Quo Vadis, India II: Fragile political environment and darkening investment climate

Quo Vadis, India II: Fragile political environment and darkening investment climate

WRITTEN BY OLIVER HERZOG & DORJE WULF – QUO VADIS, INDIA SERIES 2/4

Despite the many structural problems in India’s economy, urgently needed reforms in terms of economic liberalization, budget consolidation and government effectiveness seem to have been put on hold recently. In addition, erratic political decision-making has contributed to an unpredictable investment environment.

  • India’s fragmented political landscape continues to slow down decision making
  • During recent regional elections, a string of corruption scandals have led to massive losses for the parties of the established ruling coalition
  • Several renowned companies (foreign as well as domestic) have been alienated by unfavorable intellectual property jurisdiction, non-transparent political decision making and unpredictable turns in tax policies

In spite of the many current economic problems, there seems to be a complete lack of efforts to bring reforms back onto the agenda at the moment. The Congress Party is frequently obstructed by coalition politics and its own fading support in the country. Within its fragmented political landscape, politicians struggle to make meaningful reforms happen while five or six different coalition parties are busy fighting for their own clientele’s specific demands.

In addition, unsettled by a string of corruption scandals, voters are now punishing the long-established elites of the nation-wide parties in state elections in favor of regional leaders. According to recent studies by KPMG and Gallup, corruption has become an endemic problem by now. A prominent example for the adverse effects of corruption on business is the case of the Norwegian telecom firm Telenor which was deprived of 122 telecom licenses in India after a corruption scandal in the licensing process became public. Another reason for poor regional election results were policy flip-flopping as well as a poor record of delivery. The recent election in India’s largest state, Uttar Pradesh (UP), is a case in point. The regional Samajwadi Party won, whereas Congress and the BJP performed poorly. While these changes in voter behavior are a good sign for a working democracy, they will not make it any easier to find political compromises in the future. Too many parties and groups joust for influence, thereby frequently contradicting economic reason and the needs of the Indian nation as a whole.

As investors prefer a predictable economic and legal environment in order to take decisions, the aforementioned developments are worrying. Recently however, a number of additional incidents in India have irritated the international business community casting a shadow on India as investment destination.

At the beginning of 2011, German wind turbine manufacturer Enercon was dragged into a demoralizing lawsuit against its own subsidiary Enercon India Ltd. (EIL), following a strategy dispute with their Indian joint venture partner. In the course of the case, the Indian Intellectual Property Appellate Board temporarily nullified twelve Enercon patents. In the end, the Germans lost effective control of the Indian company with sales of close to USD 600m and were forced to entirely write off their stake in EIL. The Enercon case caused diplomatic tensions between India and Germany at the highest level. Another high-profile case is that of the Korean company POSCO’s USD 12 bn steel project which has been delayed for several years now due to local protests against land acquisition. Recently, the German carmaker Volkswagen, which has been operating in India for over ten years now, put a planned USD 380m investment on hold over a VAT argument with the state government of Maharashtra.

Moreover, frustrated by the lack of political progress and non-transparent processes, steel tycoon Lakshmi Mittal recently announced that ArcelorMittal will shift its investment focus from India to other markets – markets in which returns can be realized faster and in which investments are more predictable. Even though Mittal believes in India in the long term, it is remarkable that a leading businessman of Indian origin considers India currently as too challenging a market.

Another prominent company struggling with the Indian system is telecoms giant Vodafone. The company is to be charged retroactive taxes of INR 2 billion (USD 35.8 million) originating from the sale of an Indian subsidiary in 2007. The deal structure was opaque due to several levels of investment vehicles registered in tax enclaves to exploit double taxation agreements between India, Mauritius and the Virgin Islands. After the Indian Supreme Court had dismissed tax demands in January, Vodafone thought to have won the case. However, now the finance ministry proposed new legislation to retroactively levy taxes on transactions as far back as 1962. The new law aims to circumvent international holding structures in order to grant the Indian state the right of taxation in any case. In the meantime, Vodafone’s hearing of appeal has been deferred until July 27 by the Bombay High Court. This case is particularly delicate for two reasons: firstly, the finance ministry de facto proposed to breach effective tax treaties with sovereign states. Secondly, the retrospective character of this tax proposal would make doing business in India completely unpredictable (what other retroactive laws might follow?). Especially this retrospective character sparked worldwide indignation amongst business executives, lawyers and investors.

Summing up, a high and rising budget deficit, a lack of structural reforms and an unpredictable legal environment taken together with high costs of debt (discussed in part 1 of this blog series) reduce investors’ confidence in the Indian market in the short term. At the same time, India is desperately in need of international funds to address its massive infrastructure requirements as well as to re-boost its industrial growth.

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This blog is a part of a Oliver Herzog and Dorje Wulf’s co-authored blog series on ‘Quo Vadis, IndiaThe next part will be published in the coming week.

Related links:

  1. Quo Vadis, India: A debt burden putting pressure on growth

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