1950s and 1960s, research by Kuznets and
Chenery suggested that development would be associated with a sharp
decline in the proportion of GDP generated by the primary sector,
counterbalanced by a significant increase in industry, and by a more
modest increase in the service sector. Sectoral shares in employment
were predicted to follow a similar pattern.
With the benefit of more data on development than was available

to Kuznets and Chenery, recent literature has tended to emphasise the
growing importance of service sector activity (Inman 1985, Kongsamut,
Rebelo and Xie, 2001). For example, Kongsamut, et al, (2001) analyse
a sample of 123 countries for 1970-1989 and show that rising per-capita
GDP is associated with an increase in services and a decline in
agriculture both in terms of share in GDP and employment. In other
words, the sectoral share given up by agriculture as the economy matures
goes more to the services sector and less to industry than the Kuznets -
Chenery work had suggested. The modern view is that as an. economy
matures, the share of services (in output, consumption, and employment)
grows along with a decline in agriculture. By contrast, the share of
industry first increases modestly, and then stabilises or declines.

(Gordon and Gupta, 2003)
Share of Services in GDP

Such a pattern of growth is visible in the cross-country data on
shares in GDP (Table 21.2). These data suggest two stages of
development. In the first, both industry and services shares increase as
countries move from low income to lower middle income status, while
in the second, the share of industry declines and that of services
increases as the economy moves to upper middle and higher income
levels.
TABLE — 21.2
Sectoral Shares in GDP in 2001, Global Averages
(Per cent of GDP)
Agriculture Industry Services
Low income 24 32 45 Stage I

Lower middle income 12 40 48
Upper middle income 7 33 60 Stage II
High income 2 29 70
Source : World Bank's WDI, 2003, Table 4.2. Definition: Low income: per capita GDP<$745;
Lower middle-$746-2975; Upper middle-$2976-9205; and high->$9206.
How does the Indian experience fit in with this pattern? In the four
decade period, 1950-1990, agriculture's share in GDP declined by about
25 percentage points, while industry and services gained equally. The
share of industry has stabilised since 1990, and the entire subsequent
decline in the share of agriculture has been picked up by the services
sector. Thus, while over the four decades, 1950-1990, the services sector
gained a 13 per cent share, the gain in the 1990s alone was 8 percentage
points. Consequently, at current levels, India's services share of GDP
is higher than the average for other low income countries.
According to Gordon and Gupta, if different sectors in India grow

at the average growth rates experienced in 1996-2000, then by 2010,
the share of services would increase to 58 per cent, which would bring
the size of the India's services sector, relative to GDP, closer to that of
an upper middle income country, while still belonging to the low income
group.
Services in the Indian Growth Process 447
TABLE — 21.3
India, Sectoral Shares in GDP, 1950-2006
(Per cent of GDP)
Agriculture Industry Services
1950 58 15 28
1980 38 24 38 Stage I
1990 33 27 41
2000 24 27 49 Stage II
2003-04 22 26 53
2004-05(P) 20 26 54
2005-6(Q) 20 26 54
2006-07(R) 19 27 55
. g e l I N V N I M . 1 . . . 1 0 1 m a m ___
Source : Central Statistical Organisation.
Share of Services in Employment

Even though India has experienced profound changes in output
shares, the same is not true for employment shares (Table 21.4). A
striking feature of India's development is that in contrast to the
substantial decline in the share of agriculture in GDP, there has been
rather little change in the share of employment in agriculture
(Bhattacharya and Mitra, 1990). Similarly, although services rose from
42 per cent to 48 per cent of GDP during the 1990s, the employment
share of services actually declined by about one percentage point during
the decade. Thus, while activity has shifted to services, employment
creation in services has lagged far behind.
India's relatively jobless service sector growth is unlike the

experience of other countries, where the service sector has also tended
to gain a larger share of employment over time. When compared with
other countries India has an exceptionally low share of services
employment.
448 Indian Economy: Performance and Po!idol
TABLE — 21.4
India, Share of Service Sector in Employment and

Capital Formation (In per cent of total)
ErnploViTiell ail () • S Capital Formation
1965-66 18.1 46.1
1970-71 20.0 43.7
1980-81 18.9 44.0
1990-91 24.4 41.2
1999-2000 23.5 39.6
Source : Hansda (2002).
Which Services Have Grown Rapidly?

