Analysis of The Impact of Foreign Direct Investment On The Indian Economy

AN ANALYSIS OF THE IMPACT
OF FOREIGN DIRECT
INVESTMENT ON THE INDIAN
ECONOMY
A thesis submitted to the Ullivmity of Mysore, Mysore, through the Institute for
Social and EconolJli( Change, ISEC, Bangalore, for the award of the Degree of
Doctor of PhilosopllJ in Economics
DukhabandhuSahoo
L'ndcr thL' uf
Institute for Social and Economic Change, Bangalore
August 2004
DECLARATION
I hereby declare that the thesis titled "An Analysis of the
Impact of Foreign Direct Investment on the Indian
Economy" is the result of research work carried out by me at
the Institute for Social and Economic Change, Bangalore, under
the guidance of Dr. Maathai K. Mathiyazhagan, Economics Unit,
ISEC, Bangalore.
I further declare that it has not been previously submitted
either in part or full to this or any other university for any
degree. Due acknowledgements have been made whenever any
thing has been borrowed or cited from other sources.
Date: August, 2004
i
CERTIFICATE
This is to certify that this thesis titled" An Analysis of the
Impact of Foreign Direct Investment on the Indian
Economy" is a bonafide research work carried out by
Dukhabandhu Sahoo independently under my guidance and
supervision.
I also certify that this has not been previously submitted for
the award of any degree or diploma or associateship to any
other university or institution.
Date: August, 2004
ii
~ l L t ( J 7f:/8(ot(
Maathai K. Mathiyazhagan
ACKNOWLEDGEMENTS
Todt!Y, my dream of romplding " PI!. D. iJ I/wleli,,/ised with the co-opemtioll "nd belp, a great deal of
alld efforls of 171(//1)' people ill mallY ways . . -1J it is 1I0t passiM to ackllowledge all of Ihem, I 0111)'
meNtion a Je/f!dal/ew oj them.
Finl alld{rmIllOJI, J deeply illdebted 10 my mpen'isor 01: Alall!""i K Mathl)'a::;!Jagall IIl1der
wllOJ'e "1;/,, tlJls wOlk has be", cam'ed 0111. Hii' helpjit! critid!m, JIIggesliolls, metimlolls readillg
alld <'01I.r1(/1I1 e1/collragemml, and oterall moml .IIIPpOri made it pOJJi/;/e for lJIe to (()mpkte Ihe
11".rI." . J II) WOld 0/ appreaatioll will defillitely jail .riJorl 0/ hi.r collln/JIIlioll lowards Ihe o"kome o/Ihi.,
11-'ul"l. 111/1/ to !Jill!.
I 1I/011/t! like 10 expren my .rillcm t/}(1l1k.r to Ill)' Oodol<1l Lommittee mOII/;":! Dr. B. KaJllaiah,
Pro/e.,.,ur, emlral [J niverJity, Hydem/;ad, (llId Ms. B. P. 1/(llIi,. -1JJist(l1i1 Pro/eJJor, RBI IIlIil, ISEC,
for Iheir (olIdrll, if[olts, I'OllIable sltgge.rliollJ, (()mmelll.r (llIrI 1Il0rai mpporl.r 10 me silla Ihe begilllling of
II!}' It'st'anh It-'ork.
[ ,/lI(,'rd) (ypre.r.l Ill) p{!l<jit/llrJJ 10 the 1mlilllle for SOlia! alld Eml101Jlll' (ISEC) alld Ihe
IlIdldli COII/ilii jor Jo,ial S,ience ReseanJ, (1CfJR) for prfll'iding me all oppolillllilY 10 p"rme my
dUlloml .Ill1d,,'.r. I Ihallk Ihe praioll.r director Prof NI. COI}inda Rao alld the pm'elll director Prof
Copal K Kad.:lcodifor Iheir SJ/PPOlt alld wbile doil(g my rmart'h work,
.lJ a m<'dn/'ic/ifi/dr, I 1",11711 a 10l./;'01n PlVf Mtllia SaMh al/d Prof .'lrilldam Omgllpla, 1111 a
IIIIJIIINr of eIOIIOII}I! I.< ,1/,', diSOIJ.riolls. IJolldly ,hoiJh "lid Ilallle my assoaalioll wilh them.
,\ 1)' .Iill"'>! lihlllK., 10 1)/: I'd<'r Pedro IIi, AHOI?al, Proft.ror, II'/illiams College, US/l, for his help ill Ihe
,//I<1l1lildli!',' dlld/jl/l 0/ II,, J"I'eIllh (hapter of IhiJ the.lir. I also (/{kllowladge the vailltlbl,
WIIIINOIl, 11/1'10/ Kal/shik BaSIl, Pro/.-1I7!1nd Pallagaria, Prof K L KriJf!fla, Proj.
1\..11111<11', I'm/. .\.J.S. i\'a/{/yalla, Prof KP, Kalir"lan, Prof Viv<,kmllrty anrl Dr. Roupa
(hallda.
I IPo/llt! IiI:.,. 10 <'xpn'JJ III;' deep sense of gratitllde 10 Prof SaJhclllk Bide, Prof M.R Nart!Yana, Prof
11<'1i//"I" /i,lIO, Proj. K I / lZtljll, Prof S.N. Sal/gita, Prof D. Rajshekhar allrl Dr. S, Mahadheslvaren
jur I/;<'I/ "lIlOlIra"gemoll, 11<'1p/;1I allrl IIseflll dis(!(JJlolIJ d/lring Ihe ((Jllrse of all my Bi-aJ/l/lJal Progrw'
.1','/11111<11'1 11/ IJEC I dill ,i/,o Ihallkjit! 10 other famlty memberJ of ISEC jilr being helpjiil. I also Ihal/k
"II //;,' /'ilrlmpanls of lli'(l/III"cll j<'minars presellted al fSEC al /lariollJ sta"ges of IJI)' j'!/ldy for Ili<'lr
Wl/Jlnldll't'lommentJ.
III
A1y honest alld Jillare thallkJ to Mrs. Onistilla for helpillg me in the editorial work al
different Jtage '1 this TheJiJ. I wOllld also like to thallk Air. VS. Parthasarathy for his patient
and editing of Ihefillal draft of tIN! timir.
I am thallkflll 10 Mr. H.N. Ranganathan, E. .. :-ReglJtrar, IJEC, and A1r. V Ramappa . 41w1I1I1J
Officer. ISEC, for Iheir help. I am grateful to the Ph. D. Co-ordinaton (ISEC) al diffmlll
poillls of time. Air. K.S. Narayall alld Vel/kefesh for their JIIpport al Ihe lIeeded time.
] Jinarely ackl101vledge the help and aJJi.llallte received from AIr. K,iJ/ma Challdrall alld ;\Ir. Sal/!/J
Kamath in Ihe wmplller (mIre and the membm of Library slaff of ISEC "pedally Afr. Sharma. ,lIn.
[j/a. Kalyallappa. Vellkatesh alld Rajanna. I also like to accknowladge the help relldered 10 me I')' Ihe
Libra/Y staff o/IG] DK. RBI. Delhi School of EwnomiiJ, JNU. EXIM Bank. !IFF alld J\'I1'I-'P.
] lake tIm opporlullil), 10 thallk 111)' selliors [l,lIt/ak,iJhna. Alihir. MOllry. S itakallta . . 'lI/w. Kallall.
B/mnumorty. GhallaJhyma. Jatyanallda. J adelllallda. J aikat. Prmwka/; Amal. Geethall/ali.
Mini. Deepti alld Deepika.
FmndJ hme beell all importallt part ill Ill)' life and without their JIIpport and help. it WOII/d han bew
diff/mlt 011 my part to wmplele thl! work. I lake thiJ opportullity 10 thallk my friends 'Ii,lll. Bob/!)' .
.fd(Deepll). Ba/II, Ranjit. Anllr. Papll. Jallal. Gyana,Gopa/, Pral,,/,. Flanch/Ja. Pllma, Pmb,r .. \Iiro::a.
O)akra. Danny, S atyapriya. J atY(JJiba, Jllbodh. PratllJlma, fI anha. Ragl}/{. S ridevi. LiJ", . L/!/Jh.
K.rhyama. flmshi, Allallda. Pmtil}{l. Btlw.rh. PraJob, Venll, Jllkllmar. MaheJh. Jhalll. (;edalljaya.
Jllbir, Gilli and others for their kind help at different pointJ of time. I am also thallkftt! /0 Badn. JadJi.
alld. 4ntlla for their emotiollal support alld (/}mpany ill ISEC.
UJt bill 1101 le(JJt. I am Ihankful to my parents. brother Bima/, JiJten alld brothl'/J-ill-!-"IW allri the
,4lmighty for their constant moral sUpp0l1 in fulftlling my dream of wmple/illg the Ph. D. lim! ...
