Simplistic to think Chinese investments will improve India's trade balance

Five important points worth further reflection with respect to the Economic Survey suggestion to promote FDI from China

In the ongoing debate on the suggestion in the Economic Survey 2023-24 to promote foreign direct investment (FDI) from China, the following points may be worth further reflection.

First, developed economies contribute the majority share of global FDI outflows, with the US and Japan in the lead. Four-fifths of the top 100 multinational corporations (MNCs) undertaking investments in manufacturing abroad are from Europe, the US and Japan. FDI outflows from China have been on the rise, in the last couple of years, with greenfield investments in critical minerals, global value chain (GVC)-intensive manufacturing sectors such as electronics, motor vehicles, and green energy. Pushed by overcapacity and economic slowdown within, Chinese outbound FDI is guided by geopolitical factors, the necessity to avert higher tariffs in export markets, and to secure critical resources to ensure sustainable supply chains. A significant proportion of investments by Chinese firms are in Southeast Asian economies.  Other major host economies include member nations of the Belt and Road Initiative, where China has helped create prior facilitative soft and hard infrastructure.

Second, in the China+1 GVC diversification strategy of MNCs, India faces competition from other emerging market economies (EMEs). Alternative investment locations are being sought by MNCs as additional facilities while production in China is retained or even further enhanced. While the Chinese facility caters to its large market, the additional production facility — re-shored, near-shored or friend-shored — provides necessary flexibility by allowing quick response to uncertainties emerging from the global economic, climate and political contexts, thereby ensuring GVC resilience. Asean economies such as Vietnam, Thailand and Malaysia have already secured a lead relative to India in this process of GVC diversification. In addition, other EMEs in Central America (especially Mexico), North Africa and Central Asia are emerging as attractive alternative investment locations for MNCs, including from China. 

Third, in this competitive GVC diversification and FDI context, relative differentials are important. India’s oft-cited advantages such as the size of the domestic market and declining trade costs, therefore, need to be viewed in a comparative context. India’s middle class, though populous, remains concentrated at the lower end of consumption, with an overall lower per capita spending power across product categories relative to not just China but even some Asian markets like Thailand and Vietnam.

As for trade costs, they refer to transport and logistics-related costs, as well as to any impediment to movement of commodities across borders, including policy measures such as high tariff and non-tariff barriers. Average tariffs have declined globally to between 0 and 5 per cent over the last three decades, assisted both by multilateral commitments as well as participation in preferential trade agreements. Asean economies, for example, started reducing their tariffs through the Common Effective Preferential Tariff scheme as early as 1993. As of 2020, Asean is virtually a tariff-free region, with tariffs fully eliminated on almost 99 per cent products under the Asean Trade in Goods Agreement.  In contrast, India has seen a progressive increase in the average most favoured nation (MFN) tariffs in the manufacturing sector over the last few years. The recent reduction of tariffs in some product categories needs to be extended with the objective of aligning India’s manufacturing sector tariffs with those of its peer group EMEs.

Furthermore, Asean has a free-trade agreement (FTA) with China. All Asean economies and China are also members of the Regional Comprehensive Economic Partnership (RCEP). Consequently, common regulatory standards, cumulative rules of origins, and efficient customs clearance processes together contribute to lower trade costs, making them relatively more attractive  for FDI flows, both globally and from China. India’s FTA drive needs greater momentum, coverage and depth.

Even in logistics performance, where India has made progress in its overall rank and score in the last couple of years, it continues to lag the comparator Asean economies of Vietnam, Malaysia and Thailand in the important dimension of efficient customs clearance processes.  

An important additional caveat in this context is that a market that is protected behind high tariff walls, even if sizeable, will attract tariff-jumping FDI, which invariably is not accompanied by first-best technology and is not efficiency-seeking. India needs to liberalise its trade and industrial policies with an explicit export-orientation, as did the East and Southeast Asian economies.

Fourth, there is an inextricable link between investment and trade in a GVC world. It would be a fallacy, therefore, to believe that FDI from China will help reduce imports from China. Emerging empirical literature (see my “Limits to Supply Chain Diversification”, Business Standard, November 29, 2023) and recent trade trends (from WTO) show that, despite the ongoing GVC restructuring and a recent inward re-orientation of China’s growth strategy, it continues to be the largest exporter and importer of intermediate goods and the “world’s factory”. In lead destination economies for Chinese greenfield FDI, intermediate goods imports from China have almost tripled over the past decade (The Economist, August 1, 2024). Vietnam, Malaysia and Mexico, which have emerged as significant alternative production locations in GVC diversification by MNCs and are among the largest recipients of Chinese overseas investments, are observed to have developed more intensive supply chains linkages with China and consequently increased their reliance on China for imports used in manufacturing.

Fifth, it would be simplistic to assume that Chinese FDI in India will help increase exports to the US. Earlier this year, the US increased tariffs on imports of solar panels from Malaysia, Cambodia, Vietnam and Thailand following protests by US producers alleging re-routing with minimal local value addition by Chinese firms relocating to these Asean economies to circumvent trade restrictions. It may not be any different for India as domestic value addition through GVC integration increases only over time and if accompanied by complementary investments in domestic R&D and related infrastructure. It would, therefore, be useful, in this regard, to gain a  clearer perspective on allowing Chinese contract manufacturers (CMs) of developed economy lead firms in GVCs, as well as to understand the evolution of some CMs in China into original equipment manufacturers over time.

India’s FDI policy review, therefore, needs to focus on recognising the competition from other EMEs, and be accompanied by a more liberal trade policy, and a better understanding of trade-investment nexus in GVCs, as also of China’s placement and evolution with respect to developed economies’ lead firms in a GVC-dominated global trade context.

The writer is senior fellow, CSEP, professor, SIS, JNU (on leave), and author of India’s Trade Policy in the 21st Century, Routledge: London, 2022. The views are personal