The acceleration in services growth in the 1980s and 1990s was
not uniform across different activities (Table 21.5). Some segments grew
at a rate much faster than their past average growth rates, while for other
sub-sectors, growth rates were similar to the past trend. To identify the
growth-drivers within the services sector, Gordon and Gupta have
compared the growth rates of various activities in the 1990s with their
previous trend growth rates. The trend growth rates have been estimated
using the three year moving average of the growth rate and the period
through 1990 is included in estimating the trend (except for banking
for which the trend is estimated using the data until 1980).
Comparison of the actual and the trend growth rates shows that
growth in several service sub-sectors accelerated sharply in the 1990s
(and 1980s for banking); indicating some sort of a structural break in
their growth series. According to Gordon and Gupta these activities are
fast growers. The remaining activities grew more or less at a trend rate,
these they call trend growers.
Based on the above criterion, fast growers include business services

(which includes IT), communication services, financial services, hotels
and restaurants, community services, and trade (distribution) services.
The trend growers include real estate, legal services, transport, storage,
personal services, and public administration and defense (PAD).
Fast Growers
Business services was the fastest growing sector in the 1990s, with
growth averaging nearly 20 per cent a year. Though disaggregated data

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19

It is believed that small-scale enterprises are hampered in their

The economic argument would then be that in the face of factor

All Industrial Policy Statements since Independence have provided

The basic structure of institutional promotion of small-scale

The basic idea then was promotion of small-scale enterprises

The key elements of India's policy for the support of small-scale

Definition of Small-scale Industries

In 1950, the investment limits was up to Rs. 0.5 million in fixed

The current status of the investment ceilings for small-scale

Type of Small- Investment Limit Remarks

Small Scale Reservation Policy

In April 1967 there were only 47 items in the reserved category

The second census of small scale industries provides persuasive

Conversely, very few of the reserved products attracted significant

Reviewing the framework of Indian policies protecting and

Spatial Distribution of SSEs

Rakesh Mohan argues, the objective of dispersal might be in conflict

Impact of SSI Reservation on Exports

Looking at the record of Indian exports in comparison with East

As in other countries, the household sub-sector has declined

In spite of the vast increase in the number of reserved items,

All the evidence suggests that the Indian manufacturing sector

A particular casualty of SSI product reservations has been

New Small Enterprise Policy

vitality is founded basically on cost-efficiency, and is prone to promote

First, the definition of a tiny unit is changed, and this change is

The other definitional change is more basic. Earlier, 'industry'

This is to be welcomed for three reasons. First, service and business

The third major change relates to equity participation. The NSEP

The fourth special feature of the NSEP is the introduction of a new

A major objective for the group of village industries seems to be,

A number of measures are proposed to serve these objectives.

The NSEP has broadened the definition of 'tiny' and 'women'

Performance of Small-scale Industries

This sector has the second largest share of employment after

Note : Figures in parentheses indicate percentage growth over previous years.

Several ministries/departments/institutions deal with activities

After due consultation with the stakeholders, 180 items reserved

The logic of reserving items for domestic production exclusively

Role of Foreign Capital*

Structural reforms and external financial liberalisation measures

The experience of developing countries with harnessing capital

The standard analysis of growth accounting in an open economy

In a developing country, the consumption level lags behind the

There are three possible types of resource transfers in the external

India could conceptualy be placed at present in phase-1 of this

THE DEBATE ON THE ROLE OF FOREIGN CAPITAL

Theoretical and empirical research on the role of foreign capital in

the spillovers associated with foreign capital in the form of

In the recent period, studying the growth augmenting role of various

Growth impulses originating from FDI are primarily ascribed to

Whether FDI promotes competition or facilitates development of

Since trade is an important vehicle for growth, FDI could also

Surges in portfolio flows can, however, adversely affect growth.

An orderly transition from aid dependence to market access for

Commercial Debt Capital

It is generally believed that the potential of banking capital in

CAPITAL FLOWS AND GROWTH IN INDIA: