Politics has triumphed over economics. The UPA-2 government, which is swamped by a series of scandals, took the least politically controversial route, even if it ended up against sensible business logic. The new guidelines on foreign direct investment (FDI) in multi-brand retail have established that the ruling regime is scared that the entry of foreign retail giants can be raked up by the opposition parties, both during the state elections (later this year) and national elections (by mid 2014).

Therefore, what has emerged from the ‘clarifications’ issued by the government on June 6 on multi-brand retail is a mish-mash of a policy, which does not make sense. It goes against the grain of established global business practices; at the same time, it will allow foreign majors like Wal-Mart and others to short-circuit the restrictions imposed on them. The end result: either investments in organised retail will be delayed by a few years, as indicated by a recent Crisil study, or the inflows may be manipulated in a manner that may create fresh controversies later.

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The fact is that political fears about a possible backlash forced the government to put in certain ‘riders’ on potential investors. These included clauses related to FDI inflows, mergers & acquisitions (M&As) between foreign and Indian players, the role of the state governments and mandatory sourcing from small and medium enterprises (SMEs). The riders are likely to either dissuade foreign investors, force them to rethink their plans or find ways to wriggle around them.

Here is an explanation of how politics influenced specific clauses, its impact on businesses, and how companies may subvert them by crossing the fine line between what’s legal and what’s not.

The $100 million questions

The original policy envisaged that foreign retailers will invest $100 million over a three-year period, half of it in back-end operations like logistics, cold storage and procurement. Most international firms thought this would be easy, especially as some of them had already invested in the back-end cash-and-carry wholesale business. They reckoned that their existing investments would be included in the $50 million they had to spend on procurement-related infrastructure.

Scared that this may lead to fresh controversies, the government clarified that all investments, whether in back-end or front-end (setting up of the retail stores), had to be ‘additional’ and in ‘greenfield’ or new assets. In a single stroke, the business plans of foreign retailers went for a six. All the efforts they made in logistics to impress and mollify the policy makers to open up front-end retail seemed to be in vain. Companies like Wal-Mart, who played the waiting game, had to start ‘afresh’.

More importantly, the new rules implied that money spent on M&As between foreign and Indian retailers will not be considered part of the $100 million or $50 million investment. This crashed another pillar of the foreign retailers’ blueprint. The Wal-Mart-Bharti Retail partnership envisaged a clubbing of assets once FDI was allowed in front-end retail. While Wal-Mart had set up the back-end, which it thought would become part of the $50 million investment in logistics, Bharti owned the retail stores, in which it wanted to sell 51% stake to the foreign partner.

Other Indian retailers and owners of stores had commenced discussions with their foreign counterparts to sell 51% equity to the latter, as allowed under the multi-brand retail policy. But their hopes too were dashed. Since the ‘clarifications’ said that investments had to be in new assets, it derailed the ability of the domestic firms to take advantage of foreigners’ technology and other expertise. Was this done to safeguard the interests of Indian retailers, who did not want to join hands with global giants at this stage? Who are the real beneficiaries of the new guidelines?

Franchisees, partners and e-commerce

The June 6 rules stated that all the front-end stores have to be owned and operated by the foreign retailers. They could not set up franchisees or operate stores through partners. This was obviously done because the ruling regime did not wish to face flak from opposition parties in case a Wal-Mart or Tesco ran a store in states, which have refused to allow FDI in multi-brand, through such indirect alliances. Since most of the states that opposed FDI are opposition-ruled or managed by regional parties, it could have led to a political outcry and become a genuine election issue.

Similarly, foreign retailers were barred to sell their products through e-commerce. FDI in e-commerce in not allowed; for example, Amazon.com cannot run an Indian website and set up warehouses in India to supply to Indian consumers. However, foreign retailers like Wal-Mart, which earn sizeable revenues globally through e-commerce, thought that once FDI was allowed in multi-brand retail, they could use the e-commerce route additionally to sell their products. This was not to be.

