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Wal-Mart's decision this week to end a six-year joint venture with Indian conglomerate Bharti Enterprises is a blow to the government's drive to attract foreign investment and could force other global retailers to re-think their expansion plans into the country, analysts say.
As the world's largest retailer, Wal-Mart's foray into India's $500 billion retail segment has been closely watched by other global players looking to crack the promising yet challenging market.
The companies, which jointly operate 20 wholesale stores, sought to open full retail outlets in the country but ultimately decided to relinquish that plan. Wal-Mart will buy out Bharti's 50 percent stake in the venture.
"The Indian government has acquired a very poor reputation among global multinationals for creating considerable uncertainty regarding the approval processes and also the taxation framework for FDI [foreign direct investment] into India," said Rajiv Biswas, senior director and Asia chief economist at IHS.
"We are seeing a retreat by foreign multinationals from their investment plans in India," he added, citing South Korean steelmaker Posco's decision in July to scrap a proposed steel project in the India state of Karnataka due to long approval delays.
Following Wal-Mart's announcement, Tesco—Britain's biggest grocer—told CNBC TV-18 on Thursday that it is awaiting further policy clarity before making a decision regarding investing in the country.
While the Indian government has taken several steps to ease foreign investment rules in the past year and a half—such as allowing foreign supermarket chains to enter the country and own up to 51 percent in their local operations—there are many strings attached to its policies.
(Read more: Raghuram Rajan: India's deficit is under control)
For example, it's mandatory for companies to bring in at least $100 million worth of investment, split between the front and back end, and source at least 30 percent of their products from local companies. This creates problems for multinational firms that have global quality standards to adhere to.
Arvind Singhal, chairman of consultancy firm Technopak Advisors says foreign players' limited interest in investing in India isn't a surprise given the government's restrictive policies.
"It's not about the lack of desire to invest; it's the practicality of implementing investment plans with government conditions. For example, if you're a Walgreens or Foot Locker, you don't need to put that kind of investment into the back end. This condition is onerous, " he said. "Hopefully, this will put pressure on the government to relook at its policies."
Singhal, however, sees Wal-Mart's decision to continue its wholesale venture in the country despite its challenges as a positive signal. India allows full foreign ownership in cash-and-carry or wholesale operations.
"Macro indicators of the world are such that India does offer some kind of promise. Frustration is there, but the opportunity is still attractive enough," he said.
Despite the allure of some 1.2 billion consumers and growth levels that are superior to that of developed nations, many India watchers say it will take some time before the country sees a pickup in FDI, particularly with the uncertainty of the 2014 general elections looming.
"The nearer we get to the election, the more likelihood any investment plans will be on the back burner," said Radhika Rao, economist at DBS.
Three key reforms are urgently needed, Biswas said, noting that tax law for foreign investment should be rewritten to remove uncertainty regarding taxation of FDI, the approval process needs to be streamlined, and the restrictions on key sectors like retail should to be changed to make the regulations workable for foreign firms.
"Unfortunately the current Indian government seems to be in a state of denial about the need for such far-reaching reforms," he said.
—By CNBC's Ansuya Harjani; Follow her on Twitter: