The political and legal system to lure foreign direct investment in India

By Indra Giri on November 28, 2016

India is gaining importance globally as a rapidly developing economy. Investors from all over the world have shown faith in the flexible Indian economy. One of the major factors for rapid economic growth in India after 1991 can be attributed to the huge inflow of foreign capital. There are various determinants which led to such huge capital inflow in India. A political and legal system is one of the key factors.

Foreign direct investment during the colonial period

To be specific, the chronological background of foreign investment in India can be traced back to the founding of East India Company of Britain. During the colonial era from the 1850s’ to 1947, India’s economy was was in the hands of the British Raj. During this period, the Indian economy remained stagnant and the growth rate was not much higher than the population growth rate of 1% (Kumar 2014).

However, on the other hand, some researchers argue that the British invested the capital in making the modern railway system which was considered the fourth largest in the world. Similarly, under the British Raj, the economy of the villages’ that is income after tax rose from 27% to 54%. This sector represented one-fifth of the total investment that the British made overseas (Meena 2015).

However, the British enjoyed the fruit of the investment as the political and legal system was under their control. The inflow of foreign capital was high but the return on investment was not shared. After the Second World War, Japanese companies entered the Indian market and they enhanced their trade with India. However, the United Kingdom remained the most dominant investor until 1947 (Shin 2014).

The legal and political environment in India since 1991

Pre-1990, the Indian industrial structure was extremely weak, both financially and technologically. The major problems prevailing were:

  • inefficiencies,
  • high costs,
  • poor management,
  • non-competitiveness,
  • excessive reservation,
  • import controls,
  • lack of export orientation and
  • disincentives to the foreign investors.

The new industrial policy that was announced in the year 1991 led to competition rather than protection as the much planned and coveted policy environment. The earlier requirement of approvals and licenses for any investments and expansions were abolished for all except for 18 industries. Within a few years, only five sectors remained under the ambit of industrial licensing (Jadhav & Katti 2012).

Graph for political stability and political right in India ( 1995-2011)
Political stability and Political right in India

Apart from the economic policies, the Indian government undertakes various political and legal reforms in order to attract foreign investment. The political environment of India has also improved post liberalisation. As shown in the figure, the political rights of India have increased from 4 in 1995 to 2 (where the score close to 1 is considered as strong political right). The inflow of foreign direct investment and the political environment of the country is expected to have a positive relationship. In other words, the increase in the inflow of foreign capital if the economy is more politically stable.

Political and legal environment of India in terms of rule of law
India’s performance measured in terms of rule of law index

However, in the legal front, India’s performance has been deteriorating. According to the rule of law index given by World Bank India’s score has declined from 0.26 in 1995 to -0.11 in 2011. The low score of rule of law in India is expected to have a negative impact on the inflow of foreign investment. This also shows the inability of the Indian government to implement the law properly at the ground level.

Political and legal performance of India in terms of various freedom
India’s performance measured in terms of different freedom

Apart from the political and the legal system the inflow of foreign direct investment is determined by:

  • trade freedom,
  • business freedom,
  • investment freedom and
  • financial freedom.

Close analysis is shown in the above figure. Trade freedom and financial freedom in India has improved over the years. However, the business freedom and the investment freedom has declined.

For example, business freedom in 1995 was 55 (out of 100) which has declined to 37 (out of 100)  in 2011. This shows that India is unable to provide enough business freedom for those who want to start a business in India. One of the main objectives of the recent governments is to improve its rank of ease of doing in business. Currently, India is ranked 130th out of 190 economies around the world. Low performance in business and investment freedom in India expected to have a negative impact on the inflow of foreign funds (The Global Economy 2015).

Major policies for attracting foreign direct investment in India

After introducing the economic reforms in 1991, the Indian government has initiated different policies over the period of time. After 1991, the government introduced various new policies such as:

  • abolition of licensing,
  • freedom to import technology,
  • the contraction of the public sector,
  • the free entry of foreign investment,
  • new trade policy,
  • the growth of importance of small industries,
  • dismantling price control.

Some of the major policies with respect to foreign direct investment can be summarised as follow:

  • Foreign firms obtained autocratic rights over international brand names in 1992.
  • Abolish the rule for requirements for industrial licensing 1993.
  • Allowed 100% foreign equity in the infrastructure projects in the year 2000.
  • Allowed limited foreign investment in the print media was permitted in 2002
  • Increase in investment cap from 48% to 74% in basic and cellular telecom services from the year 2005.
  • Open foreign investment ( 48 %) in the Banking segment through the automatic itinerary
  • In 2012 India opened the section for 51% FDI in retail.
  • Allowed 100% foreign direct investment in the Indian Pharmaceuticals sector
  • Allowed 100% FDI in the chemical sector under automatic route (DIPP 2015)

Similarly, in April 2000, the government started the Special Economic Zones (SEZs’) Policy to attract foreign investments, especially in the exports sector. The policy is intended to make economic zones a growth engine which will be supported by quality infrastructure. Another important policy is the plan of India investing $1 trillion on the infrastructure from the year 2012 to 2017 (Malhotra 2014).

The relationship between the political environment and the inflow of foreign direct investment

The political and legal system of a country is considered as a determinant of foreign direct investment and has been argued by various scholars. According to Jadhav 2012, political issue is an important factor in limiting capital flows. Similarly Anon n.d.  found that foreign direct investment has grown at a faster rate than most other international transactions and political environment has been one of the key factors.

However, on the other hand, some scholars argued that it has a significant impact on the overall political and legal system in the country. In other words, there is a two-way relationship between the two.

For example, The government of India has changed its foreign direct investment rules for three years as a relaxation for local sourcing norms and changed it to five years. With the new rule now Apple can open its own retail store in India and is also expected to start manufacturing (Reuters 2016).

Hence it is evident that the political environment is a great decision maker as far as the inflow of foreign direct investment is concerned. Political risk is mainly concerned with the issues such as:

  • government stability,
  • internal and external conflict corruptions and ethnic tensions,
  • democratic accountability of government and
  • law and order.

It is more critical in importance due to the multifaceted nature of its impact (Yalew 2013).

Statistically checking the relationship between foreign direct investment and political/ legal environment

The co-integration analysis between foreign direct investment and the political environment of India show that there exists a long-term relationship between them. In other words, the political and legal environment is one of the major determinants of foreign investment in India. So to attract more capital the political stability in India is important along with the freedom in business and investment freedom

Johansen tests for cointegration between FDI and Political globalization
Trend: constant

Sample: 3-18

Maximum rank parms LL eigenvalue Trace statistics 5 % critical value
0 2 -90.861602 .
1 6 -80.309409 0.71103 7.4743* 12.25
2 8 -76.572279 0.35575
Maximum rank parms LL eigenvalue Max statistic 5 % critical value
0 2 -90.861602 . 21.1044 18.96
1 6 -80.309409 0.71103 7.4743 12.52
2 8 -76.572279 0.35575

Co-integration analysis between inflow of foreign direct investment and political environment in India 

Measure of India's political environment in terms of freedom from corruption
Freedom of corruption in India

Another main issue related to Indian political and legal system is corruption. Making India a corruption free country is one of the main agenda for all of the governments that come into power. However, there has not been much improvement in the situation despite taking several measures.


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