Dukhabandhll Sahoo
iv
CONTENTS
Declaratioll
i
Certificate ii
Ackllowledgemellts iii-iv
List of Tables ix-x
List offigllres xi
CHAPTER I 01-16
Introductory Background, Statement of the Problem and Objectives of the
Study
1.0 Introductory Background: Role of Foreign Direct Investment 01
1.1 Statement of the Problem 04
J.2 Review of TI1eories 06
l.3 Review of Empirical Studies 08
14 Objectives of the Study 12
1.5 Analytical Tools 12
1.6 Data Description, Sources and Period of the Study 14
1.7 Chapter Scheme of the Study 15
CHAPTER II 17-42
Determinants and Impacts of Foreign Direct Investment: Theoretical and
Empirical Review
2.0 Introduction 17
Section I
2.1 Determinants of FDI: A Theoretical Review 17
2.1.0 Theories Assuming Perfect Markets 18
2.1.1 Differential Rates of Return 18
2.1.2 Portfolio Diversification 19
2.2.0 Theories Based on Imperfect Markets 20
2.2.1 Industrial Organization 20
2.2.2 Internalization 21
2.2.3 An Eclectic Approach 22
2.2.4 Product Cycle 24
2.2.5 Oligopolistic Reaction 25
2.3.0 Other Hypothesis of Foreign Direct Investment 26
2.3.1 Liquidity 26
2.3.2 Currency Area 26
2.3.3 Diversification with Barriers to International Capital Flows 27
2.3.4 The Kojima Hypothesis 28
2.4.0 Review of Theories on Impact of FDI 28
v
2.5
2.4.1 The Benevolent Model of FD! and Development
2.4.2 The Malign Model ofFD! and Development
Section II
Review of Empirical Studies
2.5.1 Review of studies on the Determinants of FD!
2.5.2 Review of studies on the Impact ofFD!
29
30
30
31
35
CHAPTER III 43-63
Framework for Analysing the Determinants and Impacts of Foreign Direct
Investment on the Indian Economy
3.0 Introduction 43
43
44
47
48
48
3.1 Determinants of FD!
3.1.1 The Model
3.2. The Impact of FDI
3.2.1 Real Effects of FD!
3.2.1.1 Quantitative Effects of FD!
3.2.1.2 Qualitative Effects of FDI on the
Domestic Economy
3.2.2 Financial Effects
51
53
3.3 Framework for Measuring the Impact of FD! on the Host Economy54
3.3.1 FD! and Domestic Investment 54
3.2.2 FDI and Productivity 55
3.3.3 FD! and Income of the Host Economy 56
3.3.4 FD! and Employment of the Host Economy 59
3.3.5 FD! and Price level of the Host Economy 60
3.3.6 FD! and TB of the Host Economy 60
3.3.7 FDI and BOP of the Host Economy 61
3.3.8 FDI and Domestic Savings of the Host Economy 61
3.4 Cone lusion 62
CHAPTER IV 64-91
Policy Measures and Trends in Foreign Direct Investment Flows to India
4.0
4.1
4.2
Introduction
FD! in Pre-Liberalization period
Policy Measures for FDI in the Post-Liberalization period
4.2.1 Automatic Route
4.2.2 FIPH Route
4.2.3 Role of FIlA
4.2.4 Role of FIPC
64
66
68
70
71
71
73
4.2.5 Role ofSIA 73
4.2.5.1 Entrepreneurial Assistance Unit (EAU) of the SIA 74
4.2.5.2 Investment Promotion and Infrastructure
Development OP & 10) Cell 74
4.2.5.3 Project Monitoring Wing 75
4.2.6 Incentives for FD!
75
VI
4.3
4.4
4.5
The Impact of the New Policies and Some Stylized Facts
about FDI Inflows in India
4.3. I Growths and Size of FDI
4.3.2 Type ofFDI Inflows
4.3.3 Sources of FDI
4.3.4 Sector-wise FDI Pattern
4.3.5 State-wise Distribution of the FDI Inflows Approved
Evaluation of India's FDI Policy Measures
Conclusion
CHAPTER V
Determinants of FDI Inflows into the Indian Economy
5.0
5.1
5.2
5.3
5.4
5.5
5.6
Introduction
Framework for the Empirical Estimation
Variables and Data description
5.2.1 Explanatory Variables
5.2.2 Dependent Variable
Selection of the Explanatory Variables
Selection of the Functional Form
Results and Discussion
Conclusion
CHAPTER VI
76
77
80
80
82
83
83
86
92-113
92
92
94
94
98
98
99
100
105
The Determinants of FDI Inflows into India: A Sectoral Analysis 114-147
6.0
6.1
6.2
6.3
6.4
6.5
6.6
Introduction
Framework for the Empirical Estimation
Variables used and the Data Description
Selection of the Explanatory Variables and the
Estimation Procedure
Selection of the Functional Fom1
Conclusion
CHAPTER VII
Impact of FDI Inflows on the Indian Economy
7.0
7.1
7.3
7.4
7.5
7.6
Introduction
\1casuring the impact of FDI on the Indian Economy
at the macro level: The Methodology
7.1.1 Selection of the Lag length of the Variables
7.1.2 Stationarity of the Variables
Measuring the impact of FDI on the Indian Economy
at the Sectoral level: The Methodology
Conclusion
Vll
114
114
116
121
126
127
135
148-164
148
149
152
152
152
ISS
159
160
CHAPTER VIII
Summary, Conclusion and Policy Suggestions
8.0 Introduction
8.1 Major Findings of the Snldy
8.1.1 Trend, Composition and Dimensions of FDI
8.2 Detenllinants of FD! Intlows in India
8.2.1 Macro level Analysis
8.3
8.4
8.2.2 Sectoral level Analysis
8.2.2.1 Sector-specific Analysis
8.2.2.2 Sector-wise Analysis
Impact of FD! intlows op the Indian Economy
8.3.1 Macro level Analysis
8.3.2 Sector level Analysis
Conclusion and Policy Suggestions
APPENDIX 1.1
APPENDIX 4.1
APPENDIX 4.2
References
viii
165-182
165
165
165
166
167
168
168
171
176
177
178
180
183
ISS
187
192-200
List of Tables
Table 4.1: Sectoral distribution of the stock of FDI in India
from 1948 to 1990 87
Table 4.2: Alternative Estimates of the Actual FDI, 1991-2000 87
Table 4.3: Actual FDI Inflows from 1990-91 to 2000-01 88
Table 4.4: Actual FDI as a % of Approved FDI 88
Table 4.5: Types of Foreign Collaborations Approvals 89
Table 4.6: Source Country-wise FOI Inflows and the Growth Rates 89
Table 4.7: Sector-wise FOI inflows from 1991 to 2000 90
Table 4.8: State-wise Break-up of Foreign Direct Investment &
Foreign Technical Collaboration Approved
(from 1991 to 2000) 91
Table 5.1: The Least-Square Growth Trends of Macroeconomic
Variables of Indian Economy 107
Table 5.2: Sargan's Criterion and the Selection of the
Functional Form for the Deternlinants of FDI
Inflows at the Macro Level of Indian Economy 107
Table 5.3: Multiple Linear Regression Estimation of FDIl Function 107
Table 6.1: Least Square Growth Trend of the Variables of
Different Sectors 136
Table 6.2: Least Square Growth Trend of the Variables of
Different Sectors
Table 6.3: Sargan's Criterion and the Selection of the Functional Form
138
for the Sector-specific Detemlinants of FD[ Inflows 139
Table 6.4: Sargan's Criterion and the Selection of the Functional Form
for the Determinants of FOI Inflows at the
Sectoral Level of Indian Economy 139
Table 6.5: Multiple Linear Regression Estimation of FDIl Function of
PF Sector 140
EL Sector 140
TR Sector 141
Table 6.8: Multiple Linear Regression Estimation of FOIl Function of
CH Sector 141
FP Sector 142
Table 6.10: MUltiple Linear Regression Estimation of FOI[ Function of
the ME Sector 142
Table 6.11 :Multiple Linear Regression Estimation of FDIl Function of
DP Sector 143
TE Sector 143
Table 6.13:Multiple Linear Regression Estimation of FDIl Function of
[N Sector 144
Table 6.14: Results of Panel Regression Estimation of the FOI[ Function
(for all the nine sectors) 144
IX
Table 6.15:Results of Panel Regression Estimation of the FOIl Function
(for five major sectors) 145
Table 6. I 6: Results of Panel Regression Estimation of the FOIl Function
(for four minor sectors) 145
Table 6.17:Rcsults of Pooled Regression Estimation of the FOIl Function
(for all the nine sectors) with model S2R2 146
Table 6.18:Results of Pooled Regression Estimation of the FOil Function
(for five major sectors) with model S2R
2
146
Table 6.19: Results of Pooled Regression Estimation of the FOil Function
(for four minor sectors) with model S2Ro 147
Table 7.1: U nit-root test Results for Variables at Macro Level 162
Table 7.2: Granger Causality Test Results 162
Table 7.3: Compound Growth Rate of the Variables 163
Table 7.4: Unit-root Test Results for Variables for PCONT 163
Table 7.5: Individual Sector-wise FMOLS 163
Table 7.6 Individual Sector-wise OOLS 164
Table 7.7: Panel Group FMOLS Result 164
Table 7.7: Panel Cointegration Result 164
x
List of Figures
Figure 4.1 : FDI Inflows from 1980-0 I 77
Figure 4.2: FDI as % ofCA, GOP and CF 77
Figure 4.3: Approved and Actual FDI Inflows from 1991 to 200 I 78
Figure 4.4: Route-wise FDI Stock from 1991 to 2001 79
Figure 4.5: TC and FC from 1991 to 2000 80
Figure 4.6: Country-wise break up of FDI Stock from 1991 to 2000 80
Figure 4.7: Sector-wise break-up of FDI Stock 1991 to 2000 82
Figure 5.1: FDI Inflows into India from 1980 to 2001 108
Figure 5.2: GOPFC of India from 1980 to 2001 108
Figure 5.3: IR of India from 1980 to 2001 109
Figure 5.4: REER of India from 1980 to 200 I 109
Figure 5.5: EX of India from 1980 to 200 I 110
Figure 5.6: WPI of India from 1980 to 2001 lID
Figure 5.7: Actual and Simulated FDI from 1980 to 2001 III
Figure 5.8: Simulated FOI from 1980 to 2001 112
Figure 5.9 Simulated FDI from 1980 to 2001 113
XI
Chapter I
Introductory Background, Statement of the Problem and Objectives
of the Study
1.0. Introductory Background: Role of Foreign Direct Investment
Foreign Direct Investment (FOI) is an investment made by Multi-National Enterprises
(MNEs) or by a non-resident in an enterprise of host (recipient) countries over which
they have a control and earn private return. It is important to distinguish between
Direct and Indirect Foreign Investment (Appendix 1.1). The indirect investment
includes portfolio investment, acquisition of stock of an enterprise, medium-tenn and
long-tenn loans by financial institutions and intennediaries, and investment in new
issues of national loans, bonds and debentures. The direct investment is a long-tenn
equity investment in a foreign company that gives the investor managerial control
mer the company (Griffiths and Hall 1984). In fact, FDI is considered as an equity
capital in India though the IMF guideline prescribes to include reinvestments and
venture capital on the FOI flows (RBI 2003). Accordingly, the Government of India
redelined the FDI inflows in 2002 and included reinvestments and venture capital
along with equity capital. However, the present study has considered FOI as an
equity capital.
It is important to note that the developing countries had significantly eased
restrictions on FDI inflows and operations of MNEs in the early 1980s. This trend
became even morc widespread during the 1990s, which brought a significant FDI
inflo\\ into the developing countries. In fact, developing countries received nearly 40
per cent global PDI inf10ws in 1994-96 compared to 25 per cent in 1980-84 (United
Nations ConlCrence on Trade and Development, UNCT AD 1994). This trend of
growing share of developing countries kept on increasing till 1999-00, but it went
down to 30 per cent during 2001-02. Over the last three decades, the stock of FOI as
a percentage to the GDP has been phenomenal. It is 256 percentages for the world as
a whole but the onus is largely in favour of the developing countries as against the
devcloped countries since the percentage is 435 for developing countries and the
percentage is 210 for developed countries. I!owever, the absolute FOI stock over the
same period is Rs. 25,834,356.00 crores in the developed world whereas the samc for
the developing world is Rs 9,395,046.00 crores. Within the group of developing
III'.:, 'l! , .... :' '[ '- li.1 ... I-..J.:l' .
countries, the distribution of FDI !lows varies significantly both across regional
groupmgs and individual countries. China has been the largest developing countn
recipient of FDI since 1992 and India has been placed in the 7
'h
spot in 2002. In fact.
India opened up its economy and allowed MNEs in the core sectors as a part of
reform process in the beginning of 1990s. Since then it has attracted a big share of
FDI inflows among the developing countries and has become one of the lucratl\e
investment locations for the foreign investors. The net FDI inllow grew from Rs. 174
Crores in 1990-91 to Rs. 10,686 Crores in 2000-0 1, resulting in the annual awrage
growth rate as high as 6 per cent (RBI 200 I).
Emphasizing on the role of FDI in the developing countries, Moran ( 199X)
observes that FDI is a method of transmission of the package of 'managerial
resources' from one country to another country. The package of 'managerial
resources' may include specialized and technological knowledge in the areas of
patents, know-how, sales techniques, managerial expertise, and ability to obtam
funds and credit. Since the productivity of such transferred managerial resources is
very high in the recipient country, they make a big contribution to the development
of industry to which they are made available in the host country. Productivity is
high because these resources were earlier in short supply relative to other factors of
production. Naturally, therefore, when they are now made available, their
productivity will increase. There is quite a substantial empirical literature on FDI,
which supports this argument. Chenery and Strout (1966) state that foreign
assistance was the striking force for the rapid and sustained growth by countries like
Greece, Israel, Taiwan and the Philippines during 1950s. In each case, a substantial
increase in investment financed largely by foreign loans and grants, which has led to
rapid growth of GNP followed by a steady decline in the dependence on external
financing. The huge success of the Chinese economy in the post-Mao ear is also
credited to the FDI flows into China (Sahoo e/. a/. 2002).
The role and impact of FDI on the host economy is also subject to criticism.
In the earlier stages, a few studies had shown that foreign capital had a negative
impact on the growth of the developing economies (Singer 1950). Empirical
evidence also supports the argument of Singer. The empirical study by Xu (2000)
has investigated the U.S. Multi-National Enterprises (MNEs) as a channel of
international technology diffusion in 40 countries from 1966 to1994. This study has
2
I ntroductory Background
found strong evidence of technology diffusion from U.S. MNEs affiliates in
developed countries (DCs) but weak evidence of such diffusion in the less
developed countries (LDCs). Foreign firms bring the destructive impact on the host
economy because the foreign companies operate in industries where there are
substantial barrier to entry and increasing market concentration (Grieco 1986). In
that case, the foreign firms may lower the domestic savings and investment by
extracting rent. The foreign firms may drive out the local producers from business
and substitute imported inputs. In such a situation, the foreign finns may not bridge
the gap between domestic investment and foreign exchange. Also, the repatriation
of profit by the foreign fimls may drain out the capital from the host country.
The policy maker for the Indian economy tried to join the competition for
attracting more FD! as it was assumed that 1'01 has going to be a prominent factor to
achieve higher growth of the Indian economy. It assumed that FD! could playa
vital role as a source of capital, management, and technology in India. It has been
argued that FD! could bring technological diffusion to the economy through
knowledge spillover and enhance a faster rate of growth in India. It is important to
note that the gain in the national income also depended on the size of capital inflow
and elasticity of demand for capital, which could increase the technological and
managerial inputs and transfers and spillover to local firm. Thus. it increases the
production at faster rate at the national level. However, given the imperfect market
condition like in India may lower the domestic saving and investment by extracting
the capital through prepared access to local capital market. It can be argued that the
MNEs, in the name of FDI, may drive out the local film because of their
oligopolistic power, and also, the repatriation of profit may drain out the capital of
the host country. These arguments raise several questions. Does FDI flow help the
developing countries like India to achieve higher economic growth? If so, is the
FD! flowing to India sufficient, given the size and diversity of the Indian economy?
What are the necessary policy requirements to attract more FDJ'I In this context, it
is also relevant to observe. whether macroeconomic indicators or sector-specific
indicators or combination of both determine the FD! inflow in India') How can FD!
be used to attain higher economic growth, both at the macro level as well as at the
sectoral leveP What are the sacrifices needed to be made to usc the FDI in the
growth process of the economy') In order to answer these questions, it is necessary
3
Introductory Background
to make a detailed study of the impact and the detenninants of FDI inflows to India
at the macro level as well as at the sectoral level, which is has a short history of
liberalization. Thus, the main objective of this study is to analyze the impact of FDI
flow and the policy concems it engenders.
1.1. Statement of the Problem
The heavy reliance of the Indian economy on extemal debt in the financial year 1990-
91 due to severe balance of payment crisis led intemational credit rating agencies to
lower India's rating both for short and 10ng-ten11 borrowing. This made borrowing in
intemational commercial markets difficult and also led to an outtlow of foreign
currency deposits kept in India by the NRIs. The situation was made worse by the
Gulf war, which resulted in an increase in petroleum prices and caused virtual
stoppages of remittances from Indian workers in the Gulf These developments
brought the country almost to the verge of default in respect of extemal payments
liability. As this critical juncture, the then Finance Minister Manmohan Singh
scripted a new chapter in the history of Indian economy by initiating a programme of
macro-economic stabilization and structural adjustment supported by the I:Y1F and
World Bank. An economy, which was not considering foreign aliment favourably,
tried to mingle itself with the world economy that was hit by the wave of
globalisation. As a result of this, FDI flows into India increased significantly into the
19905. The compound growth rate of FDI was 4 per cent during 1955-66, which rose
to 75 per cent during 1991-98. Therefore, it is going to be a prominent force in the
:Y1acroeconomic Policy and Growth of the Indian economy. However, the FDI
inflows into India have been very low as compared to other developing countries like
China, Brazil, :Y1exico, Thailand and Korea. The share of the FDl inflows into India
as against the total FDI inflows to the developing countries is only 1.2 per cent (RBI
1998), Keeping the positive effects and importance of FDI flows, it is necessary to
analyse the reasons for low FDI inflows into India. In this context, it is important to
analyse the detemlinants of FDl intlows both at macro and sectoral levels.
As argued earlier, FDI can play a vital role as a source of capital,
management, and technology in India. FDI can also fill the gap between desired
investment and locally mobilized savings (Blomstrom and Kokko 1997). l.ocal capital
4
markets are olien not well developed. Thus, they cannot meet the capital
requirements for large investment projects. Besides, access to hard currency needed
to purchase investment goods is not possible locally. I'DI solves both these problems
at once, as it is a direct source of external capital. FDI also can fill the gap between
desired foreign exchange requirements and those derived from net export earning (Fry
1993). This can be done since the FDI will bring currency in the foreign
denomination and as a result the lorex reserve of the domestic country will go up.
FOI can create employment in the modem sectors of the developing countries like
India (Lahiri and Ono 1998), if the host country forces a domestic content
requirement on the lorelgn limls. In this case, the foreign firms have to employ the
unemployed and underemployed resources of the host/domestic country. As the
foreign timls are expected to reduce the set up cost in the less efficient host countries
by bringing in better technology and know how, the prices would go down. In the
light of this. the consumers in these countries can benefit through lower prices (Sahoo
e{ ui. 1001) and imprO\ed quality of goods. FDl can stimulate domestic investment
through tl)[\1 ani and backward linkages (Glass and Saggi 200 I). Output of a foreign
linn can be an input of the domestic industry and vice versa. If this is so, the I'D! can
create demand for the products of industries producing goods purchased. This would
lead to an increase in the upstream and down stream domestic investment in the host
country.
The adverse implications of FDI are those when FDI is competitive with
home imestment, and the profit in the domestic industries falls, leading to a fall in the
domestic sal ings (Chai 199)-;). The contribution of f()rcign fimls to public revenue
through coq)l)rate taxes is arguably less because of liberal tax concessions, excessivc
lll\'cstment allowances. disguised public subsidies and tariff protection provided by
the host gowmment. Foreign timls reinforce dualistic socio-economic structure and
increase inC1ll11l: inequalities. They create a small number of highly paid modem
sector executives and divert resources away from priority sectors to the manufacture
of conspicuous consumption for the elites. Added to all these problems, the out now
of profit is tuo large in many cases, putting pressure on the foreign exchangc reserves.
Moreover, the repatriation of profit by forcign tinns may drain out the capital from
the Indian economy. In tIllS context, there is a need to study the impact of FOI
lIlnows both at the macro as well as at the sectoral levels.
5
It can be observed from the fact that FD! highlights the possibility of
substantial opportunities as well as considerable dangers. Therefore, the main
objective of this present study is tu examine both the negative and positive impact of
I'DI on the Indian econumy and suggest policy measures for promoting higher I'D!
intlows, v\'hich may make a significant contribution to the economic growth in India.
1.2. Review of Theories
Theories of FD! may be classified and explained in terms of the detemlinants and its
impact. The theories on the detemlinants of FD! are explained by the assumption of
the market structure. viz .. perfect and imperfect. The theories relating to the impact of
I'DI are based on the positi\l? and negati\e impact uf FD! on the host economy.
The theories assuming perfect competitiun include differential rate of return
(lla tbauer 1975) and p0\1fol io diversi fication. It assumes that the difference in the rate
of return across the globe and the objective of reducing the risk by purtfuliu
diversification results in the FDI nows. The portfolio diversification theory is an
Imprmement mer the differential rates of return theory in the sense that by including
the risk factor. it can account for countries experiencing simultaneously inflows and
outno" s of foreign direct imestment. A more fundamental criticism of this theory has
been the argument that in a perfect capital market there is nu reason to have firms
di\ersifying actintles just to reduce the risk for their stockholders.
The tlicorie, assumll1g imperfect competition include: (a) Industrial
Organi,ation (Ilymer I 'J76). (b) Internalisation (Ruckley and Casson 1976). (c)
Product Cycle (\'ernon 1966) and (d) Oligupolistic Reaction (Knickerbocker 1973).
IIl)\\en:r, the element of all these theories can be observed from Dunning's Eclectic
Paradigm (Dunning 1977. 1979. 1988). The paradigm integrates three strands of
literature on t()reign direct investment. viz., the industrial organization theury, the
IIltemalisation theory and tIl<: location theury. lie argues that three conditions must be
satlstied if a linn is to engage in foreign direct investment. Firstly. the timl must have
som" own"rship ad\'anlages with respect to other timls and these advantages usually
arise from th" poss"ssion uf timl-specdic intangible assets. Secondly. it must be more
bendicial t(lr the tirm to usc these advantages rather than to sell or lease them to other
6
Illlroduclory Buckgroulld
independent finns. Finally, it must be more profitable to use these advantages in
combination with at least some factor inputs located abroad, otherwise, foreign
markets would be served exclusively by exports. Thus. the foreign direct investment
to take place. the finn must have ownership and internalization advantages, and a
foreign country must have locational advantages over the finn's home country.
Dunning further divided these advantages into three groups, viz., (i) Ownership
advantages, (ii) Location advantages and (iii) Internalisation advantages. All these
three advantages constitute the famous OLI (Ownership-Location-Internalisation)
model of Dunning. Though the OLI paradigm covers most of the detenninants of the
FDI flows into a specific location, it doesn't cover certain finn specific variabk like
labour producti\ ity (LPR). The LPR is a very crucial guideline for investors to invest
especially at the sectoral level.
There are two models on the impact of FDr. The first model assumes that FDI
would be more useful to the economies with the vicious circle of under development.
In this case. the potential host economy is mired in a poverty-laden equilibrium with a
vicious circle of poverty. FDI can break this circle by complementing local savings
and by supplying more effective management. marketing and technology to improve
productivity (Cardoso and Dornbusch 19/;9). The gain in national income depends on
the size of the capital flows and the elasticity of the demand for capital. Furthermore,
technological and managerial inputs, transfers and spillovers to local firnls may cause
the nation's production function to shift upward. Thus, under competitive conditions
which the presence of foreign firms may enhance FDI should raise efficiency, expand
output and lead to higher economic growth in the host economy. The emphasis on the
new resources that the foreign investors bring to remove the bottlenecks that deters
the development process is a common theme among international business groups and
multilateral agencies that urge greater acceptance of FDI in the developing countries.
The second school of thought criticises the role and motive of FDI,
particularly in the developing countries like India. In the earlier stage, a few studies
have shown that foreign capital had a negative impact on the growth of the developing
economies (Singer 1950). The foreign firn1s brought the destructive impact on the
host economy because the foreign companies operated in industries where there were
substantial barrier to entry and increasing market concentration (Grieco 1986). In that
7
Introductory 8uckground
case, the foreign finns might lower the domestic savings and investment by extracting
rent. The foreign firms might drive out the local producers from business and
substitute imported inputs. In such a situation, the foreign firms were not, able to
bridge the gap between domestic investment and foreign exchange. Further, the
repatriation of profit by the foreign firms drained out the capital from the host
cOllntry.
The abO\c disclission shows that the determinants of 1'01 flows are largely
explained by the Ol.l paradigm. This can also help develop a theoretical framework,
\\hieh can be useful to explain the detenninants of FD! in the present study.
Hlmever, the present study tries to develop the OLl paradigm and introduce some
finn specific \ ariable like LPR in the theoretical framework for the determinants of
FDL Further, the dichotomous \'iew on the impact of FDl on the developing country
can be the guideline to construct a theoretical framework for assessing the impact of
I'D! in India. This certainly helps in finding out a holistic approach towards the role
of FDI in India.
1.3. Review of Empirical Studies
Empirical studies have been grouped according to the theoretical issues they deal
\\ith. In the empirical literature, market size and growth rate of the market arc
considered as the major detenninants (UNCTAD 1993, Wang and Swain 1995,
Sianesi 19l)5. Aristotelous and Fountas 1996, Chen 1996, Jun and Singh 1996, Liu e/
af. 1997, Hasnat 1997). The earlier studies emphasize that a big market size of the
host economy would attract foreign firms to produce in the economy whereas the
small market size of the home country of the MNCs would induce the fiml to go out
for overseas production. However, it is also argued that if an economy grows at a
faster rate. it would attract more foreign finns and bring more FDJ. In this case, the
growth rate of the economy is a better indicator of the demand than the simple size of
the economy (Wang and Swain 1995).
Lucas (1993) and Jun and Singh (1996) have argued that in addition to the size
of the domestic market in the host country, FDI also depend on export markets.
Though the market size hypothesis argues that inward FDI is a function of the size of
the host country market, many export-orientated countries attract more FDI as they
serve the export market of the product. Thus, if host country's tinlls are export
8
j ntroductory Background
oriented, these linns attract :viNEs who are interested in exporting that product.
However, the study by Kumar (1990) for the Indian economy does not support this
vIew. Kravis and Lipsey (1982) and Chen (1992) identify import as the important
detemlinant ufthe MNC activities. It is based on the Kojima hypothesis as they argue
that the MNCs activities could be affected by the import from the host country. In
this case, the import of the host country would appear in the cost detenninant of the
FD!, as high import intensity of the host nation would deter the FD! inflows into that
economy.
A set of studies have proposed that tax incentives are less likely to attract
foreign investors, whose production is primarily for the domestic market (Root and
Ahmed 197R, lun 1989). These studies argue that for prospective investors, whose
im'estment is uriented towards the local market, the degree of protection is often a
crucial detemlinant of the decision to invest or not to invest and is of far greater
cuncem than tax holidays.
The empirical literature on the impact of FD! supports the dichotomous view
on the impact of FDI. Chenery and Strout (1966) state that foreign assistance was the
striking force for the rapid and sustained growth by countries like Greece, Israel,
Taiwan and the Philippines during the 1950s. Kamath (1990) has stated that FDI
made substantial impact in modemizing Chinese industries including the transfer of
low and intemlediate technology, managerial expertise and marketing knowledge.
The empirical study of Karikari (1992) for Ghana economy doesn't support the view
that FDI lead 10 ecunumic growth. Further, the cross-sectional study of Shamsuddin
(1994) for developed and less develuped countries finds negative correlation between
FDI and economic growth. Wang (1995) explains growth differentials among Chinese
urban areas due to FDI that produced technological spillover in China, The study also
states that the growth differentials in Chinese urban areas could be attributed to the
differentials in the flows of FDI to the regions. However, the empirical study for the
U.S by Kashibhatla and Sawhney (1996) suppurts a unidirectional causality from
GDP to FDJ, not the reverse. This might be due to the fact that for a developed
country, FDI followed C,DP, as GDP was an indicator for market size. Sashir (1999)
has examined the relationship between FDI and growth empirically in some MENA
countries, using panel data. The study finds that FDJ lead to economic growth; the
effect, however, varied across regions and over time. The study by Sahoo et af.
9
Introductory BJckgroulld
(2002) also supports the positive contribution of FDI towards the GOP growth in
China during the post !vIao era.
The above survey reveals the fact that there exists a dichotomous view in
respect of the role played by the FOI in a host economy. IIowever, there is no
denying the fact that FDI has emerged as a fundamental source of financing for the
developing countries like India. It is observed that most of the studies differ from
one another in respect of sample and the method of analysis. This difference in the
sample and the approach to the study could be seen from the discrepancy in the
results. The existing Indian studies also show that there are contradictions in the
findings. The study of Gopinath (1998) linds that GOP and the lorex reserves were
the main positive determinants of FDI inflows into India. The study also confirms
that the personal disposable income contributed positively towards the flow of FDI
in India. However, the study has ignored some of the key policy variables like
degree of openness of the economy and exchange rate, which determined the FDI
flows. The study by Jaya Krishna (200 I) considers these policy variables, but
ignores the variables such as GDP and exports and imports. llowever, neither of
these t\\O studies has considered all the variables comprehensively.
The studies relating to the impact of FDI are very limited. The study by
Dua and Rasid (1998) shows a uni-directional causality from Index of [ndustrial
Product (l[P) to FO[ but not the reverse. III' is taken as the proxy for GOP in this
study. However, lIP cannot be a proper proxy for GOP as industrial sector
contributes less than 30 per cent to the GOP in India. Chakraborty and Basu (2002)
have tried to lind the short-run dynamics of FDI and growth in India by using a
thrifty vector error correction model (VECM). The model reveals three important
features Ie, (a) GOP in India was not Granger caused by FDI; the causality ran
more from GDP to FDI; (b) trade [iberalization policy of the Indian government had
some positi\'e short run impact on the FDI flow; and (c) FDI tended to lower the unit
labour cost suggesting that FDI in India was labour displacing. This study has also
ignored an important role of FDI, which is to add to the domestic capital. These
studies have not considered the total impact of I'D[ on the macro economic variables
of the Indian economy. The other studies like Pant ([ 995) and Subrahmaniam
(1967) differ in their opinion. All these studies have tried to find the impact of
import and 1'01 on export capacity at the firm level. The fOimer two studies accept
10
Introductory Bac'ground
a positive impact of import intensity on export capacity of the finns. These studies
have used import intensity as a quantitative dependent variable and estimated the
model by simple OLS method. The latter study rejects even the probability of
export capacity by import intensity by using the quality response model. Moreover,
none of these studies has explored the impact of FDI on other finn level variables
like productivity and factor cost. There is also hardly any study to access the
detenninants of FOI at the sectoral level.
The above discussion reveals the fact that the studies at the macro level in
India did not cover all the macro economic variables to assess the detenninants and
impacts of FOI. The existing studies have ignored important macro economic
\ariables like capital formation and savings while assessing the detenninants and
impacts of FDI in India. It is also observed from the literature that the policy
\ariables like interest rate and exchange rate have been ignored in the existing
studies. The present study tries to include these variables in the analysis of the
detemlinants and impact of FOI in India at the macro level. Further, there is hardly
any study in India, which looks into the detenninants and impact of FDI at the
sectoral level. Thus, the present study is an endeavour to explore the detenninants
and the impact of FDI inflows into India, both at the macro level and at the sectoral
level in the post liberalization period. The current study differs from the previous
studies to a large extent and contributes to the existing literature in the following
\\ays: First, the present study tries to explore the detemlinants of FDI inflows both
at the macro (national) level and at the sectoral level of the Indian economy.
Second, the study tries to take care of the limitations of the OLI paradigm and
includes variables othcr than the those postulated in the OLI paradigm and the
empirically tested variables. In this context, it can be said that important variable
like LPR is ignored as the detemlinant of FDI in the existing literature. In fact, LPR
is the crucial guideline for the investors for investment at the sectoral level. Third,
the present study tries to analyze the impact of FDI inflows on the Indian economy,
both at the macro (national) level and at the sectoral level in the post liberalization
period. There is hardly any study that accounts for both the detenninants and the
impacts of FOI inflows in India. The present study is expected to become the first
study of this kind where both dctcnninants and impact of FDI inflows are analyzed
simultaneously in India. Fourth, the present study uses the Panel Co-integration
II
Introductory l3dC kground
(PlONT) technique to examine the relationship among the variables at the sectoral
le\el. This is a new venture in this area as rarely PlONT is used in the studies
related to the impact of FDI.
lA, Objecthes of the Study
Keeplllg in \iew the importance of the role of FDI and the identificd rcsearch gaps
li'om the earlier studies, the present study frames thc following objectives. The
general objel,ti\e of this study is to analyze the impact of FDI and the policy
l'oncern it endangers. The specific objectives of the study are:
to analyse the trends, growth and patterns of FDI inflows into India with
special focus on the post-liberalisation periods;
to lind out the deternlinants of FDI flows to India both at the macro level as
\\ ell as at the sectoral Ie\ el;
to lind out thL' impact Llf I DI Ill",s to India both at the macro level as well as
at thl' sectoral Ie\ el:and
tLl suggest the strategy for policy measures to attract more FDI into the
Indian Econom\.
I,S, Analytica[ Tuuls
In order to meet the obJecti\e ofanalY/ing the trends. gn)\\th and patterns ofFDI into
India \\ ith special 1()l'US on post-liberalization periods, the study tries to evaluate the
,tructural translimllation of the FDI inflows at the macro level for both pre-
libcrali/ation and post-liberali/ation periods. In this case. the growth rate of the FDI
\\ as calculated fi)r comparison. In order to examine the pattern and dimension of FDI
intl()\", the study uses percentages and growth rates.
lhe study applies the linear sll:p-wise regression method to amve at the
dc.:tcrnlinants of 1,])[ inflows at the macro level. The regression has been carried out
In three steps [n the first step. it has taken into consideration all variables in the
c'limablc mOLkl. In the second step. dropping the insignificant variables has solved
the problem or Illulti-colinearity and thus. the variables selected. In the tinal step. a
,olution to thc p",blem or autocorrelation in the model has been solved; in order to
12
,
study the detemlinants at the sectoral level, the study has used the pooled regression
analysis with corrections for heteroscedasticity and autocorrelation. A simple
regression method has been used to the pooled data with a view to sorting out the
problem of heteroscedasticity and autocorrelation.
Granger causality test has been used to analyzc the impact of FDI inflows on
the macroeconomic variables. The two-way Granger causality test has included the
macroeconomic variables like gross fixed capital fonllation, export, gross domestic
product at factor cost. real effective exchange rate, total savings. wholesale price
index. imports and capital account along with the FDI inflows. For thc causality test.
the \'ariables need to be stationary. and therefore, all the variables have bccn madc
stationarY.
In order to assess the impact of FDI inflows at the sectoral level, the study has
made usc of the Panel Co intq;ration (PCONT) method. This has helped to examine
the existing n.:lationship among the sector specific variables. It is important to note
that the sectoral k \ t ~ 1 data of India are available only from 1990-91 to 2000-01.
Therefore. in order to measure the impact of FD[ on the sectors with robust
estimation. the study has pooled the data of thc nine sectors over the time period (i.e ..
10 years) Howe\er. the pooled data sets raise special probkms in cstimation. As
Pesaran and Smith (1995) shol\'. unlike in static models, pooled dynamic
heterogeneous models generate estimates that are inconsistent even in largc samples.
The time period IS not that high to allol\' individual country estimation (i.e., by
reducing the number of explanatory variables). nor the number of cross-section units
11Igh enough to exploit the cross-section dimension of the data. While it is
implausible that the dynamic specification is common to all sectors, it is at least
conceivable that the l<lng-run parameters of the model may be common. [n this case,
estimation can be done either by avcraging the individual sector estimates or by
pooling the data. if the data allows. and estimate the model as a system. The
estimation of the model as a system by pooling the data requires the efficiency of
pooled estimation \I hile avoiding the inconsistency problem owing to pooling of
hdcrogcncous dynamic relationships. The study has applied the estimation of the
Illodel as a system by pooling the data.
J 3
In order to draw policy conclusions on thc detenninants of FDl inflows into
India. the study has used the simulation method. The policy variables that have been
used as the determinants of FDl inflows into India are interest rate (lR) and real
efrecti\e rate (REER).
