Can India replace China as the major recipient for Japanese investments?

Prime Minister Modi’s is visiting Japan for 5 days starting on August 30. Japan’s Prime Minister Abe is scheduled to personally welcome him as Mr Modi arrives in Kyoto, the ancient capital of Japan, on the first day. It is in fact not the first time they meet. Their relation started as early as in 2007 when Mr Modi visited Japan as Chief Minister of Gujarat to promote the state as the destination of Japanese investment abroad.

Through his effort, Mr Modi successfully brought a number of Japanese investment to his state, including Maruti Suzuki’s new factory. This time around, one of Mr Modi’s goal is to replicate the same for the whole of India.

Mr Modi’s visit to Japan will certainly help raise the status of India as a prime investment destination in the minds of Japanese corporate managers. China used to be a natural choice for Japanese manufacturers when they consider opening overseas production base in Asia.

By 2013, Japanese manufacturers have invested 7.6 trillion yen (US$76 billion) as foreign direct investment (FDI) in China, accounting for 14% of their total FDI. In comparison, India accounts for 1.0 trillion yen (US$10 billion), 2% of Japan’s total FDI overseas.

However, the rising tension between China and Japan is eroding the desirability of China as an oversea FDI destination. The anti-Japan protest in China in 2012 that led to boycotting of Japan-branded products and caused severe disruptions in business operations was shocking for Japanese business managers. According to a survey undertaken by Japan Bank for International Corporation, China had for years consistently ranked among Japanese manufacturers as the most desirable country to expand their business to.

However, in 2013, China slipped to a 4^th place in the survey for the first time since the survey started in 1992. In 2013, only 38% of responding companies to the survey listed China as a desirable country to expand to. In comparison, India took the second place with 44% score, closely behind Indonesia which topped the list in 2013.

The loss of appetite among Japanese businesses toward investing in China is already being reflected in data. In 2013, while the total FDI flow from Japan expanded by 35% from a year ago, the FDI to China fell by 18%. Clearly, Japanese FDI is shifting away from China. Can India, then, benefit from such shift? In other words, can India replace China as the recipient for investment flow from Japan?

While India is already seen as a desirable country to invest as the aforementioned survey shows, a shift of FDI from China to India is not yet happening. FDI from Japan to India in fact fell slightly between 2012 and 2013. It was Thailand, Indonesia, Malaysia and Vietnam that seem to have benefited most from the Japan’s FDI shift away from China in 2013.

What is preventing India from receiving larger investment from Japan? Japanese business managers typically point to two maladies in India, namely the poor industrial infrastructure and regulatory red tapes in India.

According to the 2012 World Bank ranking for the logistics performance index, India ranks at 65^th among the total of 186 countries, ahead of Indonesia (83th) and Vietnam (101th), but below Malaysia (32th) and Thailand (50^th). India fares much worse when it comes to regulatory red tapes. According to the 2012 World Bank Doing Business ranking, India, at 131^st among 189 countries surveyed, ranks at the near bottom of Asian countries, below Malaysia (8^th), Thailand (18^th), Indonesia (116^th) and vietnum (98^th).

With this background, the hope is already high among Japanese corporate managers that Prime Minister Modi could significantly ease the difficulty for them to invest in India. Prime Minister Modi is well known in Japan as a charismatic leader of Gujarat state who succeeded in improving the infrastructure and removing the regulatory barriers.

As the Chief Minister of Gujarat state, he has a history of being proactive in building better environment for businesses, based on his ideology ‘Less government and more governance’. Under his leadership, Gujarat has been providing good infrastructure with regular power and excellent road and port networks that are particularly important for Japanese businesses who are keen to set up manufacturing base in India.

Will Modi be able to replicate Gujarat model into India? While his track record as the Chief Minister of Gujarat is excellent, Mr. Modi would face a number of additional challenges in reforming India. First up is the political leadership. BJP-led NDA government achieved a complete control of lower house of the parliament in the last election, but still lacks a majority in the upper house and runs only eight out of 29 states in India. Central government can only legislate on matters directly related to defence, external affairs, infrastructure, banking and telecommunication.

While areas like land, agriculture, water, and local markets fall under the purview of states. Mr Modi has already started to tackle this need for corporation by highlighting the manifesto to improve centre-state relation, administrative reforms and developing infrastructure. Even then, we suspect many of the opposition controlled states may not be particularly forthcoming to cooperate. Bureaucracy is rigid and slow while corruption is considered to be pervasive.

Given the current willingness of Japanese businesses to diversify away from China, the next few years would be a golden opportunity for India to attract a significant investment flow from Japan. The critical element will be whether Prime Minister Modi could actually deliver on his promise ‘Come, Make in India’.