India is way below China in attracting FDI inflows and in more desperate need of FDI than China, which is anyway an export driven economy.

Why is India in need of FDI?

India needs foreign capital inflows to finance its current account deficit. The current account deficit is expected to be around 4% of GDP for 2011-2012, which is an alarmingly high level and the highest in eight years.

India cannot keep funding its current account deficit through foreign portfolio inflows which are volatile and can exit the country anytime. FDI is a long term investment in creating a fixed asset, and is unlike hot foreign money which can exit the country anytime. Posco, for example, which bought in the largest amount of FDI is planning to set up a steel plant in Odisha.

India desperately needs FDI like that, to sustain the current account deficit, which has widened and threatening to go out of control. This has impacted the rupee, which has already dipped to a record low in December and is threatening to do so once again. It would be an understatement to say that India is in “desperate” need of FDI.

Retrospective tax may now threaten FDI inflows

On Thursday the government decided to suspend FDI hike in insurance to 49%, from the existing 29%, due to political compulsions – one more setback in attracting FDI into the country. Already, there is a political impasse for increasing the FDI limit in multi-brand retail to 100%, an issue which foreigners have openly voiced concern about.

Retrospective tax will now add to the misery, though in the short term the government's ability to use the retrospective tax tool might add money to its coffers. However, in the long term it might be an impediment to attract FDI, as foreign investors might believe that India has a “hostile” attitude towards foreign investment.

The Chief Economic Advisor Kaushik Basu has said that amending the Income Tax Act with retrospective effect will not impact foreign investments into India. In the last few weeks, foreign institutional investors (FIIs) have voiced their concern over the retrospective tax issue and they do not seem to be happy about it.

In the last few days they have been net sellers in equities, an action that could very well suggest that they are not in agreement with Basu on the retrospective tax issue. Though, FIIs are not investors who bring in FDI, they have invested around $8 billion in the Indian markets in the current year and they are foreign investors after all, who play a big role in funding the current account deficit.

The government is clear that it would push through the retrospective tax reforms, with Pranab da categorically saying that India could not be treated as a “tax haven”. While the idea of retrospective tax is fine, the timing may be wrong, especially in view of the precarious current account deficit and the falling rupee.

GoodReturns.in