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:
- high costs,
- poor management,
- 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).
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.
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.
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.
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 rank||params||LL||eigenvalue||Trace statistics||5 % critical value|
Co-integration analysis between the inflow of foreign direct investment and the political environment 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.
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