(FORTUNE Magazine) - Walk into the Big Bazaar store in Inderlok, a lower-middle-class neighborhood in Delhi, and you can see the business opportunity as clearly as you can see the merchandise. Electronic equipment is displayed alongside women's panties, bags of rice are spilling out of packing cases, tennis balls are piled next to handbags.

"It's a typical bazaar feeling," says store manager Nitin Anand. "A little bit of clutter attracts customers."

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Indeed, the store, one of 90 owned by Pantaloon, India's largest retail group, pulls in up to 8,000 customers a day with its two-for-one offers, its air conditioning, and its wide array of merchandise.

Inderlok is at the heart of India's growing middle class, which makes up a third of the country's 1.1 billion population. And that's exactly where international retailers like Wal-Mart (Research), Tesco (Research), and Carrefour want to be.

But those companies' stores, ubiquitous in other countries, are nowhere to be found in India, thanks to restrictions on foreign investment. Even the promise of lower prices and more efficient supply chains isn't enough to offset the political power of India's 12 million shopkeepers, who account for 97 percent of the country's $258 billion in annual retail sales. Or the muscle of large Indian companies that have recently realized the potential of moving into retail and are urging the government to slow down reforms that would open the sector to foreign competition.

"Make it difficult - then the foreigners will have to pay more," says Kishore Biyani, founder, chairman, and managing director of Pantaloon. "Why should we make it easy for them?"

Biyani, who plans to expand the floor space of his $450 million retail empire fivefold over the next three years, is believed by his peers to be bulking up to boost the price he can ask from a foreign joint venture partner - possibly Wal-Mart.

Biyani denies that, and Wal-Mart spokeswoman Beth Keck wouldn't comment beyond saying the U.S. giant is open to all investment structures and has been talking to potential partners, "though we would prefer a controlling interest."

But there's no denying that retailers such as Pantaloon and RPG Enterprises are rapidly expanding their operations - and that Reliance, the Indian conglomerate, plans to spend up to $2.5 billion over the next two years to open 1,500 supermarkets and hypermarkets - in advance of an anticipated Western retail onslaught.

Opponents of foreign investment focus on the risk of heavy job losses in the industry, which employs more than 25 million people. Mohan Guruswamy, head of the Centre for Policy Alternatives, a Delhi think tank, estimates that eight million people would lose their jobs if Wal-Mart or similar stores took just 20 percent of the retail trade, unleashing a "pipeline of cheap Chinese goods" that would also hurt Indian manufacturers.

Others, like Sanjiv Goenka, vice chairman of RPG Enterprises, which owns the Spencers stores, talk about unfair competition. "With their deep pockets," Goenka says, "retailers with a multinational presence may resort to predatory and therefore unfair pricing."

But Arvind Singhal, chairman of Technopak, a Delhi retail consultancy, argues that India is an underserved market and that there is plenty of room for foreign companies as well as for big Indian players and small shops.

"Almost every major city will have one or more Indian-owned large stores within 24 months," he says, "and that won't displace existing outlets because of growth in traditional retail, so no one loses."

Singhal estimates that $15 billion will be invested in the sector over the next five years, boosting annual sales in modern stores from $8 billion to $50 billion.

How much of that investment will come from foreign companies like Wal-Mart and how much of those sales will wind up in foreign pockets is anyone's guess. Prime Minister Manmohan Singh is in favor of allowing foreign investment because of the positive impact he believes it will have on development, especially in agriculture.

But policy changes planned just before Singh visited the U.S. last July had to be shelved, partly because India's two Communist parties have taken up the twin issues of job losses and small shopkeepers' losing their livelihoods. Officials in Singh's government, which depends on those parties for its parliamentary majority, say they hope the Communists will allow the Prime Minister to take some initiatives after regional elections in two of their strongholds in May.

But Prakash Karat, leader of the main Communist Party, says that he has no intention of relaxing his position and does not expect government reforms in this area "in the foreseeable future." Administration officials also acknowledge that moves could be delayed by the business lobby.

Commerce Minister Kamal Nath says he is looking for an "incremental model that creates new jobs and does not replace or displace employment in small neighborhood shops." Foreign companies, he adds, would also be expected "to invest in the back-end processing and packaging" of farm produce.

Nath might initially limit companies such as Wal-Mart to India's six biggest cities and allow them to open only one store a year in each city, with not less than 100,000 square feet, so they can't be located in inner-city neighborhoods, where real estate is expensive. At least half the retail space would have to be allocated to food to stimulate the development of upstream agriculture. And the percentage of foreign equity would be limited at first, as it has been in insurance, banks, and telecoms, probably to 26 or 49 percent.

The only opening in the retail sector so far has been to allow 51 percent foreign stakes in single-brand consumer stores, such as those selling only Nokia (Research), Reebok, or Cartier products. But the concession, introduced in January as a politically significant start, hasn't gained much traction.

"It's a good first step forward, but we don't have any need to use it," says Subhinder Singh, managing director of Reebok India, which has 225 stand-alone franchised stores where it sells Indian-manufactured and imported goods.

Wal-Mart, Tesco, and Carrefour would not discuss their India investment strategies, though Wal-Mart acknowledges it is conducting feasibility studies and all have been talking to possible partners. Tesco is believed to be closest to Bharti Enterprises, India's largest private-sector telecom operator, which is diversifying into agribusiness and wants a retail joint venture when the policy allows it.

Wal-Mart already buys Indian goods worth more than $1.5 billion a year, ranging from bath towels to jewelry, and has asked for permission to open a liaison office. Tesco also sources in India and has an IT center in Bangalore.

Both companies are rumored to be considering opening wholesale operations, which are allowed under the current law and which have been pioneered in India by Germany's Metro. But it looks as if they are waiting to be able to retail what Wal-Mart's Keck calls a "wide assortment of general merchandise and food."

With retail sales increasing by an average of 10 percent a year, spending on luxury goods rising nearly twice as fast, and two-thirds of India's population under 35, consumer demand is clearly growing. Whether that demand is met over the next few years by Reliance, Pantaloon, and other homegrown retailers or by the Wal-Marts of the world depends on how successful India's Communist parties and its leading capitalists are in delaying the inevitable opening of the doors to foreign investment.

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