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 the East India Company of Britain. During the colonial era from the 1850s to 1947, India’s economy 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 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 was 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 a score close to 1 is considered a strong political right). The inflow of foreign direct investment and the political environment of the country are expected to have a positive relationship. In other words, the an 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 is measured in terms of the rule of law index

However, on 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 the 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 is 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 have improved over the years. However, business freedom and investment freedom have declined.


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 business. Currently, India is ranked 130th out of 190 economies around the world. Low performance in business and investment freedom in India is expected to negatively impact 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 initiated different policies over a 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 the importance of small industries,
  • dismantling price control.

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

  • 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.
  • 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 the automatic route (DIPP 2015)

Similarly, in April 2000, the government started the Special Economic Zones (SEZs’) Policy to attract foreign investments, especially in the export 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 for India to invest $1 trillion in 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 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 the political environment has been one of the key factors.

However, on the other hand, some scholars argue 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.


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 issues such as:

  • government stability,
  • internal and external conflict corruption 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 the political/ legal environment

The co-integration analysis between foreign direct investment and the political environment of India shows 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 political stability in India is important along with freedom in business and investment freedom.

Johansen tests for cointegration between FDI and Political globalization

  • Trend: constant
  • Sample: 3-18
Maximum rankparamsLLeigenvalueTrace statistics 5 % critical value

Co-integration analysis between the inflow of foreign direct investment and the 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 the 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.


  • Anon, Determinants of Foreign Direct Investment in India DETERMINANTS OF FOREIGN DIRECT INVESTMENT IN INDIA AND CHINA. , pp.82–105.
  • Bagli, S. & Adhikary, M., 2014. FDI inflow and Economic Growth in India An Empirical Analysis. Economic Affairs, 59(1), pp.23–33.
  • DIPP, 2015. Overvies of FDI in India, New Delhi.
  • Dr. Dhobale Sunil, R., Advantages & disadvantages of FDI in India. Advantages & disadvantages of FDI in India , pp.428–437.
  • Jadhav, P., 2012. Determinants of foreign direct investment in BRICS economies: Analysis of economic, institutional and political factor. Procedia – Social and Behavioral Sciences, 37, pp.5–14.
  • Jadhav, P. & Katti, V., 2012. Institutional and Political Determinants of Foreign Direct Investment: Evidence From BRICS Economies. Poverty & Public Policy, 4(3), pp.49–57.
  • Kim, H., 2010. Political Stability and Foreign Direct Investment. International Journal of Economics and Finance, 2(3).
  • Kumar, I., 2014. The Economic History of India, 1857 to 1947 by Tirthankar Roy: A Review, Thiruvananthapuram.
  • Malhotra, B., 2014. Foreign Direct Investment: Impact on Indian Economy. Global Journal of Business Management and Information Technology, 4(1), pp.2278–3679.
  • Meena, H.K., 2015. The Impact of British Rule on Indian Villages. American International Journal of Research in Humanities, Arts and Social Sciences, 12(1), pp.94–98.
  • Mitra, A. & Giri, I., 2016. Factors that attract foreign direct investment in India. , 37, pp.5–14.
  • Reuters, 2016. India opens the door for Apple retail with new FDI rules. Reuters. Available at:
  • Shin, S., 2014. FDI in India. Economic and Political Weekly, xlix(3), pp.66–71.
  • The Global Economy, 2015. Overview of Indian economy. The Global Economy. Available at: [Accessed November 21, 2016].
  • Yalew, M., 2013. Effects of Political Factors on Foreign Direct Investment flows.


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