1.6. Data lkscription. Sources and Period of the Study
lhe present study has t\\O dimensions of analysis. I'iz .. one, at the macro level and thO:!
l>ther. at the sectoral le\d For the macro level analysis, the aggregate Indian
e,'"nlllny has been taken as one unit and sectors have been taken as the units for
se,toral level analysi,. The sectors ilK IudI'd III tbe analysis are power and fuels (pr),
lek"ommunication (ILL). elel'lrical equipment (EQ). transportation (TR). chemicals
(other than fertilizers) (C1I). food processing (FP), metallurgical (ME). industrial
machinery (1:\). dnlgs and phal1naceuticals (DP) and textile (TE). These sectors have
been chosen on the basis of the FDI inflows they receive. These ten sectors account
fllr more than per cent of the total FDI intlows into India. However, for the
cmpirical anal) ,IS purpose. TEL ,ector has been deleted from the analysis because of
non-a\ailabillt\ of data on certain crucial \ariablcs like interO:!st paid exports and
Imports. Further. It IS Important to note that all \ariabks except indices have been
Clll1\erted into Rupel'" III Crores to maIntain homogeneity. and all the nominal values
of the variabk, (nccpt indices) han: been deflated to get the real values of the
\ariables. I he price indice, hale been cOl1\ertcd to a single base year i.e .. 1993-
94= I UU and lhlh. hllllHlgenelty ha, b\."-'n Illallltailll:d.
For the anah ,i, of the relation bcl\\Ten Illacro <':collomie variables and the FDI
Illllu\\ s. thc study perIod chuscn was from 1979-SU to 2()OO-O I. This was partly
because thuugh the Indian economy was liberalized in 19')1. with some tentativeness.
11 has been open to the world economy in the mid 80s and partly because of tbe non-
.1\ arlability of data before 1979-XO. Ilowc\'er, for the sectoral analysis. the study
pcrrod ranges from 19')(J-')] to 2000-0 I. This is mainly because of the non-
a\allabilityof the 111I Illllo\\ data at the sectoral Ie \'(: I bel\m: 1990-91 for the Indian
cl'onomy and partly ilecalhe thc eCOIlOmY I\as liberali/ed Ilith robustness only after
I 'J')O-I) I .
There is a cOllsidnahlc amoullt of alllbiguity ill thc quantitative data on FDI in
IndIa (Smastava 20U3; 20()3; Sahou and Mathiya/hagan 20(3). It is mainly
14
because of the discrepancy in defining the FD! data by different agencies. The
Ecol1()I1zic SII/Tey (ES) includes Americall Depositary Receipts (ADRs) and the Global
Depositary Receipts (GDRs) in the FD! inflows whereas the RBI considers ADR and
GDR as portfolio investments. Thus, the figures on FD! as given by the Economic
Survey overstate the FDI inflows. Therefore, the present study has adopted the FD!
data gi\'en by the RBI. The data on macro economic variables have been collected
from the Hw/(Ihook of'Statistics 011 the IlIdiwz Ecollom)' (HSIE) for the study period.
Ho\\cver. the liSlE gives the data on FD) only after 1990-9\. In order to get the data
for the period 1979-80 to 1990-91, the study resorted to the report submitted to the
\Iinister of Commerce and Industry. GOI'erlllllellt oj'lndia (GOI), by the Boston
Consulting Group in 2UUU. We have also checked for the consistency of the data of
both the sources. The FD) data at the sectoral level have been collected from various
Issues of Secretariat for Industrial Assistance (SIA) newsletter. The other variables of
the sectors have been collected from the Annual Survey of Industry (ASI) CD-Rom.
Howe\'er, the ASI has given data only till 1997-98. So, the present study has
e\trap%led the data beyond 1997-98 till 2000-01 for all the sector level variables
c"cept 1'01.
I. 7. Chapter Scheme of the Study
The present study has been organised in eight chapters. The first chapter presents the
background of the study, role of FDI and its core concepts and the statement of the
problem. This chapter also outlines the objectives, analytical tools and data
description. In order to address the research questions and to identify the research
gaps of the study, a re\'iew of existing literature on FDI (both theoretical and
empIrical) has been carried out and placed in the second chapter. This has helped to
prepare the ta"onomy of thc I'D! inflows into the host country. In the third chapter, a
general framework has been de\eloped for statistical testing. In order to understand
the growth pattem and the different dimension of the FD! inflows in India, it is
necessary to understand the I'D! policy of the successive Indian govemment. Thus.
the policies of the govemmcnt of India here been reviewed and their impact on the
1,])1 flows arc analysed in the fourth chapter. The chapter also highlights some of the
,tylised fact of the FDI inflows of India. The analysis of the determinants of FD!
Inflows at thc macro level has been explained in the fifth chapter. It also provides a
15
simulation analysis for the macro level determinant equation. The sixth chapter
discusses the major detetminants of the FDI inflows at the sectoral level. The
analysis of the impact of FDI inflows at the macro level as well as at the sectoral level
has been carried out in the seventh chapter and all the major findings and conclusions
have been reported in the last chapter.
16
Chapter II
Determinants and Impact of Foreign Direct Investment: Theoretical
and Empirical Review
2.0. Introduction
Foreign direct investment has long been a subject of interest. This interest has been
rene\\<;d in recent years for a number of reasons. One of them is the rapid growth in
global foreign direct investment Dows. Another reason is the possibility offered by
foreign direct investment for channeling resources to developing countries. Although
foreign direct investment has not been a signi ficant component of total capital inDows
into developing countries over the years, its relative importance may increase now
because of the ongoing competition among the developing countries and the economies
of transition to attract more FDI, as these economies have quite limited access to other
sources of financing.
As a result of the continuous interest in foreign direct investment, a large number
of studies ha\e analJ1ed both the determinants and the effects of such investment. In this
chapter, the study tries to survey the existing theoretical and empirical literature on both
the detenninants and the Impact of FDI inDows. It facilitates to identify the research
issues and gaps for the present study. In the literature in FDI it has always been
suggested to take into account the fundamental difference between portfolio investment
and direct ill\cstment so that the concept of FDI is interpreted correctly (Lizondo 1991).
Thus, in this chapter the difference between the two has been brought out whenever it
\\as necessary. The present chapter is organized into two sections. The first section
re\le\\ s the theories of FDI relating to its detenninants and impact and the second section
summari/es the existing cmpirical studies on the detemlinants and the impact of FDI.
Section I
2.1. Determinants of FDI: A Theoretical Review
Thc theories relating to the deten11inants of FDI can be grouped in two parts, according to
the assumption made regarding the market structure: firstly, the theories assuming the
pLTfcct market and secondly, the theories assuming the imperfect market. The present
Detern1inants and Impact of FDI: Review of Literature
section reviews both sets of theories to develop a comprehensive a framework for
explaining the detenninants of FDI in a holistic way.
2.1.0. Theories Assuming Perfect Markets
1.1.1 Differell1ial Rates of Return
In tillS approach it is argued that foreign direct investment is the result of capital flowing
from countries \\ ith low rates of return to countries with high rates of return. This
propositlon follo\\s from the idea in evaluating their investment decisions: finns equate
exp.::cted marginal returns which are higher abroad than at home, the marginal cost of
capital is the same for both types of investment, and there is an incentive to invest abroad
rather than at home.
This theory gained wide acceptance in the late 1950s when U.S. foreign direct
il1\estment in manufacturing sector in Europe increased sharply. At that time, after tax
rates of return of U.S. subsidiaries in manufacturing sector were consistently above the
rate of return on U.S. domestic manufacturing. However, this relationship proved to be
unstable. During the 1960s, U. S. foreign direct investment in Europe continued to rise,
although rates of return for U.S. subsidiaries in Europe were below the rates of return on
domestic manufacturing (Hatbauer 1975).
There arc certain aspects of foreign direct investment, which cannot be explained
by tillS theory. Since this theory postulates that capital flows from countries with low
rates of return to countries \\ith high rates of return, it assumes implicitly that there is a
sll1glc rate of return across activities within a country. Therefore, this theory is not
consistent \\ith some countries experiencing simultaneously inflows and outflows of
foreign direct investment. Similarly, it cannot account for the uneven distribution of
foreign direct il1\estment among different types of industries. These considerations, as
well as the weak empirical results, suggest that the differential rate of return theory docs
not satisfactorily explain the detenninants of foreign direct investment flows.
18
Deternlinants and Impact of FDI: Review of Literature
2.1.2. Portfolio DiI'ersijicatioll
Since expected returns do not appear to provide an adequate explanation of foreign direct
imestment. attention is next focused on the role of risk. In choosing among the various
available projects. a firnl is presumably guided by both expected returns and the
possibility of reducing risk. Since the returns of activities in different countries arc likely
to have less than the perfect correlation. a firm reduces its overall risk by undertaking
projects in more than one country. Foreign direct investment can, therefore. be viewed as
international portfolio diversification at the corporate level.
Various attempts to test this theory have been made. One approach is to explain
the share of foreign direct investment going to a group of countries by relating it to the
average return on those investments. and to the risk associated with those investments, as
measured by the \ariance of average returns. A variant of this procedure was to estimate
tirst the optinlJl geographical distribution of assets of multinational tinns based on
portfolio considerations. and then to assume that finns gradually adjust their flow of
foreign direct imestment to obtain optimal distribution. Another line of inquiry is to
ascertain whether large fillllS with more extensive foreign activities show smaller
tluctuations in global profits and sales.
The portfolio diversification theory is an improvement over the differential rates
of return theory in the sense that. by including the risk factor, it can account for countries
experiencing simultaneously inllo\\ s and outflows of foreign direct investment. However,
It cannot account for the obsencd differences in the propensities of different industries to
iJ1\est abroad. In other \\ords. It does not explain why foreign direct investment is more
concentrated in some industries than in others.
A more fundamental criticism of this theory has been the argument that in a
perfect capital market there is no reason to have firnls diversifying activities just to
reduce the risk for their stockholders. If individual investors want reduced risk, they can
obtain it directly by diversifying their individual portfolios. This criticism implies that for
diversification motive to have any explanatory power for foreign direct investment, the
assumption of perfect capital markets must be dropped.
19
Detenninants and Impact of FDI: Review of Literature
2.2.0. Theories Based on Imperfect Markets
The theories outlined in the previous section did not make any specific assumption about
market imperfections or market failures. Hymer (1976) was perhaps the first analyst to
point out that the structure of the markets and the specific characteristic of firms should
playa key role in explaining foreign direct investment. Thc role of these factors has been
analyzed in both static context, which focuses on issues associated with industrial
organization and the internalization of decisions, and in dynamic framework, which
highlights oligopolistic rivalry and product cycle considerations.
2.2.1. Illdustrial Orgallizatioll
Hymer (1976) has argued that the very existence of multinational firms rested on market
imperfections. Two types of market imperfection were of particular importance:
structural imperfections and transaction-cost imperfections. Structural imperfections,
\vhich held the multinational finn to increase its market power, arose from economies of
scale, advantages of knowledge, distribution nctworks, product diversification, and credit
advantages. Transaction costs, on the other hand, made it profitable for the multinational
finn to substitute an internal "market" for external transactions. The literature focusing
on structural imperfections gave rise to the industrial organization thcory of foreign direct
investment whereas that focusing on transaction costs led to the internalization theory of
foreign direct investment.
The industrial organization approach brings out that when a foreign firm
established a subsidiary in another country, it faced a number of disadvantages when
competing with domestic firms. These included the difficulties of managing operations
spread out in distant places, and dealing with different languages, cultures, legal systems,
technical standards, and customer preferences. In spite of those disadvantages, if a
foreign firnl did engage in foreign direct investment. it meant that it had some firm-
specific advantages with respect to domestic firms. The advantages of the multinational
firnl were those associated with brand name, patent-protected superior technology,
marketing and managerial skills. cheaper sources of financing, preferential access to
markets, and economies of scale.
20
Determinants and Impact of FDI: Review of Literature
The industrial organization theory, in the restrictive sense, IS not a complete
theory of Foreign Direct Investment. Whi Ie the existence of some firm-speci fic
advantages explains why a foreign firm can compete successfully in the domestic market,
such advantages do not explain why such competition must take the form of Foreign
Direct Investmcnt. The foreign fiml could just as well export to the domestic market or
license or sell its special skills to the domestic firms. The intemalization theory and the
eclectic approach, discussed below, offer explanations of why firms choose Foreign
Direct Investment over the other altematives.
2.2.2. Illternalizatioll
This hypothesis explains the existence of foreign direct investment as the result of firms
replacing market transactions with intemal transactions. This, in tum, is seen as a way of
avoiding imperfections in the markets for intermediate inputs (Buckley and Casson
1976). Modem businesses conduct many activities in addition to the routine production
of goods and services. All these activities, including marketing, research and
development, and training of labour. are interdependent and are related through flows of
intermediate products. mostly in the fonn of knowledge and expertise. However, market
imperfections make it di fficult to price some types of intermediate products. For example,
it is often hard to design and enforce contractual arrangements that prevent someone who
has purchased or leased a technology (such as computer software programme) from
passing it on to others without the knowledge of the original producer. This problem
provides an incentive to bypass the market and keep the use of the technology within the
fiml. This produces an incentive for the creation of intra-firm markets.
The intemalization theory of foreign direct investment is intimately related to the
theory of the firm. The question of why firms exist was first raised by Coase (1937). He
argued that the fiml's intemal procedures with certain transaction costs are better suited
than the market to organize transactions. These transaction costs arose when strategic or
opportunistic behaviour is present among agents to an exchange, the commodities or
services traded are ambiguously defined, and contractual obligations extend in time.
When these three conditions are present, enforcement and monitoring costs may become
prohibitive. Under those circumstances, the firm opts to intemalize those transactions.
21
Detenninants and Impact of FDI: Review of LIterature
The main feature of this approach, therefore, is treating markets on the one hand, and
finns on the other, as alternative modes of organizing production.
It is the internalization of markets across national boundaries that gives rise to the
international enterprise, and thus, to foreign direct investment. This process continues
until the bcncfits from further internalization are outweighed by the costs. As indicated in
Agarwal (1980), the benefits include avoidance of time lags, bargaining and buyer
uncertainty, minimization of the impact of government intervention through transfer
pricing, and the ability to use discriminatory pricing. The costs of internalization include
administrative and communication expenses. The difficulties in fonnulating appropriate
tests for the internalization theory were examined further by Buckley. He argued that the
general theory couldn't be tested directly; rather it could he sharpened to obtain relevant
testable implications. Since much of the argument rests on the incidence of costs in
external and internal markets, the specification and measurement of those costs is crucial
for any test.
2.2.3. All Eclectic Approach
Dunning (1977, 1979, and 1988) has developed an eclectic approach by integrating three
strands of literature on foreign direct investment: the industrial organization theory, thc
internalization theory and the location theory. He argues that three conditions must be
satisfied if a finn to engage in foreign direct investment. First, the firm must have some
ownership advantages with respect to other finns; these advantages usually arise from the
possession of finn-specific intangible assets. Second, it must be more beneficial for the
finn to use these advantages rather than to sell or lease them to other independent finns.
Finally, it must be more profitable to use these advantages in combination with at least
some factor inputs located abroad; otherwise, foreign markets would be served
exclusively by exports. Thus, the foreign direct investment to take place, the fiml must
have ownership and internalization advantages, and a foreign country must have
loeational advantages over the firnl's home country. Dunning further divides these
advantages into three groups. They are: (a) Ownership advantages, (b) Location
advantages, and (c) Internalization advantages.
22
Detem1inants and Impact of FDI: Revie\\ of Literature
These three advantages constitute the famous OLI model of Dunning. Here,
ownership advantages consist of:
benefits the firm can obtain from its SIze, monopoly power and better resource
capacity and usages; and
benefits derived from the enterprise's ability of operation and management (such as
know-how, organizational and marketing systems).
