India: Easing of investment restrictions could rekindle foreign interest in retail sector

23 Mar 2016

India: Easing of investment restrictions could rek...

  •   The focus of India’s 2016/17 federal budget on boosting rural spending and lifting the limits of foreign investment in processed-food retailing provide potential opportunities for the retail sector, especially single-brand retailers. 
  •   However, challenges such as poor infrastructure, political opposition, and outstanding policy restrictions remain, while the past experience of foreign investors in India underscore the risks associated with the market. 

The second budget unveiled on 29 February by the administration of Prime Minister Narendra Modi lacked the kind of big ticket reforms that investors have come to expect from the ruling Bharatiya Janata Party (BJP). It did, however, contain several initiatives thataim to continue the BJP’s efforts to reform India’s economy and attract foreign investment. These include reform of the financial sector through the introduction of a bankruptcy code, tax breaks for start-ups, and a pledge to cut the fiscal deficit to 3.5 percent of GDP.

Of particular note was the focus on the rural economy, given that farmers have been grappling with both weak and unseasonal monsoons that have destroyed crops and hurt their spending power. Proposed measures to boost the agricultural sector include the allocation of USD 13 bn for rural development, mainly infrastructure and irrigation, employment schemes for the rural poor, and a pledge to double farmers’ income by 2022. The government will also now permit 100 percent foreign direct investment (FDI) in the retailing of processed food, which it hopes will help farmers fetch better prices for their produce and create much-need back-end infrastructure.

The focus on improving the spending power of the rural population could present opportunities for the retail sector, given that more than 65 percent of all Indians live outside urban areas. Foreign players have long tried to tap into India’s diverse market of more than 1 bn consumers. However, tough operating conditions and a challenging regulatory environment have long undermined their attempts to break into the retail sector. The latest easing of FDI norms and the promise of further reforms under a stable government could, albeit tentatively, revive the interest of foreign firms in India.

Easing restrictions 

Previously, India had allowed 100 percent FDI in single-brand retailing – aimed at companies that sell diverse merchandise under a unified brand name, such as Reebok, H&M and Nike – and cash and carry operations, in which firms are only permitted to sell to wholesale or commercial buyers. For foreign multi-brand retailers like Carrefour and Walmart, FDI is capped at 51 percent on concerns that deregulated foreign investment in the sector would put small store owners at risk; the Federation of Indian Chambers of Commerce & Industry (FICCI) estimates that there are some 12 million such shops in India. In this context, the budget decision to allow 100 percent FDI in multi-brand retailing for processed food is noteworthy, marking the first time India has shifted from its rigid stance on the issue.

The move is particularly positive for firms such as Swedish retailer Ikea, which in 2013 won government approval to invest nearly USD 2 bn to open its own retail stores across the country. The company, which has acquired land in cities such as Hyderabad and Bengaluru to set up premises, can now include its popular cafes as part of its retail experience; an issue that was previously contentious, given the limits on FDI in food retailing. The UK’s Marks and Spencer – which currently operates in the country via its joint venture with Reliance India – also stands to gain, and can set up standalone M&S Food stores. Other measures introduced in the budget aimed at improving the ease of doing business include digitising land records to make it easier for foreign firms to acquire land in India, and increased spending in infrastructure that could also indirectly boost foreign interest in the retail sector.

Importantly, the scale of the industry and the low rates of market penetration provide a wealth of opportunities for foreign companies. The overall retail industry in India was valued at USD 600 bn in 2015, according to data from the US Foreign Agriculture Service, while market penetration in the organised retail sector was only 6 percent as of 2012 compared with 85 percent for the US, based on estimates from FICCI. Added to this are a young population with a median age of 25 and a steadily growing middle class, presenting an attractive picture for Western firms facing saturated markets in their own economies.

