The reasons why China received $92bn in FDI in 2008 and India got only $46.5bn are intriguing.

Indeed, if we analyse the Indian FDI data at the relevant microstate level for the period 1992 to 2005 and compare it with the Chinese data for period of 1978 to 2005 at the economic zone level, some stark differences emerge.

The Indian FDI model reveals that the country has grown mainly due to the quality of its human capital, the size of its market, the rate of growth of its market, and the political stability witnessed in the past two decades. India has abundant ‘human capital’, which means a vast pool of engineers and other educated professionals. English-speaking graduates also contribute to this stock of human capital, helping India in business process outsourcing, IT and IT-enabled services.

India also has the youngest population in the world, with the highest fertility rates, giving the country a ‘demographic dividend’ competitive advantage over China, where people will start retiring from 2017 after contributing to the economic activity for nearly 40 years. This human capital from India can provide continuous educated cheap labour to the globalised markets for decades to come. It can be said that this human capital has attracted some FDI to India to a greater extent than China.

Another factor for the growth of FDI into India has been the size of its economy. The size of the Indian market has been growing almost continuously for the past two decades. It has grown from less than $500bn in 2003 to more than $1200bn in 2008. The Indian economy, in terms of size, is now the 10th largest economy in the world and in terms of purchase power parity it is the fourth largest after the US, Japan and China. Companies are attracted to this market size and want to hedge their risks as markets in the developed world have matured, not giving any incremental growth opportunities to companies in their homeland. India’s GDP size has also attracted increased FDI in past few years.

Companies have also been attracted to India due to the rate of growth of the Indian market. The Indian economy has been growing at the rate of about 8% to 9% for the past 10 years. Even in the recent economic downturn, when the entire developed world witnessed negative growth, the Indian economy still grew at 6% to 7% in 2008 and growth has continued in 2009.

Political stability also plays a major role. In India, the past four governments have completed their full five-year term and the latest government has achieved its second consecutive term with a majority in parliament, for a term of office which runs until 2014.

Business climate factors

A different model seems to be emerging for China. For China, ‘congenial business climate’ factors comprising structural changes to the economy, creating strategic infrastructure at SEZs (special economic zones) and taking strategic policy initiatives seem to have helped the economy to grow. The strategic policy initiatives involved a fourfold approach – providing economic freedom, opening up the economy, attracting diaspora and creating flexible labour laws. These factors were identified as drivers for attracting FDI and the model was found to be significant.

The Chinese government’s approach was to invest heavily in the development of the basic infrastructure. It also focused on hinterland connectivity to join mainland China with the coastal area. It increased the total road length significantly, invested extensively in building a telecommunications network and ensured water availability for augmenting industrial production. The electricity availability in China was increased to meet the investors’ production requirements and electricity consumption in the country has increased manifold in the past 20 years.

Also, China created strategic infrastructure at its SEZs. Places such as Shenzhen were developed as coastal SEZs. The location of these SEZs was strategic to connect them with international shipping lines to feed developed markets. This led to a manufacturing boom in China.

In addition to the above changes, certain strategic policy initiatives were taken. These included providing economic freedom to foreign companies. As a result, more economic activity was opened to the private sector. This reduced the government participation in the economy significantly. The Chinese government opened up its economy, increased trade with the rest of the world, reduced entry barriers, gave tax holidays to investors, allowed 100% repatriation of profits and permitted ownership of 100%-owned subsidiaries of foreign companies. The government encouraged export-oriented unit promotion, and allowed fringe benefits to companies that were exporting 100% of produce to their global markets.

The Chinese government did not originally have the necessary expertise and connections with the Western world. In order to develop that link, the government started attracting diaspora from Hong Kong and other east Asia-based expatriates. These expatriates brought capital, intellectual wealth and their global network from the developed world to China.

China initially benefited immensely from these ‘guanxi’ networks of expatriates. Finally, the Chinese government introduced a ‘hire-fire’ labour policy so that entrepreneurs could set up companies in the country without any hitches. China created flexible labour laws so that labour and capital could freely move across borders and benefit the country. The old ‘rice-bowl’ system of permanent employment was replaced by a merit-based system, rewarding hard work, making professionalism more acceptable and introducing a risk-reward system which helped China to attract FDI. Flexible labour laws helped China to reduce trade unionism, improve labour productivity, allow bankruptcies and free ‘entry-exit’ to global firms.

Game of catch-up

While India’s reasons for attracting FDI were different to China’s, India should follow some concrete steps to catch up with China and become the leading destination for FDI inflows.

The major improvements that India needs to make are in the structure of its economic underpinnings. Infrastructure-related industries must receive major investments. The Indian infrastructure has to improve significantly and $500bn has to be allowed by the government to freely enter into the country through the FDI route. India has witnessed some success in completing a few important and successful infrastructure-related projects such as in metro rail (DMRC), highways (Golden Quadrilateral), electricity (DVP) and telecommunications (mobile usage). These successful projects should be emulated in other parts of the country and infrastructure should be developed at rapid pace by allowing free capital inflows.

Just making structural changes in the economic set-up will not provide inclusive and complete growth. India has to develop ‘large but few’ SEZs instead of building ‘small and many’ SEZs on the coastal areas of the seven lesser-developed states of Bihar, Madhya Pradesh, Orissa, Uttarakhand, Uttar Pradesh, Chattisgarh and Jharkhand. Organising labour-intensive manufacturing – mainly export-oriented – in these SEZ’s will help to feed and capture global markets.

India must also adopt a policy of openness – beginning with privatisations in such sectors as oil, banking, steel, air travel and cement manufacturing. It should also increase global trade by lowering tariffs to 20% levels. Instead of protecting government-owned companies and saving inefficient private sector firms, government should allow them to freely compete openly with foreign companies or be bought by these companies if they cannot fight competition from them.

One major step that the government needs to take is to involve the experienced, talented and foreign-educated diaspora. The rich Indian diaspora, about 3 million in number, has to be attracted from the US to invest in India. Successful Indians outside India should be honoured and invited to obtain free ‘dual citizenship’ of India. This diaspora can be asked to contribute to the growth of mass manufacturing in the SEZs and export products to the Western world.

Diaspora can be attracted by announcing a free seven-year tax holiday on their personal income. The consumption itself from these non-resident Indians will push the economy up. Immediate visas, on Indian ports of entry, should be granted to diaspora who wish to travel, live and invest in India. Diaspora should be allowed to contest elections to weed out corrupt Indian politicians and diaspora ministries should be set up in the centre of all states to invite non-resident Indians (NRIs) to the ‘ghar chalo’ (come home) programme.

Like the Chinese ‘chun-hui’ programme, India can attract NRIs through a ‘sambandh’ (relationships) programme to form a network of NRIs and encourage them to start up firms in India. Indian banks can be required to attract investment from NRIs through special close-end mutual funds especially targeted towards them. Bonds with higher interest rates should also be created to attract them to their motherland.

Finally, flexible labour laws will help to increase manufacturing activity in India. The government should repeal the law which states that a firm that employs more than 100 employees cannot lay off workers. Current bankruptcy filing laws restrict laying off workers and make it very difficult for firms to declare bankruptcy. This change will help to improve labour productivity and attract more FDI to India.

Dr Swapna Sinha is CEO of consultancy Strategism and a professor at Northwestern Polytechnic University in California.