There's More To India's FDI Slowdown Than Meets The Eye

India's foreign direct investment flows have been witnessing a decline, with the trend being towards a rise in the share of reinvested earnings than of new investments.

Gross FDI inflows weakened significantly in fiscal 2023, at a time when India’s engagement with the world in terms of share in global trade was rising.

Despite an increasing share in global trade and buoyant foreign investment sentiment, FDI inflows into India have surprisingly slowed and declined to $32 billion in April-December 2023, according to government data.

Net FDI into India—which is the difference between inflows and outflows—has more than halved to $13 billion in the last four quarters.

There has been a rise in share of reinvested earnings in net FDI flows as compared with new investments. "This means that the economy is struggling to attract newer investments as FDI in new equity grew by just 2.5% YoY in FY13-23, while reinvested earnings increased by 7%,” said economists at Ambit in a note.

“Part of this slowdown reflects global and cyclical factors from the slowdown in the global trade flows, particularly in the manufactured goods sector," said Jeremy Zook, director-sovereign ratings at Fitch Ratings.

The global FDI kitty has also shrunk, leading to a fall in flows across the world on the back of higher rates and tighter liquidity around the world, which has taken a toll on all kinds of investments.

"As a result, we saw FDI slow in many countries as global firms pushed off new investments. Further, foreign investors targeting India last year tended to prefer portfolio equity flows rather than FDI,” said Zook.

Part of the slowdown, however, is indicative of the significant competition that India faces—in both the Asia-Pacific region and globally—to attract FDI inflows.

"That (rise in share of reinvested earnings) is a normal cycle. Even in China, bulk of the FDI is reinvested earnings. As major global firms already have presence in India, they might not need to have new investments. Most of the capital gets reinvested, which becomes a large part of FDI,” said Rahul Bajoria, managing director and head of EM-Asia economics at Barclays.

"India’s market is segmented and there is massive competition at every level... It might not make sense for all companies to be here," he said. "...There is also a possibility that some may have excess capacity in other regions and would not see need to shift."

Much of India’s FDI inflows over the past several years have been related to the services sector. Manufacturing flows, while picking up in nominal terms, account for a modest quarter of overall FDI flows into India.

A report by HSBC found that FDI into India tends to be rather concentrated, i.e. periods of rising FDI in the past have been led by a fewer number of sectors.

And rather counterintuitively, in periods when investment sentiment rose across more sectors, overall FDI weakened. "This could mean that India has well-oiled machinery to attract inflows in select sectors, but not across the board," said the report released in January.

There have been notable changes across sectors over time. Those in prominence a decade ago—like metals, conventional power, tourism and construction—are no longer the leading ones, whereas renewables, semiconductors and pharma have gotten bigger.

The strong and broad-based market rally tempted strategic investors, especially private equity and venture capital or PE/VC funds, to accelerate their exit to a greater extent as compared with previous quarters.

Investment sentiment shows a recent shift from "a few" pandemic-period sectors to "several" futuristic sectors like renewables, green hydrogen, AI, EVs and semiconductors, said Pranjul Bhandari, chief economist-India at HSBC.

“As new sectors settle, and critically, if ease of doing business improves, gross FDI inflows could double from FY24 levels, going back to the peak of $55 billion per year in a couple of years,” she said.

There has been limited improvement in new project announcements from foreign entities. However, India presents a cumulative investment opportunity of $1.4 trillion over the next decade, according to Kotak Institutional Equities.

“The realisation of this vast opportunity is predicated on gradual ramp-up of investments in manufacturing-oriented sectors,” the brokerage said in a note in July last year.

Fitch expects a pick-up in FDI inflows, including in manufacturing, over the next couple years. "The government’s efforts to boost capex to plug infrastructure gaps could also support FDI," said Zook.

However, despite some recent progress, he thinks that the regulatory hurdles and market regulations dampen India’s competitiveness in manufacturing FDI relative to other countries, which may keep FDI inflows somewhat constrained.