There are two types of location advantages. The first type accrues from attractions
special location advantages provided by the host country, such as cheaper labour forces
market for the product and the govemment's preferential policies. The second one is
generated from the limitations of the home. The investors are forced to decide on dircct
investment abroad because they suffer from disadvantages in their own countries such as
a small market for their products, lack of raw materials and higher production costs.
Intemalization advantages refer to the benefits that the fim1 can secure by using its
ownership advantages intemally, between the parent company and its subsidiaries.
Dunning believes that the OLI model covers the major aspects of FOI activities. 0
deals with the 'how' of MNE activity; L is concemed with the 'where' of production
(location factors); and I explain the 'how' of investment. According to Dunning, the
importance of the role played by 0, L and I in his model is different, which detem1ines
the fim1s' choice of intemational trade or direct production abroad. Of the three
advantages, ownership advantages are essential. An enterprise is unable to engage in FDI
without any ownership advantages. However, if the firm has only ownership advantages
without the other two advantages, it will benefit from licensing rather than FDI. If the
firm has advantages of ownership and intemalization but not location advantages, it will
prefer to sell its products by exporting. FOI occurs only when a firm has all these three
types of advantages. The combination of OLI not only makes the firm's FOI possible, but
it also decides the firm's selection of FOI location or destination. It implies that countries
with low labour costs and/or natural resources tend to have an above avcrage inward
investment because of their locational attractions, while rich industrialized countries have
an above average outward direct investment, because their factor endowments favour
mobile ownership advantages (Dunning1988).
23
Deternlinants and Impact of FDI: Review of Literature
The eclectic approach postulates that all foreign direct investment can be
explained by reference to the above conditions. It also postulates that the advantages
mentioned above are not likely to uniformly spread among countries, industries, and
enterprises and are likely to change over time. The f10ws of foreign direct investment of a
particular country at a particular point in time depend on the ownership and
internalization advantages of the country's firms, and on the locational advantages of the
country at that point in time. Dunning used this approach to suggest reasons for
ditTerences in the industrial pattern of the outward direct investment of five developed
countries, and to evaluate the significance of ownership and location variables in
explaining the industrial pattern and geographical distribution of the sales of U.S.
affiliates in 14 manufacturing industries in seven countries.
Dunning claims that all forms of international production by all countries can be
explained by his eclectic paradigm. However, a single theory is unable to explain all the
characteristics of FDI. For example, this model can explain neither the case of some
developed countries that are heavily involved in both inward and outward FDI, nor the
fact that it is the developed countries not the developing countries which have the largest
share of inward FDI. In addition, the macro-economic effects of FDI are largely ignored
and there is no thorough integration of some macro-economic issues and the theory of
FDI. These macro-economic issues or effects may cover the political complexities in the
M:\Es' activities. :v1oreover, it is arguable that if ownership advantages playa necessary
role in deternlining the firm's investment, internalization explains why firnls exist in the
absence of such advantages (Buckley and Casson 1976) and firms in some developing
countries without ownership advantages actively accept FDI.
2.2.4. Prodllct Cycle
This hypothesis postulates that most products follow a life cycle in which they first
appear as innovations and ultimately become completely standardized. Foreign direct
investment results when firnls react to the threat of losing markets as the product matures,
by expanding overseas and capturing the remaining rents from development of the
product. This hypothesis, developed by Vernon (1966), was mainly intended to explain
the expansion of U.S. multinational firnls after World War II.
24
Dctenninants and Impact of FDl: Review of Literature
Innovation can be stimulated by the need to respond to more intense competition
or to the perception of a new profit opportunity. The new product is developed and
produced locally both because it is designed to satisfy the local demand and because it
will facilitates the efficient coordination between research, development, and production
units. Once the first production unit is established in the home market, any demand that
may develop in a foreign market would ordinarily be satisfied by exports. However, rival
producers eventually emerge in foreign markets, since they can produce more cheaply
(owing to lower distribution costs) than the original innovator. At this stage, the
innovator is compelled to examine the possibility of setting up a production unit in the
foreign location. If the conditions arc considered favourable, the innovator engages in
foreign direct investment. Finally, when the product is standardized and its production
technique is no longer an exclusive possession of the innovator, he may decide to invest
in developing countries to obtain some cost advantages, such as cheaper labour. The
explanatory power of the product-cycle hypothesis has declined considerably as a result
of changes in the intemational environment.
2.2.5. Oligopolistic Reactioll
Knickerbocker (1973) states that in an oligopolistic environment, foreign direct
investment by one fiml would trigger similar investments by other leading finns in the
industry to maintain their market shares. Using data from a large number of U.S.
multinational firms. he calculated an entry concentration index for each industry. which
showed the extent to which subsidiaries' entry dates were bunched in time. As indicated
in Hafbauer (1975), the entry conccntration index positively correlated with the U.S.
industry conccntration index. It implies that an increascd industrial concentration caused
increased reaction by competitors to reduce the possibility of one rival gaining a
significant cost or marketing advantage over the others. The entry concentration index
was also positively correlated with market size, implying that the reaction was stronger,
the larger the market at stake. The entry concentration index was negatively correlated
with the product diversity of the multinational firms and with their expenditure on
research and development. This suggested that the reaction of firms was less intense if
25
Deternlinants and Impact of fDI: Review of Literature
they had a variety of investment opportunities, or if their relative positions depended on
technological considerations.
An implication of this hypothesis is that the process of foreign direct investment
by multinational finns is self-limiting, since the invasion of each other's home market
will increase competition and thus reduce the intensity of oligopolistic reaction (Agarwal
1980). However, while foreign direct investment increased competition in many
industries, this had not resulted in a corresponding reduction in foreign direct investment.
This hypothesis has also been criticized for not recognizing that foreign direct investment
is only one of several methods of servicing foreign markets. In addition, there is no
explanation of the reason for the initial investment that starts the foreign investment
process.
2.3.0. Other Hypothesis of Foreign Direct Investment
2.3.1. Liquidity
MNEs traditionally committed only modest amounts of resources to their initial foreign
direct investment and subsequent expansions of their activities were carried out by
reil1\esting local profits. As a result, it has been postulated that there is a positive
relationship between internal cash flows and the investment outlays of subsidiaries of
multinational finns. This relationship is said to arise because the cost of internal funds is
lower than the cost of external funds.
Agarwal (1980) has concluded that the liquidity hypothesis had some empirical
support. An expansion of foreign direct investment seemed to be partly determined by the
subsidiaries' internally generated funds. This factor might be particularly valid for
inyestment in devcloping countries owing to their restrictions on movements of funds of
foreign firms and the lower degree of development of their financial and capital markets.
2.3.2. Currellcy Area
AJiber (1970,1971) postulates that the pattern of foreign direct investment could be best
explained in terms of the relative strength of the various currencies. The stronger the
currency of a certain country, the more the likely firms from that country would engage
26
III foreign investment and less likely that foreign finns would invest in the domestic
country. The argument is based on capital market relationships, exchange rate risks, and
the market preferencc for holding assets in selected currencies.
The crucial assumption of this theory is the existence of a certain bias in the
capital market. This bias is assumed to arise because an income stream located in a
country with a weak currency has associated with it a certain exchange risk. Investors,
however, are less concerned with this exchange risk when a finn owns the income stream
from a strong currency country than when owned by a finn from a weak currency
country. According to Aliber (1971). this could reflect the view that the strong currency
finn might be more efficient in hedging the exchange risk or that the strong currency finn
could provide the investors with a diversified portfolio at a lower cost than the investor
could acquire on his own. Alternatively, investors might take into account exchange risk
for a strong currency firm only if substantial portions of its earnings were firm foreign
sources.
For any of these reasons, an income stream is capitalized at a higher rate by the
market (has a higher price) when a strong currency firm than when owned by a weak
currency finn owns it. As a result, firms from countries with strong currencies have an
advantage in the capital markct in acquiring this income stream. Strong currency
countries. therefore, tend to be sources of foreign dircct investment and weak currency
countrics tend to become host countries.
2.3.3. with Barriers to lmernatiollal Capital Flows
As noted earlier, there is no reason for firnls to carry out diversification activities for their
stockholders in perfect capital markets, since any desired diversification can be obtained
directly by individual investors. Agmon and Lessard (1977) have argued that for
international diversification to be carried out through corporations, two conditions must
bc satisfied. Firstly, barriers or costs to portfolio flows must exist that are greater than
those to foreign direct investment. Secondly, investors must recognize that multinational
finns provide a diversification opportunity that is otherwise not available. They postulate
a simple model in which the rate of return of a security is a function both of a domestic
market factor and of a rest-of-theworld market factor by assuming the first condition.
27
They tested the proposition that securities prices of finns with relatively large
international operations were more closely related to the rest-of-the-world market factor
and less to the domestic market factors than shares of finns that were essentially
domestic. They obtained favorable results for a sample of data applying to U.S. finns.
However, as noted by Agmon and Lessard ( 1981), these results were consistent with the
second condition mentioned above but did not support a fully developed theoretical
model.
2.3.4. The Kojima Hypothesis
The Kojima Hypothesis (1973, 1975, 1985) was concerned with explaining the FDI out-
tlO\\S from Japan. He mentions that the inability of the domestic finns in Japan
compelled them to invcst overseas. These finns were competed away by the more
efficient local firn1 in the home country as a result of which the weaker finns find their
way in some overseas countries. However, this hypothesis could not explain the
expansion of business acti vities by the domestically competent firm overscas.
The above discussion reveals the fact that there are various theories and
hypotheses, which emphasize different microeconomic and macroeconomic factors that
are likely to affect the tlow of FDI. While most of those have some empirical support, no
single hypothcsis is sufficiently supported to cause the others to be rejected. Theories
derived from industrial organization approach have probably gained the widest
acceptance. They seem to provide a better explanation for cross-country, intra-industry
investment, and for the uneven concentration of foreign direct investment across
industries, than do alternative models. However, in a broader prospective, the OLI
paradigm of Dunning has been widely accepted by those researchers who try to explain
the detern1inants of the FDI tlows. The present study tries to develop over the OLI
paradigm and introduce some finn specific variable like LPR in the theoretical
framework for the detenninants of FDI.
2.4.0. Review of Theories on the I mpact of FDI
In this section. an attempt has been made to review the theories, which explain the impact
of FDI on the host economy. There are two alternative conceptualizations to guide the
28
understanding of the impact of FDI and its potential contribution to the economic
development of the host economy. The first emphasizes the net addition of inputs that
FDI may bring to the domestic economy. The second emphasizes the potentially
distortionary impact that the FDI from imperfectly competitive international industries
may have on the domestic economics that are themselves riddled with market
imperfections (Moran (998).
2.4.1. The Benevolent Model of FDI and Development
This model assumes that FOr is more useful to the economies, which are caught in the
\icious circle of under-development. If the potential host economy is mired in a poverty-
laden equilibrium with a vicious circle of poverty, the FDI can break this circle by
complementing local savings and by supplying more effective management, marketing
and technology to improve productivity (Cardoso and Dornbusch 1989). The gain in
national income depends on the size of the capital flows and the elasticity of the demand
for capital. Furthennore, technological and managerial inputs, transfers and spillovers to
local finns may cause the nation's production function to shift upward. Thus, under
competiti\'e conditions (which the presence of foreign finns and FDI may enhance), FDI
should raise efficiency, expand output and lead to higher economic growth in the host
economy]. The emphasis on the new resources that the foreign investors bring to remove
the bottlenecks that deters the development process is a common theme among
international business groups and multilateral agencies that urge greater acceptance of
FDI in the developing countries.
Nevertheless, this model assumes that the gaps in savmgs and in foreign
exchange, sets the limit to the long-tenn growth at the macro level. It also assumes that
the additional supply of capital by the foreign firnls should lower the relative returns on
capital while the additional demand for labour should bid up the wages of workers. In
reality, these assumptions may not be valid to validate the argument of this model.
I For more discussIOn. see .Cardoso and Dornbusch 1989.
29
Oetenlll11ants and Impact of FDl: Re\lc\\ of LIlI.TJIUIC:
2.4.2. The Malign Model of FDI and Development
The role and motive of MNEs has been in the suspicIous eyes of the people of the
developing countries. Thus, there exist a long history of criticism of the \l:\Es. In the
earlier stage, a few studies showed that foreign capital had a negatiye impact on the
growth of the developing economies (Singer 1950). The foreign fimlS made dcstructlYC
impact on the host economy because they operated in Industries where there \\cre
substantial barriers to entry and increasing market concentration (Grieco 1986) In that
case, the foreign finns lowered the domestic savings and investment by extract111g rent.
The foreign firms drove out the local producers from business and substituted imported
inputs. In such a situation, the foreign firms might not bridge the gap betwecn domcstlc
investment and foreign exchange. Also, the repatriation of profit by the foreign finns
drained out the capital from the host country.
The above discussion adds to the debate that which of these conceptualt/ations,
the first overwhelmingly favourable and the second forcefully unfavourable, better
describe the role of FOI, particularly in the developing countries like India. :\evertheJcss,
the dichotomous view on the role of FOI in the developing countries has triggered
interest in the academia to verify the impact of FOI empirically. The abo\e discussion
shows that the determinants of FOI flows are largely explaincd by the OLl paradigm.
This can also help to develop a theoretical framework, which can be useful to explain the
determinants of FDI in the prescnt study. As mentioned earlier. the present study tries to
improve over the OLi paradigm and introduce some fim1 specific variables like LPR in
the theoretical framework for thc detemlinants of FOI. Further, the dual opinion on the
impact of FOI on the developing country can be the guideline to construct a theoretical
framework for assessing the impact of FDI in India. This certainly helps in finding out
a holistic approach towards the role FDI in India.
Section II
2.5. Review of Empirical Studies
The main objective of this section is to review the existing empirical literature on the
determinants and impact of FOI inflows on the host economy. It facilitates to identify the
research issues and gaps for the present study. The empirical literature on the
.10
Oetenninants and Impact of FOI: Review of Literature
detenninants of FOI inflows has been in accordance with the theoretical literature as a
result of which the line and facet of the empirical literature has undergone excessive
change ever since the pioneering work of Vernon in 1966.
2.5.1. Review of Studies on the Determinants of FDI
Market size and the growth rate of the market are considered as the major detenninants of
FDI inflows to a specific location (UNCT AD 1993, Wang and Swain 1995, Sianesi 1995,
Aristotelous and Fountas 1996, Chen 1996, Jun and Singh 1996, Liu el at. 1997, Hasnat,
1997). These two variables are essentially identical, except the market size of the host
country, which is gauged by the magnitude of the GOP, and market growth of the host
country is measured by either the percentage change or the change in levels of the GOP.
The market size hypothesis postulates that a positivc relationship exists between the
inflows of FOI and the size of the host market in tenns of GOP or GNP. As per the
market growth hypothesis, FDI is positively related to the growth potential of the host
market in terms of GOP or GNP growth. The earlier studies emphasize that big market
size of the host economy will attract foreign finns to produce in the economy whereas,
the small market size of the home country of the MNCs would induce the firn] to go out
for overseas production. However, it is also argued that if an economy grows at a faster
rate, it attracts morc foreign finns and brings more FOI. In this case, the growth rate of
the economy is a better indicator of the demand than the simple size of the economy
(Wang and Swain 1995). By using the causality test, Oua and Rashid (1998) in their
study on the on the Indian economy assert that there has a causality from Index of
Industrial Production (lIP)2 to FOI but not the reverse. The study had taken liP as a
proxy for the GOP in India. However, the industrial sector contributes hardly a quarter to
the GOP. Thus, lIP cannot be used to represent the GOP for the Indian economy.
