This article has been written by Siddharth Jayaprakash, who joins The Boardroom Lawyer Team as an Associate Editor. Siddharth is a law graduate of the University of Oxford and an incoming MBA student at IIM Bangalore. His main research interests concern the intersection between economics, public policy and the law.

Introduction

Barely a few months after it made history by acquiring a 77% stake in India’s Flipkart for a record USD 11 billion, Walmart was hit by a blinder of a curveball in the form of the Department of Industrial Policy & Promotion’s (DIPP) revised FDI policy. The logic behind restricting FDI (to a certain extent) in India’s retail sector is sound. Only a rabid Neoclassicist would extoll the virtues of free trade while completely ignoring its effect on an under-prepared – yet highly essential – domestic retail sector only now beginning to realise the possibilities of the digital age. Alexander Hamilton’s ‘infant industry argument’ – i.e. the idea that emerging companies need to protect their fledgling industries through government regulation and protectionism – has certainly been informing a lot of India’s retail/e-commerce rules across multiple governments. And it certainly has academic support. But be that as it may, the purpose of this article is to ask a completely different question: will the latest rules put a major wrench in Modi’s Digital India?

The E-Commerce Rules in a Nutshell

Very briefly: Currently, India has no over-arching legislation concerning retail or e-commerce. The applicable rules are housed in a smattering of different statutes – the Information Technology Act 2000, Competition Act 2002, and most importantly, the DIPP’s Consolidated Foreign Direct Investment (FDI) policy.

Apart from a few notable exceptions – for instance, allowing 100% FDI under the Automatic route to online marketplaces – the FDI policy has periodically chipped away at Amazon and Flipkart’s profitability by issuing rules almost tailor-made to detrimentally affect their business models. First, the DIPP enunciated the difference between the ‘marketplace’ model and the ‘inventory’ model. For the uninitiated, the former refers to websites where the owners do not sell goods themselves – they only offer the online infrastructure for others to sell. And the latter refers to websites where the owners themselves sell a large part of the goods offered by keeping an ‘inventory’ of goods stored somewhere. The DIPP categorised Amazon and Flipkart as members of the ‘inventory’ species – for which FDI is currently restricted – encouraging them to use companies controlled by them (such as Flipkart’s WHRetail) to sell goods on their platform. This was later outlawed, prompting them to switch to companies in which they had equity participation but not of a controlling variety (such as Amazon’s Cloudtail – a joint-venture in which it has a 49% equity stake), and also entering into exclusive deal arrangements with certain companies. But this too was outlawed by the latest iteration of the FDI policy – the marketplace cannot have even the smallest equity participation in any of the vendors, and no vendor can have more than 25% of the sales.

The result: Amazon and Flipkart are not allowed to have any inventory at all, even by a round-about method, and exclusive deal arrangements are now a thing of the past.

The Fallout

The picture painted by the Indian media of this entire saga has been somewhat simplistic. Amazon and Flipkart’s escapades with Cloudtail and WHRetail have been depicted solely as villainous attempts to evade the long arm of the law. However, it may do a world of good to consider for a moment why they were pushed to go to such great lengths. The short answer: having an inventory of some kind is necessary for the effective functioning of an online marketplace.

A large part of Amazon and Flipkart’s success can be traced back to two things – (a) their remarkable logistics, and (b) their periodic discount schemes. Logistically speaking, Amazon is a marvel of project management. It is no easy feat to ensure product quality, manage timely delivery, co-ordinate product returns, and guarantee a good stock of all the various products their customers log on to buy. In fact, both companies manage to do so without a hiccup largely because of the de-facto inventories that they until now could maintain. Additionally, the sheer frequency of their discounts – a large factor in the success of online marketplaces – would effectively become unsustainable given the ban on exclusive deal partnerships with certain brands.

So How does this Affect Digital India?

Over the past ten years, the growth in India’s digital penetration has been simply astronomical. While it is certainly true that Amazon and Flipkart have been riding that wave, it could also be argued that these two companies have played their part in creating that wave. As various studies indicate, after social media, the urge to participate in online retail is a big reason why many Indians log onto the Internet. In 2016, about 49% of Indian consumers used their mobile phones to purchase goods and services from online marketplaces – well above the global average of 38%. This is amazing, considering that India’s internet penetration was around 5% in 2009. As will be explained below, it is no coincidence that the growth in India’s Internet usage correlates with the rise of online retail.

Traditionally, Indian consumers have always responded to economic incentives more than they ever have to outreach and education schemes. Despite Paytm (and its advertisements) existing for years before 2016, it was only after demonetisation made online wallets a much more palatable system of payment that Indians flocked to the service. Similarly, no amount of outreach by the government and NGOs could have incentivised Indians to use the Internet if online marketplaces not made online purchases so stunningly cheap. The low prices that – as discussed above – are now under threat by the new e-commerce rules.

India still has a long way to go with a little over half the country ‘in the dark’, so to speak. According to a recent report, around 18% of ‘non-transactors’ – i.e. people who do not buy products from online marketplaces – cite a lack of trust in getting the right products as their reasons for sticking to brick-and-mortar stores. Such product quality issues would only be exacerbated if online marketplaces cannot keep ‘rainy day’ inventories in case many of their vendors happened to have quality issues. This problem is especially acute given that 20% of users who are unhappy with their first purchase are unlikely to ever log on again – the retention rate is abysmal. Furthermore, 13% of non-transactors cited inability to return products, as well as delivery time issues as negative factors – again, such logistical problems will be exacerbated by the new policy.

The Take-Away

India needs online marketplaces – so much is clear, and uncontentious. Even the SMEs that the new e-commerce policy is meant to protect, fare much better profits-wise in a world where online marketplaces exist than in a world in which they do not. Mom-and-pop stores now have a penetration that they could not have dreamed about ten years ago. They have the most to lose if running an online marketplace becomes more trouble than its worth.

And the issue is not just confined to the retail industry. Online marketplaces are major drivers of Internet penetration in India. Customers who become Internet-savvy to avail of lesser prices on websites like Amazon and Flipkart are the same people who power the growth of other technology start-ups offering products which require perhaps a higher level of tech-savviness. That is a powerful consideration – one that has unfortunately not received the air time it should.