Open and shut

Indian Express, 13th December 2012

FDI in retail will bring competition to non-tradable services, and make Indian firms globally competitive

India removed barriers to trade in goods in the 1990s. Removing protection brought global competition and raised productivity. But introducing global competition in services is harder. In certain services that are tradable, like legal or financial services, the removal of trade barriers can introduce competition and increase productivity. But these often involve complicated and time-consuming multilateral negotiations. In other services that are not tradable, like retail trade, global competition can be introduced and improvement in productivity can be achieved by opening up the sector to foreign direct investment.

Reducing protection in the market for goods, cutting custom duties on imports, and removing quotas and other restrictions on trade raises few questions today. The case for trade liberalisation in goods is well understood by now. Trade liberalisation exposes local firms to global competition. Domestic firms have to innovate, produce better products, improve their technology, and reduce costs of production when imported products enter domestic markets. Under such pressures, these firms become more productive. These productive firms become exporters. The most productive firms invest abroad. Both face further competition in foreign markets and productivity growth continues. In contrast to the pre-trade liberalisation regime, productivity in the economy is higher and keeps growing. This results in higher growth of incomes and standards of living in the country. Trade liberalisation has transformed many countries, such as those in East Asia.

India has also seen the benefits of reducing protection in goods markets. Trade liberalisation in the 1990s, which continued into the early 2000s, saw Indian industry transform. At the same time that barriers to trade were reduced, domestic restrictions on production imposed through the licence raj were removed so that incumbents, who had long outlived the infant industry stage, faced both domestic and global competition. The FDI regime in manufacturing was, however, accommodated continued support to Indian industry. While opening up manufacturing to trade and to foreign investment, policy encouraged joint ventures that gave an advantage to Indian firms by not allowing 100 per cent FDI. The limit on how much could be invested by a foreigner was only slowly raised over the years. Clauses such as Press Note 18, which did not permit the foreign investor to start new ventures without the permission of its domestic partner, were put in place to support Indian firms. The result of higher competition and a carefully calibrated policy environment has been to create Indian firms that are strong enough now to become multinationals. Without the process of reducing tariff barriers and removing protection for Indian industry, Indian firms would not have ended up being so strong in world markets today. More than 300 Indian firms are multinationals now. They compete successfully with foreign companies on their turf.

Just as reduction in trade barriers brought competition to goods markets, tradable services can also be opened up to competition if the barriers are brought down. Services trade was growing rapidly before the global financial crisis, but it still represented a small share of the international economy. One reason for this, as a study by Sebastien Miroudot et al suggests, was high trade costs. In the goods markets, these costs include tariffs, non-tariff measures, transport charges, "behind-the-border" regulatory measures, and frictions related to geographical, cultural, and institutional differences. In the services sectors, trade costs are largely related to regulatory measures that either create entry barriers or increase the cost burdens faced by firms, in addition to geographical, cultural, and institutional differences. According to the World Bank's Services Trade Restrictions Database, which measures protectionism in services across the world, there are huge barriers to services trade. The absolute levels of trade costs in services are very high in the major economies; over 100 per cent ad valorem in all cases, and over 200 per cent for India. Trade costs in services markets are much higher than for goods and a multiple of two or even three times is sometimes seen. Trade costs in services can, therefore, be reduced by reducing trade restrictions.

Any reduction in trade restrictions in services is, however, likely to involve long and complicated multilateral negotiations. In many cases, improvement in domestic regulation, such as in finance, will be a precondition before trade in services is opened up. Competition, and the consequent higher productivity in tradable services, may therefore still take a while.

But for non-tradable services, such as retail trade, there are no such trade barriers to be removed or difficult negotiations to be held. This can be achieved by opening up these sectors to FDI. Sectors of the economy whose productivity is low can benefit from this. For instance, though modern retail has grown in India, especially in the last decade, the sector remains largely informal and this growth has been limited. Unlike trade in goods, the advantages of FDI in retail, such as better technology, management and the move to a modern, formal, tax-paying sector, will probably unfold slowly. There are many hurdles retail businesses have to cross before investment spending can begin.

The government might have supported FDI in retail to make a political point, to send a signal to investors, or to bring in foreign capital and prevent rupee depreciation. But whatever the reasons, this move takes India a step closer to increasing competition and achieving higher productivity in non-tradable services. With 51 per cent, rather than 100 per cent, FDI being allowed in multi-brand retail, large Indian companies that are either already in the business or have planned to enter it, are likely beneficiaries. Chances are, in twenty years it will be Indian companies running retail stores in towns and cities all over the world.