Market size and factor cost advantages may be counteracted if the foreign
investors perceive the host country to be economically unstable. A high rate of inflation
- a measure of economic instability - is a signal of internal economic tension, inability
or unwillingness of the government and the central bank to balance the budget and to
restrict money supply. Thus, inflation rate is expected to be negatively related to the
, lIP is taken as a proxy for GOP In their study
31
inflow of FDI (Schneider and Frey, 1985; Balasubramanyam and Salisu, 1991; Gopinath,
1998). Inflation not only affects the demand but also the cost of production. This is
because both customers and creditors may lose confidence in a country if it is troubled by
high inflation. Thus, Gopinath predictcd a negative sign for inflation rate in his analysis
of the deternlinants of FDI inflows in the Indian economy. The price of a product
produced by a foreign facility in a high inflation host country may be distorted and the
foreign firnl may have to pay a high cost to obtain any financing for that particular
operation.
The portfolio diversification theory asserts that besides maximizing their rate of
return, foreign investors also try to reduce total risk by spreading their direct investment
among various host countries. Thus, FDI is positively related to the rate of return of the
im'estments but negatively related to their risk. It is believed that MNCs with a more
diverse and internationalized portfolio of productive activities may have smaller variation
in their global profits (Agarwal 1980). Cost of labour in the host country is also another
important cost determinant of FDI inflows (Lucas 1993). Lucas challenged the earlier
literature on the negative relation between wage rate and FDI, and showed as an
indeterministic relationship between wage rate and FDI by using Constant Elasticity
Demand and Cob-Douglus cost function. Further, this study also covered seven East and
South East Asian countrics and showed a negative relation between wage rate and FDJ.
On the other hand, this study also concludes that wage differential (with one period lag)
had a significant negative relation with FDI. Wage has considered, as the cost for labour,
but the study by Lucas asserts that wage could be a positive or a negative determinant of
FDI Inflows in the host location.
Lucas (1993) and Jun and Singh (1996) argue that in addition to the size of the
domestic market in the host country, FDI also depcnded on export markets. Though the
market size hypothesis argues that inward FDI was a function of the size of the host
country market, many export-orientated countries attracted more FOr as they served the
export market of the product. Thus, if the host country's firms were export-oriented, these
firms would attract MNCs who were interested in exporting that product. However, the
study by Kumar (1990) for the Indian economy did not support this view. Kravis and
Lipsey (1982) and Chen (1992) identifies import as an important determinant of the
32
Oeternlinants and Impact of FOt: Review of Literature
MNC activities. It was based on the KOjima hypothesis as thcy argued that the MNCs
activities could be affected by the import of the host country. In this case, the import of
the host country would appear in the cost detemlinants of the FD!, as high import
intensity of the host nation would deter the FOI inflows into that economy. The degree
of openness of an economy' is found by the ratio of the summation of import and export
to the GOP and it is measured by the ratio of the total trade of the economy to its GOP.
Apart from the abO\e t\l'O variables (i.e. export and import), the empirical literature on
the detenninants of FOI also showed that degree of openness of the host country was
another detenninant of FOI. The degree of openness of an economy represented the
e\t<:'nt of globalisation of that economy. Higher the globalisation, higher would be the
FOI inflows. Thus, it could be a positive detenninant of FD! inflows into the host
location.
It IS important to note that the tariffs competition also plays a vital role in
detcrnlining the FDI inflo\l's of the host country. If host country's tariffs is lower as
compared to simi lar other countries as a motivating factor to attract FD! by MNCs, it
incr<:'as<:'s host country FDI (Brander and Spencer 1(87). Aliher's (1970,1971) currency
area hypothesis impli<:'s that the presence of different currency areas could bc used to
explain the pattern of FOI among different countries. The hypothesis maintains that FD!
is affected by di fferent exchange risks affiliated with di fferent currencies and argues that
portfolio imestors tend to ignore the exchangc risk on foreign earnings of a finn.
Accordingly. the firnls from strong currency areas are able to obtain finances for their
imcstment at lower costs and capitalise the earnings on their FOI in weaker currency
areas at higher rates of return than the local finns. Empirical studies have focused
pnman lyon the n:lation between FOI and exchange rates (Cushman 1985, Lucas 1993,
Kogut and Chang 1(96). An over-valuation of a currency is associated with outflow of
FDI and under-Ialuation with inflow of FDI. The study of Urata and Kiyota (2001)
I'iews that exchange ratc is expected to affect a finn's cash flow, expected profitability
and the attractiveness of domestic assets to foreign investors. In their study a positive
impact is found when the domestic currency is relatively weak compared to that of the
foreign investors' currency.
J Degree of openness of the ecol1omy=(Exports + Importsj/GDP
33
Some studies propose that tax incentives are less likely to attract foreign
investors, whose production is primarily for the domestic market (Root and Ahmed
1978). These studies argue that for prospective investors, whose investment is oriented
towards thc local market, the degree of protection is often a crucial detenninant of the
decision to invest or not to invest and is of far greater concern than tax holidays. If the
market is heavily protected, profits are certain at significant level in big economy. If the
market is small or highly competitive, tax holidays will not be seen as significant, since
taxable profits will be small. Therefore, the incentives alone will not attract investors to
small or highly competitive markets. Proponents of incentives feel that incentives may tip
the balance in il1\estor choice between country locations (Woodward and Rolfe 1993).
The value of incentives in attracting FDI has come under heavy criticism. Root and
Ahmed (1978) in an empirical test of FDI flows to several developing countries found
that incentives did not show statistically significant as a detemlinant variable.
A major risk associated with FDI is emanated from socio-political developments
in the host country. Socio-political disturbances such as strikes, riots, revolutions, and
\\ars not only can damage property or haml people but they can also disrupt the
economic process. Prolonged interruption of commercial activities caused by social or
polItical instability in a host country is also likely to discourage the inflows of potential
FDI. Kobrin (1976) mentions that the clements of socio-political risk that had a
"potential manifestation as constraints upon foreign investors" might be more relevant in
detennining FDI. Socio-political instability affected the production efficiency of the
labour force in thc host country as it could cause disruption in production or business
acti\ities, which has a potential cost to foreign investor."
The abo\e analysis reveals the fact that the major detenninants of FDI into a
particular location could be explained with the help of Dunning's OLl paradigm.
However, there is a dearth of studies to identify the detenninants of FDI in India both at
the macro level as well as at the sectoral level. Several empirical studies in other
economics have tried to explore the determinants of FDI inflows into a specific location
with di fferent tools across the globe. Though there is no consensus on all the
34
Oetenninants and Impact of FOl: Review of Literature
detenninants by the scholars, the foregoing survey of empirical literature confinns the
fact that market size, growth rate of market size, inflation rate, cost of capital and labour,
exports. imports, degree of openness, tariff rate, tax rate, exchange rate and the socio-
political stability of the host location are the prime detenninants of FDI inflows.
2.5.2. Review of Studies on the Impact of FDI
The analysis of studies relating to the impact of FDI covers foreign firnls both at macro
and micro levels. Thus, the empirical literature on the impact of For inflows can be
either at the macro (national) level or at the micro (sector) level. Chenery and Strout
(1966) state that foreign assistance was the striking force for rapid and sustained growth
by countries like Greece, Israel, Taiwan and the Philippines during 1950s. In each case, a
substantial increase in investment, financed largely by foreign loans and grants, led to
rapid growth of GNP followed by a steady decline in the dependence on external
financing. Taking the case of Pakistan. the study has shown that the growth rate of the
Pakistani economy after independence depended in external assistance as a prominent
factor. \\hich helped them raise their saving rate and growth rate of GOP. Kamath (1990)
has stated that the FOI made substantial impacts in modernizing Chinese industries
including the transfer of low and intennediate technologies, managerial expertise and
markctll1g knowledge.
The empirical study of Karikari (1992) for Ghana economy doesn't support the
\ie\\ that FOI leads to economic growth. Chen el a/., (1995) using time-series data for the
period of 1979-93 estimated the regression between GNP, domestic saving in one period
lag, and FOI in one period lag (all in logarithmic value). The results show that there was
a positive relationship between FOI and GNP exits and it was significant at 5 per cent
Inel for the Chinese economy. Wang (1995) explains growth differentials among
Chinese urban areas due to FOI that produced technological spillovers in China. Further,
the study states that the growth differentials in Chinese urban areas could be attributed to
the differentials in the flows of FOI to the regions. However, the empirical study for the
C.S. by Kashibhatla and Sawhney (1996) supports an unidirectional causality from GOP
to FOI, not the reverse. This may be due to the fact that for a developed country, FOI
, Studies by Rana (19gS), Lucas (1993) and lun and Slllgh (1996) have utilised the workdays lost in
llldustnal disputes per employee vanable as a proxy variab1c for socio-poiltlcal rrsk.
IS E C LIBRARY, SA.NGALORE
. (/-I
N,I)C' ...... ':I\ .. , . - -

35
follows GOP, as GOP has an indicator for market size. Bashir (1999) has examined the
relationship between For and growth empirically in some MENA countries, using panel
data. The study found that FOI lead to economic growth; the effect, however, varied
acroSS regions and over time. The study by Sahoo el ai., (2002) also supports the positive
contribution of FDI towards GDP growth in China during the post- Mao era.
Willmore (1976) in his study has analyzed the foreign trade behaviour of the
TJ\Cs through a recursive model of exports and imports of manufacturers, where
imports depended on exports. Lsing a logistic model, the study has concluded that
foreign ownership had a very strong and positive effect on both export perfonnance and
import propensities. Barrell and Pain (1996) in their seminal work "An Econometric
Analysis of C.S. Foreign Direct Investment", argue that For could enhance growth in
the host economy. The study has used the panel data analysis and concluded that for
the European countries the FDI enhanced export and as a result a higher GDP growth
\\as achieved in these economies. Aitken et al. (1997) have shown that the external
effect of FDI on export with example of Bangladesh, where the entry of a single Korean
multinational in gannent exports led to the establishment of a number of domestic
export finns, creating the country's largest export industry. Xu (2000) has investigated
the US. MNE as a channel of international technology diffusion in 40 countries from
1966 to 1994, using panel data. This study has found strong evidence of technology
diffusion from U.S. MNEs affiliates in developed countries (DCs) but weak such
diffusion in the less developed countries (LDCs) was weak. The rcsult for the DCs
indicates that US MNEs were almost as important as international trade for technology
spillover. Nearly 40 per cent of the total factor productivity (TFP) of DCs was
attributable to the technology transfer of US affiliates. Further, the study has also found
that the level of human capital was crucial for a country to benefit from technology
spillovers of MNEs. A country needs to achieve a human capital threshold of about 1.9
years (in tenns of male secondary school attainment) to benefit from the technology
transfer by the MNEs. The results are consistent with the findings of single country
study that the technology spillover effects of MNEs are positive in advanced countries
but are insigni ficant in less developed countries.
36
Detcnl1lnants and Impact of FDI R(:\ 1(:\\ of LIt..:r.ltur,
Fry (1993), in his influential work, "FDI in a \1acroeconomic Framc\\ork.
Finance, Efficiency, Incentives, and Distortions" has studied a series of impact of FDI
on OECD countries, developed countries and developing countries. Using simultaneous
equation model, he has concluded that FDI acted as an additional balance of paymcnt
(BOP) financing for the OECD countries and sixteen developing countries. Hc
continllS that FDI helped in triggering up domestic investment in the fi\c Pacdic Baslll
developing economies, whereas FDI curtailed domestic ill\estment in the elc\cn
remaining developing countries. However, FDI has found to deter sa\ing in all thl'
sixteen developing countries. Fry also tried to find out the trade effect of FDI on thc
sixteen developing countrics. For the sample developing countries, his study found that
FDI had a negative impact on the current account balance of those countries. Howevcr,
the study found that FDI affected the total factor productivity of these countries
positively.
Agarwal (1980) has examined the capital intensity of both the sets of finllS, the
reasons for difference in capital intensity and the reasons for their capital intenSitY
differences in the context of factor unit cost and technological choices. He has argued
that capital was cheaper for the foreign firms whereas labour was cheaper for the
domestic finns. Thus, the foreign firms were more capital intensive than the domestic
firms. The study by Lall and Kumar (1981) has used the multiple regression analysis
and concluded that foreign finns in the Indian engineering industry have not pro-export
biased. Lall and Sharief (1983) have examined the impact of foreign ownership on
export perfom1ancc and concluded that there is was apositive relationship between the
foreign shares holding and export propensities. Kumar (1987) has provided an empirical
basis for the debate on the issue of the contribution of foreign enterprises with the
expansion of export of manufacturers from and to the generation of employment in the
export processing zones in developing countries. The results show a positive
relationship between degree of foreign equity participation and enterprise performance
in export but a negative relation with employment.
Sastry (1990) has examined the relations between expenditure on Rand D and
imported technology. His study showed a positive relationship between import of
technology and expenditure on Rand D incurred by the enterprise. In the study, import
37
of capital goods and payment towards royalty and technology fees showed the same
positive impact. Katrak (1990) has examined how Indian enterprise's in-house
technological effort was influenced by their imports of technology and size. This study
considered three aspects of imports, namely, type, right to sale and number and
concluded that this had less social benefit than the private benefit and needed
restrictions. Pant (1995) has found that the export capacity of domestic finn depended
on its import intensity and since foreign finns were more import intensive, their export
perfornlance was assumed to be better.
The study by Subrahmaniam (1967) does not support the positive relationship
bet\\een technology import and domestic technology efforts of firnls under foreign
collaboration. FDI didn't enhance the export of the finns rather they catered to the needs
of the domestic market during the study period and the FDI had no significant influence
on the finn's export probabilities. The study of Dua and Rasid (1998) does not support
causality from FDI to Index of Industrial Production (lIP). In their study, lIP was taken
as a proxy for GDP. Alam (2000) in his comparative study of FDI and economic
growth for Indian and Bangladesh economy has stressed that though the impact of FDI
on growth is more in the case of Indian economy yet it was not satisfactory. Shanna
(2000) used multiple regression technique to evaluate the role of-FDI on the export
perfornlancc in the Indian cconomy. The study concludes that the FDI did not have a
statistically significant role in the export promotion in Indian Economy. This result is
also con finned by the study of Pailwar (2001) and the study argues that the foreign
finns were more interested in the large Indian market rather than aiming on the global
market. By using a vector error correction model (VECM), Chakraborty and Basu
(2002) tried to find out the short-run dynamics of FDI and growth in India. The model
reveals three important features vi::. (a) GDP in India was not Granger caused by FDI;
the causality ran more from GDP to FDI; (b) trade liberalization policy of the Indian
government had some positive short run impact on the FDI flow; and (c) FDI tended to
lower the unit labour cost suggesting that FDI in India was labour displacing.
The above survey reveals the fact that there exists a dichotomous view (i. e., one
favouring and the other rejecting) in respect of the role played by the FDI in a host
economy. However, FDI has emerged as a fundamental source of financing for the
38
Oetenninants and Impact of FOI: Review of Literature
developing countries like India. It is also evident from the existinu studies that there are
'"
differences in the findings of various studies. The study of Gopinath (1998) has found
that GOP and the forex reserves were the main positive detemlinants of FOI inflows
into India. The study also confinns that personal disposable income contributed
positively towards the flow of FOI in India. However, the study has ignored some of
the key policy variables like degrce of openness of the economy and exchange rate,
those detemlining the FOI nows. The study by Krishna (2001) has considered these
policy \'ariables, but has ignored the variables such as GOP and exports and imports.