Challenges remain 

However, several noteworthy barriers to foreign investment remain, and a flurry of investment activity is not guaranteed. Inadequate infrastructure and poor logistics pose significant obstacles. Bad or unpaved roads, scant storage and refrigeration facilities, and patchy electricity can all prove extremely difficult. Political opposition to foreign investment has also slowed liberalisation and deterred investment. The ruling BJP itself has in the past been a vocal opponent of allowing multi-brand retailers to invest in India. Even after the budget was unveiled, a far-right group affiliated with the BJP filed for a motion to scrap 100 percent FDI in processed-food retailing.

Local content requirements also present challenges. By law, foreign retailers must source 30 percent of their raw materials locally, which jumps to 100 percent for food retailers. The requirement to source and manufacture food in India aims to boost domestic manufacturing and enhance opportunities for Indian farmers, who were a major political target in the budget. If companies are unable to adhere to the local content requirements, their FDI will be capped at 51 percent.

Against this backdrop, it comes as little surprise that even though India has permitted 51 percent FDI for multi-brand retailers since 2012, the UK’s Tesco is the only such firm currently operating in the country through an equal joint venture with Tata Group. This reality is not likely to change drastically just because the government is now allowing unrestricted investment only in the processed-food segment, even as it limits FDI to 51 percent in all other aspects of multi-brand retailing. For instance, a company like Tesco is unlikely to be tempted to set up a standalone store where it can sell multiple brands of processed food and merchandise under the Tesco brand but little else. For such retailers, franchising and joint ventures are still far more attractive options.

Understanding the nature of the retail market and consumer patterns in India are additional obstacles. Organised retail – the space in which most foreign companies can expect to compete – accounts for less than 10 percent of the total retail market in India, while unorganised retail, composed of local small shops, hawkers, owner-operated stores, and informal holdings account for the rest. Foreign retailers will also find it hard to break loyalty patterns: Indian consumers tend to prefer local stores or vendors who are easily accessible and sell fresh produce for everyday shopping, rather than heading to hypermarkets to stock up on weekly or monthly groceries.

A cumbersome bureaucracy and myriad government-mandated middlemen – by law, farmers in India are not allowed to sell directly to companies and must rely on intermediaries who typically take a large cut – could also drive up expenses for hypermarkets and expose foreign firms to risks of bribery and corruption. Walmart’s experience in emerging markets offers a useful cautionary tale. The retailing giant was accused of paying millions of dollars in bribes in countries such as India, Mexico, Brazil and China, and was investigated by US federal authorities who claimed that it had violated anti-bribery laws governed by the Foreign Corrupt Practices Act. A Wall Street Journal report in October 2015 alleged that Walmart – which first entered the Indian market in 2007 in partnership with Bharti Enterprises – had paid bribes ranging from USD 5 to USD 200 to help clear goods through customs or to secure real estate permits in the country.

The episode highlights the wider problems of operating in India, characterised by the combination of restrictive labour, land, and tax laws that have made the country a fertile ground for bribery. Although the Modi government promised progress in simplifying tax codes when it unveiled the latest budget, the delay in the implementation of the Goods and Services Tax – which aims to replace the complex web of state and federal taxes currently in place with a unified levy – is a major impediment to business. One of the benefits of enforcing GST is that it will decrease direct contact between companies and government officials – as the law will rely on technology to ensure compliance – thus limiting the scope for corruption.

Incremental progress

The easing of foreign investment restrictions in the processed-food segment in multi-brand retailing represents a step forward in India’s liberalisation process. Retailers like M&S and Ikea could benefit from it as they look to roll out independent stores in the country. M&S in 2014 opened its first standalone lingerie store in India, and the UK retailer said in 2015 it plans to open 19 more stores over 15 months. This success could extend to food stores too.

Lifting investment restrictions in other segments of multi-brand retailing is, however, vital to accelerating foreign investment, although such a move would face major political obstacles, because of opposition from small and medium-sized businesses and the agriculture sector, which employs nearly half of the population. In the near term, simpler tax and land acquisition laws and improvements to infrastructure will help ease the path of companies seeking to enter India and – along with recent legislative reforms – will facilitate gradual increased investment in this potentially lucrative market.   

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