The sad state of the policy on FDI in retail

[Update: An alternate interpretation of the real estate issue has been added]

This was a good wake up call back to reality after all the dreaming about the possibility of 100% FDI going all the way to convertibility on the capital account. No! The Indian government is not going to do the economically sensible thing. It will insist on putting spokes in the wheel and hurdles in the path of the eager investor.

It will burden the capitalist with burdens so big that he will begin to wonder if all the hoopla about the humongous Indian market is worth it at all. It will get down to telling the capitalist how to run his business and where to put his money. It will dictate what goods he may sell, where he may source his goods from and therefore at what cost, thus throwing all business strategies of the capitalist out of the window.

The simple case of mandatory investment in real estate

This is from the newspaper article cited today.

Senior executives and representatives of these companies met government officials in New Delhi this week to lobby for concessions. These included relaxing the local sourcing conditions, making investment in real estate part of the mandatory $50-million investment that foreign retail companies have to make in back-end infrastructure, as well as lowering the minimum investment figure itself.

The hallmark of a real estate bubble is that property prices go completely out of sync with rental prices of the same property. For instance, when a plot of vacant land that would get a bare rental price of Rs. 3 lakh p.a. has a market price of Rs. 1 crore or more, the market is betting that the prevailing expectation on interest rates is around 3%. This is simply because the market price of the land is nothing more than the discounted present value of all future rental income flows against that property. Given that land rentals are best seen as rentals in perpetuity, the discounted present value of all future rental income flows is nothing but the sum to infinity of a Geometric Progression with
• initial term (a) = Rental Price of land/(1+i/100) (Year 1 rental comes at the end of the year in the basic model)
• common factor (r) = 1/(1+i/100)

Market price of land = {Rental Price/(1+i/100)}/{1–(1/1+i/100) or

Market price of land = Rental Price/(i/100)

So a market price of Rs. 1 crore given a rental price of Rs. 3 lakh implies an expectation that

i = (3 lakh/1 crore)*100 or 3%

A 3% nominal rate of interest when price inflation is estimated anywhere from 6% (based on WPI) to 11% (based on CPI) means negative expectation on real interest rate. If ever you could say B-U-B-B-L-E, it is under such circumstances.

So, given that there is indeed a bubble in real estate, it is eminently possible that a multinational that specialises in the business of retail and is focused on keeping costs as low as possible as part of its business strategy would clearly have reasons to prefer leasing to buying, especially if it can get the requisite security of tenure. If, on the other hand, it is forced to invest in Real Estate, there is clearly less capital left to invest in other aspects of the business. In this manner, government actually gets to tell the retail chain where to put their capital.

A company whose core competence is running a chain of retail supermarkets through leased real estate would hardly consider it its core competence to make profits through real estate plays. By forcing the retail chain to play the real estate game, government is actually dictating their business strategy. Someone tell me what sense this makes!

[Update] – It may also be interpreted that these retail chains are asking to be allowed to include their real estate investments as part of the mandatory $50 million that they have to invest in back end infrastructure. If this interpretation were correct, then all they are trying to do is to free themselves from other mandatory investments and leave themselves free to make the rest of the investments most in keeping with their business plans. Not allowing them to do so, however, will still remain another way of dictating investment terms to the investing capitalist. I fail to see how this makes sense at all.[Update ends]

30% mandatory local sourcing hurts the Indian consumer

The policy on FDI in retail includes a mandatory requirement of 30% local sourcing. If the retailer prefers to source from suppliers in other countries, it implies that suppliers in this country are overall less efficient and involve greater cost for the retailer. Protecting local industry in this manner automatically implies hurting the local consumer burdening him with higher costs. In the name of protecting the Indian manufacturer, this policy hurts the Indian consumer.

To make matters worse, it is a classic case of Bastiat’s dictum of the seen vs the unseen. The employment that is created in the lines of production favoured by the policy is very visible and is seen. The employment destroyed in the industries that are disfavoured because the consumer now has less disposable income and is therefore unable to spend on those is unseen and can never be known or estimated, though it is very real.

The most one can say is that the spending caused by the policy is forced upon the consumer while the unseen spending that the customer would have engaged in would have been volitional and would hence have left him better off. That he would be better off is a logical necessity as the very use of force indicates that the option being forced is valued less by the consumer for if it weren’t, the force wouldn’t be needed in the first place. Thus, in economic terms, the policy of forced local sourcing leaves the Indian consumer worse off.

Time to review the policy

If the government wants to do something good for Indians in general, it needs to reconsider its policy on FDI in retail and allow foreign capitalists to invest as they wish to and stop dictating terms to them.

The sad state of the policy on FDI in retail
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