Ho\\e\er. neither of these two studies had considered all the variables comprehensively.
The studies relating to the impact of FOI were also very limited. The study by Oua and
Rasld (1998) shows a uni-directional causality from Index of Industrial Product (liP) to
FOI but not the reverse. liP has taken as the proxy for GOP in this study. However, lIP
could not be a proper proxy for GOP as industrial sector contributed only 25 per cent to
the GOP in India. The study by Chakraborty and Basu (2002) has ignored an important
role of FOI. \\hich has to add to the domestic capital. These studies had not considered
all the impact of FOI on the macro economic variables of the Indian economy. The
other studies like Pant (1995), and Subrahmaniam (1967) differed in their opinion. All
these studies have tried to find the impact of import and FOI on export capacity at the
fiml le\el. The rOmler two studies accepted a positive impact of import intensity on
export capacity of the finns. These studies used the import intensity as a quantitative
dependent \ariahle and estimated the model by simple OLS method. The later study
rejects e\en the prohahility of export capacity by import intensity hy using the quality
r.::sponse model. \Ioreover, none of these studies explore the impact of FOI on other
finn le\el \anablcs like producti\'ity and factor cost. There is also hardly any study to
access the detemlinants of FDI at the sectoral level.
The above discussion reveals the fact that the studies at the macro level in India
do not cover all the macro economic variables to assess the detenninants and impacts of
FDI. The existing studies have ignored important macro economic variables like capital
fomlation and savings whilc assessing the detemlinants and impacts of FDI in India. It
can also be observed from the literature that the policy variables like interest rate and
exchange rate have been ignored in the existing studies. The present study tries to
39
Oetemlinants and Impact of FDI: Review of Literature
include these variables in the analysis of the determinants and impact of FOI in India at
the macro level. Further. there is hardly any study in India, which look into the
detemlinants and impact of FOI at the sectoral level. Thus, the present study is an
ende:l\our to explore the deten11lnants and the impact of FOI inflows into India, in the
post liberalI?ation period. both at the macro level and at the sectoral level. The current
stud\' differs from the previous studies to a large extent and contributes to the existing
literature in the following \\ays. Firstly. the present study has tried to explore the
detCIlll1nants of FOI intlows both at the macro (national) level and at the sectoral level of
the Indian L'COllOI11\. Secondly. it has included variables other than the variables
postulated ill the 01 I paradigm. In this context, it could be said that important variable
like bbour producl!\ it: (LPRj is Ignored as the detcIlllinant of FOI in the existing
literature. In fact. at the sectoral Ie\e!. thiS \ariable is a crucial guideline for the investors
for 1Il\ estmcnt. Tlmdh. the present study has tried to analyze the impact of FOI inflows
on the Indian econom\. both at the macro (national) level and at the sectoral level in the
post liberall?atInn penod Ihere IS hardly any study that accounts for both the
determII1ants and the impacts of FOI II1flows in India. Thus, the present study is a
pioneering one \\ here both the deteIl11inants and the impact of FOI inflows have bcen
anah/ed SIIllultaneoush In the IndlJn context. Fourthly. the present study has tried to
usc a P;lIlel Co-inl<:gration (PCONT) technique to know the dynamic relationship among
the \ ariablcs at the sectoral Ie\ el. ThiS is a new \'Cnture in this area as hardly PCONT is
used In the studies related to the Impact of FOI.
The abo\ c re\ ic\\ of both thcon:tical and cmpirical literature on the detenninants
and Impact of FOI has helped to conceptualise some of thc qucstions raised in the first
chapter. ThiS has also been hcnclicial in identIfying the research issues and the research
gap,. \\ 11Ieh arc mainly the cdi liccs on which the objectives of the present study are based
011. F ur1her. the thcun:tical re\le\\ pro\'idcs a base line for developing taxonomy' of the
FDI 111 order to assess the determinants and impacts of FOI inflows into India.
IiO\\C\ cr, fur cmpirical purpose, it is always indispensable to specify the
relatIOnship among the \ariablcs in the functional form. The specification of the variables
in the functiunal form wi II help c\ aluatc the relationship among the variahles statistically.
----- ----------
\ -I he taxonomy ha\ Ol:'l'n prcscnleul.1t the l'I1U of thiS chapter.
40
Detenninants and Impact ofFDI: Review of Literature
In this context, it is quite essential to convert the above taxonomy into a functional fonn,
so that the empirical analysis can be carried out in an estimable framework. Thus, a
framc\\ork for the analysis of the detenninants and impacts in its functional fonn has been
pn;scntcd in the next chapter, which will facilitate the empirical analysis of this study.
41
Framework for the Dderminants and Impact of FDI
DETERMINANTS
OF FDI
r
At the Macro Level:
{( GOP, growth rate of
GOP, export (EX). trade
balance (TB). degree of
openness of the economy
(OPEN), domestic capital
formation (eF), inflation
rate or price level (WPI),
interest rate (IR) and
exchange rate (ER):
l
At the Sectoral Level:
{(Gross Output (GO). profit
(PR), exports (EX). degree of
openness (OPEN), gross value
added (GY A), labouT
productivity (LPR), gross
capital formation (GCF),
wholesale price index (WPI),
imports (1M). number of
workers (WO). value of the
total inputs used (IN), wages
paid (W A) and the interest paid
IIR)l
FDI
r
At the Macro Level:
{Domestic
investment (INY),
productivity (PRO),
GOP, employment
(EMP), WPI, trade
balance (TB), balance
of payments (BOP):
IMPACT
OF FDI
I
At the Sectoral Level:
{(Gross Out put (GO), profit
(PR), exports (EX), labour
productivity (LPR), gross
capital fomlation (GCF),
imports (1M), wages paid
(W A) and the interest paid
(lR) :
42
Chapter III
Framework for Analysing the Determinants and Impact of Foreign
Direct Investment on the Indian Economy
3.0. Introduction
In order to explore the empirical relationship among the economic variables, it is always
important to express this relationship in functional form. This facilitates to specifying an
econometric model for the economic phenomenon to be examined empirically. Indeed,
the economic theory influences the specification of statistical model as it determines the
choice of variables for the modelling of the phenomenon of interest. [n fact, any sensible
modelling cannot begin without some theoretical base and parameters cannot be
interpretable in the absence of a well-articulated theory. Hence, the present attempt in
this context is to present a model for analysing the FD[ determinants and its impact on
Indian economy. [n the previous chapter, an extensive and intensive literature on the
FDI was surveyed and this has helped construct the taxonomy of the f'DI. [n the current
chapter, an attempt has been made to translate the stated taxonomy into an estimable
form.
It is important to note that there has been an attempt to review the theories of fDl
by Agarwal (1980), Mainardi (1987), Lizondo (1991), and Rayome and Baker (1995).
These reviews did not make any attempt to present the theory of FDI in a unified
framework but instead classified these theories into different categories, which are more
or less adage. [n fact, Lizondo (1991) feels that "at present there is no unique widely
accepted theory of foreign direct investment". Contrary to Lizondo's claim, there is a
consensus among all the theories of fDI that by definition FDI is undertaken by tbe
multinational corporations (MNCs) and its theory can be viewed as a subset of the theory
of the firm. Thus, the study tries to specify the FD[ determinant function derived from
the theory of firm and provide a framework for analysing the determinants of FDI
inflows in the host economy.
3.1. Determinants of FDI
An MNC can be viewed as a multi-market, multi-plant, multi-product firm, where the
number of market is identified with the number of countries in which it sells products
and the number of plants with the number of countries in which it has production
facilities. Moreover, FDI is the result of the MNC activities and FDI is carried out
Framework for Analysis
exclusively by these MNCs. Thus, at a very general level, the FDI by the MNCs can be
viewed as a special case of the theory of derived demand for capital. Therefore, the
derivation of the general model for the determinants of FDI is based on a multi-market
and multi-plant fiml. The multiple product dimensions of MNCs can be easily
incorporated in the model. However, it adds a little additional insight into FDI process
of the MNCs (Barrell and Pain, 1996). In fact, must firms operate in an uncertain
environment and plan their activities for several years. This suggests a model of a firm,
which maximises the utility of its uncertain profits over a multi-year planning horizon.
However, the existing mathematical models are all deterministic and static. Therefore,
the current model is also specified as a detemlinistic and static model of firm behaviour
as it is sufficient to generalise the existing models. Of course, as Lizondo's scheme
suggests some FDI determinants in empirical research reflect dynamic concerns or
uncertainty. Nevertheless, this docs not undernline the usefulness of the present model.
3.1.1. The ;\'lodeI
Assume that a MNC serves m markets (i = 1, ... , m) from n productiun plants (j = 1, ....
n). Let Q'J denote output from plant j supplied to market i, total supply tu market Q" and
total output of plant QJ. Therefore,
m
Q
= IQ ............... (31),
, "
! =1
j = 1, ... ,n,
.,
Q
= IQ ............ (3.2),
, "
i = l, ... ,m,
,= I
where i=j= 1 is used to denote the MNC's home market and productiun facility. Further,
markets and plants are numbered with the same subscript (i.e., i = j), which denotes the
same location for buth plants and markets. Production technology is assumed at each
location j by the production function as:
Q, = Q,(K,L), .......... (33)
j = 1, ... , n
where K
J
and L, are the quantities of capital and labour employed respectively. The
(inverse) demand fur the MNC's product at location i is assumed to be p, (Q" Z,), where
Z, is a vector of demand determinants. The price Pi is given in currency units of the
44
MNC's home country. Demand determinants may include the characteristics of the
markets i such as GOP, prices of close substitutes from different competitors and tax
rates.
The cost of production at location j in the currency of the home country is given
by:
C (Q ,y ) ..................... ,(3.4)
l " I
Where Yj is a vector of cost parameters. That is, given a level of output QJ'
Q
"
C
( ,y ) = IV L + r K ........................ (3.5)
I I I I I I J

where L
J
and K
J
are the labour and capital quantities respectively that minimise the
cost of producing QJ' and w
J
and r
J
are the "user" costs per unit of labour and capital
respectively or, in other words, the cost per unit bome by the MNC
I
. The (inverse)
demand for the vINe's product at location i is assumed to be P,(Qi. Z,), where Z, is a
vector of demand determinants. The price Pi is given in currency units of the MNC's
host country.
Finally, the cost of transporting a unit of output from plant j to market i is
denoted by T". This cost may vary, though in this exposition, it can be taken as given.
Thus, the problem facing the M:--JC is to maximise the profits and its profits are given by:
!II 1/
n
= '" "'[P(7. Q ),) - C (Y Q )Q - T .Q.J ................... ,(3.6)
~ L J !,,' ~ ' l !," I I} 'I"
" =1 !-I
Hence, the MNC has to maximise the profit function as given by equation (6) subject to
, .,
the follow1I1g constra1l1ts-:
m
Q
= IQ " ........ (3.6a)
, "
I = I
"
Q
= "Q ..... (36b)
, L.. 'I
, -I
j = I, .. "n,
i = 1, ... ,n1,
I for a diSCUSSion orthe user cost oreapital, see, ror example, Shah (1995).
'Thus, the "'1"(' has mil + II + II ~ (111+]) n variables to choose subject to 111+;11 constraints in (I) to (3).
45
Q = Q (K,L) ......... (36c)
, ,
j = I.. .. ,n,
In the above optimization solution for the finns. three points are \I or1h
mentioning. Firstly, not all Q'Js need to be positive at the optimum lew!. In particular.
the fiml will qualify for the label of "MNC" only if some Q,) for j=2 ... n is positm:.
Otherwise, the firm will have production facilities located only in its home country.
Secondly, in order to allow the MNC the use of foreign production facilities to supply to
the third countries, the model must satisfy both m and n>2. It is important to note that no
mathematical model of FOI in the literature has this feature. Thirdly, the main interest
here is the derived demand for capital (or desired capital stock), which fonns part of the
solution to the MNC's problem. Note that demand and cost factors from all potential
market or production locations can, in principle, affect factor demands in each location.
which can be the vectors Y=(Y
1
,Y
2
, ... ,Y m), Z'=(ZI,Z2, ... ,Zn), and T=(T11,T1l, ... ,T mn).
Then, the desired capital stock in location j can be written as:
, .
K!= K,(Z,Y.T). ............... (3.7)
j=l, ... , n.
Conceptually, investment will occur if the actual capital stock in a location, K) is
less than the desired capital stock. This investment will be FOI ifj>1 or if the investment
is not in the home country of the MNC. In the literature on FOIl, it is evidenced that
capital depreciates and involves adjustment costs. This depreciation and adjustment
costs is reflected in the FOI equation (3.8). Let A) be the proportion of the gap between
desired and actual capital stock that is closed per time period in location j and 8) be the
fraction of beginning of period capital stock that depreciates during the year. Then, the
following partial adjustment model of FDI results:
FDI
= A (TT' -K )+8 K ................. (3.8)
// I \I\... /1 /1-1 f ,11-1
In equation (3.8), FOI
J
represents FOI in location j, j=2,3, ... , n, in period t.
Combining equations (3.7) and (3.8) and using the compact notation Z=(T, Z', /'1. 1.2 , ... ,
) For example. Stevens and Lipsey (1992); Pam (1993). Barrell and Pam (1996); and Baja-RubiO and
Sosvlila-Rlvero (1994).
46
An ,iii ,Ii, , ... ,lin) for the vector of cost parameters, including transport cost, adjustment
cost and depreciation parameters, the tinal determinant equation for FDI is obtained as:
j=2, ... ,n.
where Z is the vector of demand determinants of FOI, Y is the vector of cost
detem1inants of FDI and K'.I is the capital stock at time period t-\. As an economic
priory, it is assumed that the demand determinants are the attracting force for the FOI
inllows \\hereas the cost determinants are detrimental to the FDI inflows. Thus, the
relation is such that DFDI!o(Z) > 0, and oFDI/o(Y) < 0. It is also important to note that
the clements of the two vectors, ie., 'Z' and 'Y' vary (i.e. the clements of these vectors
for the aggregate analysis of an economy would be different from the elements for the
sectoral analysis). In the present study, for the macro level analysis of FDI inllows in
India, ,z' vector includes GOP, growth rate of GOP, export, trade balance, degree of
openness of thl? economy, domestic capital formation and ,y' vector includes inflation
rate, interest rate and exchange rate. On the other hand, for the sector level analysis of
FDI inflows in India, 'Z' includes gross output (GO), profit (PR), exports (EX), degree of
openness (OPEN), gross value added (GY A), labour productivity (LPR), total factor
productivity (TFP), gross capital formation (GCF), wholesale price index (WPI) of the
sectors, and vector 'Y' includes imports (1M), number of workers (WO), value of the
total inputs used (IN), wages paid (WA) and the interest paid (lR) by the sectors.
A model was developed to accommodate the determinants of the FOI inflows
mto India. The model, derived from the theory of the firms gives an estimable form of
the FDI function, where FDI inllow is considered as the dependent variable of the
explanatory \ariables stated above. In order to explain the impact of FOI m a host
economy, the next section tries to specify a framework in a functional form.
3.2. The Impact of FDI
The impact of FDI on the domestic economy mainly depends on domestic policy, the
kinds of FDI the domestic country receives and the strength of domestic enterprises.
