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The Investment Risks of India's Federal Structure

By Finserv MARKETS - Dec 30,2019
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Investment risks of India's federal structure

With its 1.3 billion people, rising middle class and a growing startup ecosystem, India as a market is a no-brainer for international investors chasing high returns. Around the world, India figures in the top 10 list of countries receiving the most amount of Foreign Direct Investment. Most international investment in India flows in communications, manufacturing and financial services sectors.

In 2019, India was ranked at 77th position out of 190 countries in the Ease of Doing Business Index published by the World Bank. While this is a significant improvement considering India’s spot at 100th position just a year ago, a lot more needs to be considered before investing in India and one of the key risks for investors is actually India’s strength – its federal structure.

 Investment risks of India's federal structure
India follows a federal legislative structure where the powers of decision making are decentralized to the local municipality level. What this means is that while the central government can frame overarching laws and run pan-India projects, the implementation of such projects often becomes the responsibility of Indian states. Moreover, subjects such as healthcare, labour, infrastructure development, land acquisition and management are left to the discretion of state legislatures.

This means that investors looking to put their capital in Indian companies or start their own in the country must not rely on a pan-India strategy as it is imperative to plan differently for each state rather because the business environment in underdeveloped Uttar Pradesh can prove to be vastly different from fast-rising Gujarat.

For instance, India’s policy thinktank NITI Aayog tracks the progress of states in enabling businesses to function and tries to enable competitive spirits to speed up the reforms. Its recent report after surveying 3,000 Indian companies found that things like taking an electricity connection could vary vastly in time and effort across the country.

It takes 52 days on average in the country to get an electricity connection for firms but this number is 41 days for Karnataka, 32 in Gujarat and a whopping 95 days in the state of Odisha implying that any strategy that doesn’t focus on specific regions is going to be met with disruption, delays and cost overruns.

The data is similarly varied for state performance across other indicators such as land acquisition, single-window approvals and in some cases, even local taxes and surcharges on corporations differ across taxes – a product of India’s federal structure where states are empowered to determine their own revenue and expenditure strategy.

As an investor, this could mean a lot of extra work. For instance, it’s not just the federally allocated powers that one has to consider. It is also the result of these executive decisions which alter markets. For instance, some states in India have heavily regulated taxi-hailing apps such as Ola and Uber on the basis of industry lobbying and consumer complaints. Even as the government promotes Make In India, there have been instances of companies forced to shut shop or move their factories from one state to another seeking a conducive business environment.

Additionally, market structures differ greatly. With the arrival of the nationwide Goods and Services Tax, the indirect tax structure has been simplified but the bureaucratic red-tape is still very much ingrained in the system. Even as the government is trying to simplify GST slabs and filing processes, currently, firms doing business in several Indian states have to comply with local taxation laws too and even obtain licenses in certain cases from all states to be able to produce and supply goods across the country, which exponentially increases the paperwork.

Thus, India can be a very difficult market for investors for both Indians and foreign entities. However, navigating its federal structure can provide access to a bulging workforce, younger population, rising disposable incomes and a rapidly digitizing nation standing at the cusp of history.

The Indian stock market indices are still among the best performing in the developing economies group consisting of Malaysia and China etc. Meanwhile, the country is creating both soft and hard infrastructure at a rapid pace to ensure equitable access to the fruits of its growth story for one and all.

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