Obviously, the policy makers felt that the criticism on sales through internet and mobile will be worse. In the past, critics of FDI have maintained that e-commerce is a larger threat to pop-and-mom shops and those employed in unorganised retail than the physical stores. Even certain constituents within the government too believe in this logic. If e-commerce had been allowed under multi-brand, it may have led to a new uproar against the government and its policies on retail.

There is no rocket science to conclude that foreign retailers will find ways around these stipulations. When FDI in front-end stores was barred, the Wal-Mart-Bharti Retail tie-up found ways out. The front-end stores, owned by Bharti, were managed by Wal-Mart; the foreign retailer took decisions on the size, location and design of the stores, as well the products to stock and their quantities. Although the stores were not called Wal-Mart, the inputs came from Wal-Mart. Bharti paid an annual sum to Wal-Mart for its services; Bharti’s employees claimed they worked for Wal-Mart.

The 30% disadvantage

In September 2012, the initial policy stated that 30% of the products sold by the foreign retailers through their stores would need to be procured from SMEs. Small industries were defined as enterprises with a maximum investment of $1 million in ‘plant & machinery’. In June 2013, the government clarified that such procurement would include only manufactured and processed goods, and not ‘fresh produce’ like fruits and vegetables. In addition, the 30% figure would be calculated on what is supplied to the front-end stores, and not to the wholesale business and/or for export purposes.

It is evident that the government wished to avoid public criticism that by including wholesale purchases and exports in the calculation, it allowed the foreign retailers to wriggle out of their obligations. Also, there was a realization that the wholesale and exports figures could be manipulated by the foreign entities, which might lead to fresh charges. There could be allegations that the government had allowed the Wal-Marts to sell mostly foreign goods in their stores.

Yet again, there is no reason to disbelieve that the SME nomenclature is likely to be abused. Since the June rules stated that a certificate by the ‘district industries centre’ is enough to ‘confirm status as small industry’, corruption will play a huge role. Companies are likely to bribe the officials to get these certificates even if they do not qualify. Foreign retailers, along with their Indian partners, may set up new firms, owned indirectly or through benami, to get this certificate.

One needs to consider the definition of manufactured and processed goods. What is the value-addition required for a product to be considered manufactured or processed? Are packaged fruits processed, or only juices and jams qualify? If a foreign retailer imports certain products, and gets it reassembled by an Indian firm, owned indirectly by it, would it be considered manufactured? These are important questions as they may allow retailers to trawl around the 30% sourcing rule.

The unanswered questions

The government itself has admitted that the June ‘clarifications’ still leave a few unresolved issues. The first is the manner in which the 50% investment in back-end operations, out of an overall investment of $100 million, will be calculated. Since no foreigner will invest $100 million in one go, but in phases, will the back-end investment be calculated on an increment basis (every dollar invested at each stage) or on an overall basis (after the $100 million are invested in three years)?

It is possible that the small industries, from whom the foreign retailers procure goods, may become bigger over time, i.e., the former’s investment in plant and machinery may exceed $1 million. In such cases, the foreign retailer may take time to switch to another small supplier. In such a scenario, will the government allow procurements to continue from such entities; if not, how much time will it give the foreign retailer to find alternative source of supplies?

At present, 12 states are opposed to FDI in multi-brand retail. But the June guidelines stated that if the foreign retailer can convince such states to allow FDI, the centre will make the relevant changes. This encourages the foreigners to lobby with the anti-FDI states in the near future. Also, the new rules said that states that allow FDI can impose additional laws on the retailers. Thus, if there is a regime change in a state that today allows FDI, it may turn into an anti-FDI state and come up with new restrictions.

At the end of day, FDI in multi-brand retail has become more complex than the period when no FDI was allowed. The same has happened in the case of single-brand retail, where the government has grappled with what to allow and what to restrict out of the hundreds of items sold by European giant IKEA through its international outlets. Clearly, the government did not think through the policy process in its hurry to allow FDI. Now that it has entered into the elections mode, it does not wish to do anything that can provide ammunition to opposition political parties. A typical Catch-22!