Very little can be said on a priori basis, as FDI results in a wide range of impact to the
host country and these impacts may vary across country. The identification and
appraisal of the impact on the host economy is not a trivial matter, but some delimitation,
however tentative, is indispensable. The question of quantitatively measuring the impact
47
of FDI inflows is pertinent here as most of the developing countries are interested to go
for FDI in place of fonna1 contractual agreements for foreign loans. However, in
undertaking any analysis of the impact of FDI, it should be borne in mind that FDI flows
record in the financial flows, which mayor may not correspond to changes in the capital
fonnations. In the literature on FDI, the view prevails that FDI can serve two purposes
(Fry 1993). Firstly, it can be an additional investment to the domestic investment of the
host country and thereby it can raise the investment level of the host economy. Secondly,
it can add to the foreign exchange reserve of the host country and relieve foreign
exchange shortages of the host economy.
FDl is believed to raise the domestic investment or provide additional financing
for a pre-existing current account deficit or achieve some combination of the two.
However, the linear combination of these two effects should always sum up to one.
IIence, the effect of the FDI on the host country's economy can be from two directions.
On the one hand, FDI can affect the real sector of the economy as an additional
investment to the existing domestic investment and on the other hand, it can affect the
financial sector of the economy as an additional financing for a pre-existing current
account deficit. On this line, the impact of FDI on a host country could be measured
through two effects of FDI on the host economy, i.e. real effects and financial effects
(Chai 1998).
3.2.1. Real Effects of FDI
The real effects of FDI inflows into the domestic economy may have implications on the
domestic investment, income, employment, productivity, price level, export !,'Towth,
technology growth, spill over (linkages) effects and the structural change of the economy
as a whole (Chai 1998). The effects of the FDI on the domestic investment, income,
employment, productivity, and price level and export growth are quantifiable as they are
static in nature. The effects on the technology growth, spillover (linkages) effects and
the structural change of the economy arc more qualitative and dynamic in nature.
3.2.1.1. Qualltitative Effects of FDI
The quantitative effects of FDI on the domestic economy are measurable and generated
due to a change in the domestic investment (Chai 1998). In this process, FDI can affect
the growth of the host economy if it introduces new goods to the host economy
especially by introducing new technologies and by investing in human capital. It is
48
known as "crowding in" (eI) effect of FOI on domestic investments. The tenn 'crowding
in' (CI) is used, when the presence of the foreign direct investment by a foreign finn
stimulates new downstream (backward effect) and upstream (forward effect) investments
that would not have taken place in their absence. The CI effect appears only when host
country's government maintains restrictive regimes and FOI is allowed after proper
screening. The success ofCI effect ofFOI also requires differential treatment to different
finns.
If FOI enters the host economy in different sectors, where there are competing
domestic firms or firnls already producing for export markets, it may take away
imestment opportunities open to domestic entrepreneurs prior to the foreign investments.
In this case, the FDI may not reduce domestic investments in the first instance but it may
reduce the domestic investment at least in the future. The contribution of such FOI to
total capital formation is likely to be less than FDI itself. It is known as "crowding out"
(CO) effect of FDI on domestic investment. A 'crowding out' (CO) effect takes place
\\hen foreign firms and their foreign investment displace domestic producers or take
over their investment opportunities. The CO effect also occurs when the host countries
(particularly developing countries) maintain or move to 'open' regimes for foreign finns
and their investments without a proper screening of them.
The relationship between FDI and domestic investment IS likely to be
complimentary when investment is in an under-developed sector of the economy (i.e.,
owing to technological factors or lack of knowledge of foreign markets). In fact, the FOI
is more likely to substitute for domestic investment, when it takes place in sectors where
there are plenty of domestic finns or when domestic firms already have access to
technology that the foreign finns bring into the country. In case FDI does not displace
domestic investment, it may not stimulate new downstream investments in the domestic
production and therefore, it might fail to exert CI effects on domestic investment. It is
important to note that neutral effect takes place in the economy when the same amount of
tDI leads to exactly equal amount of domestic investment In this context, an obvious
question may be raised, that is; if investment is a key variable in determining economic
growth, does the presence of foreign flrn1s in an economy and the FDI flows associated
with them result in increased total investment or reduced total investment in the
economy')
FDI may also raise the productivity of the host economy, particularly in the case
of developing economies (Bonelli 1998). As FDI results in a direct injection of capital
49
and technology, the FDI-receiving companies are expected to perform better than local
companIes. In addition to this direct effect of FDI, there are also various spillover
effects of FDI on local tirnls. In this case, FDI can generate a beneficial transfer of
know-how and technology. In fact, an injection of capital and technology in domestic
firms certainly stimulates competition in the local market, if the initial difference in
technology between foreign firnl and the domestic firm are large and human capital is
poor. In this situation, the foreign firms will stranglehold the local unproductive
competitors. In case, the technology gap is moderate and human capital is strong in the
domestic firms, it will increase the competition and increase productivity catch-up of
local firms.
The discussion on the impact of FDI on domestic investment reveals that the
effects of FDI on the domestic investment are two-fold: one is crowding-out effect, and
the other is crowding-in effect. When these FDI crowds-in the host country's domestic
imestment, the host country's national income goes up. Since the CI effect of the flows
of FDI raises the levels of investments in the host economy, it can be argued that the
levels of income of the host economy will rise through the Keynesian income multiplier
effect. In this case, the multiplier operates in the forward direction. However, when FDI
crowds-out the host country's domestic investment, the host country's national income
will go down. The multiplier works in the forward direction when there is a CI effect of
FDI, whereas, the same multiplier operates in the backward direction when there is a CO
effect of FDI. However, the income level will be same over a period of time, if FDI is
considered as a stock. Nevertheless, it will not affect the domestic investment and the
income !e\el of the host economy when there is a neutral effect of FDI on domestic
investment. The other agreement that is raised in favoqr of FDI to raise the income level
of the host economy is derived from the endogenous growth theory 4, which argues that
contrary to the neo-classical growth theory5, the growth of an economy can be
accelerated by having increasing returns to the factors of production. This can be done in
case of an I'DI host economy as the new technology would raises the productivity and
the returns to capital increases.
In addition to the I'Dl effect on the domestic investment, productivity and income
of the domestic economy, Lahiri and Ono (1998) advocated another important effect (i.e.
price effect) of the FDI. The price effect of the FDI could be established in the host
, For more details. scc ,Harro and Salal-I- Martin 1999.
50
economy through productivity increase of the domestic firms. As Lahiri and Ono put it:
when the productivity of the domestic firms increased due to the FOI inflows, it gave a
downward pressure on the cost of production, which marked a downward pressure on the
price level of the economy.
Similarly, FDI might raise the employment level of the host country, if the
foreign firms are required to use the local resources for their production (Brander and
Spencer 1987, Lahiri and Ono 1998). When the foreign firms were compelled by the host
country's government to use the host country's unemployed and under-employed
resources, the overall employment level of the host country would go up. In this case,
there would be uppefbargaining power of the host country. On the other hand, when the
foreign firms were only interested in exploiting the natural resources of the host country
to cater to the export demand of their product (in the international market), the total
export of that economy would go up.
The trade effect of FDI can be the sum of export generating effect (EGE), export
displacement effect (EOE) and import generating effect (IGE). FDI generates imports in
the host economy by the capital inflows, which provides necessary materials and
components. Local production also replaces purchases of similar products previously
imported. The new overseas plants also export their output to cater the global market as
a result of which export of the domestic economy goes up.
The above discussion reveals that, some of the effects of foOl are on the real
sector of the domestic economy. Though some of these effects are static in nature, it is
possible to quantify and measure them. These effects include the effects on the host
economy's domestic investment, income, employment, price level, and productivity and
trade balance.
3.2.1.2. Qualitative of FDI on the Domestic Economy
Though the qualitative effects of FOI on the domestic economy are dynamic in nature
and difficult to measure, these effects are of strategic importance to the host economy
and needs to be addresscd. These effects include the effects on the technology of the
firnls in the domestic economy, the spillover effects and the effects on the structure of
the economy. In this connection, it is important to note that the conventional method of
importing foreign technologies by paying royalty or so-called license fees has become
, Sec. Solow 1956
51
increasingly unpopular because license holders are charging prohibitively high royalty
fees. Therefore, most of the developing countries, which are lacking in original
technologies, are turning to the Foreign Direct Investment method to gain access to
leading foreign technologies (Lichtenberg 2000). FDl has a number of effects on the
import of technology and capital. Thus, FDI affects technology inducement in two ways:
Firstly, the foreign parent company transfers its newly developed technology directly to
its overseas subsidiary company. Secondly, the parent company transfers its technology
indirectly through investing in the capital goods of domestically invested companies.
These new technologies improve the quality of technique of production and in the
process helps the domestic technology to improve.
New technologies transferred through the above mentioned two methods entail
significant spillover etTects, which have a critical and beneficial effect on the host
economy (DritTield. e/ al. 200 I). First of all, there are positive spillover effects to
domestic industries in the process of manufacturing end products by making use of
purchased intermediate goods, implanted with valuable technology, from foreign-
invested companies. This is called as the 'forward linkage effect'. Similarly, foreign-
invested tirms extend technical assistance to subcontractors or companies, which provide
parts to them. This is known as 'backward linkage effect'. Thus, the existence of
backward or forward linkages from the establishment of foreign investors is a key
consideration for detemlining the total impact of FDI on capital formation.
The most important qualitative dynamic impact of FDI on the domestic economy
is the structural change of the economy due to the integration of the economy with the
global economy. In this scenario, the host economy moves towards a more market-
oriented economy and in the process bring changes to the economy. These changes may
be a vertical inequality in the growth rate of different sectors of the economy. In this
case, the sectors those attract more FDl will grow at a faster rate than otherwise and
create an imbalance in the economy.
It can be concluded that all the three effects such as technological change,
spillover effects and structural change of the economy can be captured qualitatively by
looking into the micro level of the economy. In order to measure these effects at the
micro level of the economy, more in-depth firm level qualitative research is required.
However, the present study tries to measure the impact of the FDI inflows on the macro-
variables and sectoral variables of the Indian economy. This can bc done only with the
52
quantifiable variables. Thus, this qualitative real effects of the FDI fall outside the scope
of this study.
3.2.2. Financial Effects
The financial effects of FDI on the domestic economy are the effects on the balance of
payment (BOP) of the domestic country and the effects on the domestic savings of the
host country (Chai 1998). The effect on the BOP is exerted when the FDI finances the
deficit in the cutTent account of the BOP of the domestic country and thus helps to
improve the BOP position. This effect of fDi on the balance of payments can be
positive or negative depending upon the FDI inflows of the host economy.
Apart from the BOP effect, fDi also atfects the domestic savings of the host
economy. Both domestic saving and foreign savings flow through several channels
before reaching the investors (Fry 1993). FDI is one such channel that helps the foreign
savings to reach the domestic investors. If a country faces cutTent account deficit, foreign
saving plays an important role, which can be channelled through FDI. In such a
situation, the FDI never becomes investment in the real sense: mergers and acquisitions
(M&As) are mere transfers of ownership of existing assets from domestic to foreign
tilTlls. In this context, FDI can be seen as a financial flow and its effects are the
financial effects on the host economy. The financial effects of FDI on the host economy
inc lude the impact of FDI on the balance of payments and on the domestic savings.
To sum up: the impact of FDI on the host economy can be adjudged from two
effects of FDI on the economy. These two effects include the real effect and the financial
effect. The real effect includes both qualitative and quantitative effects. The quantitative
effects of FDI include the effects on domestic investment, productivity, price level,
income, employment and on the trade balance of the domestic economy. The qualitative
effects of for include effects on technological change, spillover effects and the effects
on structural change of the economy. The financial effects of the FDI on the host
economy include the impact (measurable) on balance of payments and on thc domestic
savlllgs. As mcntioned earlier, the direction (forward or backward) of all these effects
(both real and financial effects) depend on domestic policy, the kinds of fDI that a
country receives, the strength of domestic enterprises and the structure of the domestic
economy.
53
3.3. Framework for measuring the Impact of FOI 011 the Host E c o l l o m ~
3.3.1. FDI and Domestic Investment
[n order to measure the impact of FDI on the domestic Inwstment. it IS appropriate to use
the version of the accelerator model. since the estimation of the nco-classlCalll1\cstmcnt
function is difficult, particularly in case of developing countries.
The accelerator model has the desired capital stock K* proportional to rcal output
y: I.e.,
K' = ay ............... (3.IO)
This can be expressed in terms of a desired ratio of investment to output (I/Y)*
(J / Yj' =ay ............. (3.11)
where y is the rate of growth of output. The partial adjustment mechanism specified for
the investment ratio is somewhat more complicated than the equivalent mechanism for
the level of investment. Specifically, there can be a lag in achieving the same investment
ratio for this year as last year, if output rises rapidly for the last year. It means that this
year desired investment level will be higher than last year despite a constant desired
ratio of investment to output. In order to incorporate this adjustment lag, the last year's
growth rates Y,.I can be included as an explanatory variable.
The adjustment mechanism allows the actual investment rate to adjust partially in
anyone period to the difference between the desired investment rate and the investment
rate in the previous period, i.e.,
fI.(/ / Yj = )dU I Yj * -(1/ Yjt-1l .............. (3.12)
or
1 I Y = A(/ I Yj * +(1-),)(I! Yjt -1 ............ (3.13)
where A is the coefficient of adjustment. The flexible accelerator model allows
economic conditions to influence the adjustment coefficient t .. Specifically,
A = (3" +[[3,z, + (3,.::, + ...... ./(1 IYj*-(I iYjt-lj ............ (314)
54
lor :\n..th .... 1 ....
where z, is the variables (including an intercept term for the depreciation rate) that afkd
Ie. Since"),. is the adjustment coefficient, the investment function for estimation will be a
function of the Z, variables. From the accelerator model and the classical
macroeconomic model, it is observed that the Z variables are income I Y) and interest
rate (r) (Branson 1994). If we introduce FD! as another \ariable, then the Imcstment
function will be:
I, = l,(FDI"Y"r,)(3.15)
3.2.2. FDI alld Productivity
The impact of FD! on the productivity can be derived from the standard neoclassical
production function, which states that
Y(t) = A(t)F[K(t),L(tI] ......... (3.16)
where Y (t) is the production, A (t) is an index of the level of technology, which is also
called as total factor productivity (TFP) in the growth economics literature, K and L are
capital and labour respectively. In order to measure the growth rate of TFP, one has to
find out A'IA and from the above production this A'/A is:
AI A = YI Y -[a(t)KI K +[I-a(t)LI L} ............. (3.17)
This approach helps one to measure the TFP growth rate in discrete time-series
and it may be given as:
+ 1)1 A(t) = + I) 1 Y(t) j- {a(t) 10g[K(t + I) 1 K(t) j + [I -a(t 1]log[L(t + 1)1 I
Where a(t)=[ a(tl+ a(t+ I) 1/2 is the average share of capital over the periods t and
t+ I. However, in order to estimate the TFP effect of the FDJ. it is essential to introduce
I'D! as a determinant in the TFP function along with other detcmlinants of TFP like
output (0), capital (K) and labour (L). Thus, the estimable relation between 11-1' and I'D!
may be written as:
ss
TFP, = f(FDJ"O"K"L,) .......... (l9)
3.3.3. FDl alld lllwllle oftlr" Host Ecollomy
The relation between FD! and the domestic income of the host economy can be derived '
from the endogenous growth model (l3ashir 1999). The functional relation can be
established by using the production function as:
r = AH"-u,,' (k la ....................... (3.20)
L.., /:1 I
\\'here, O<a < I, Y is the aggregate output, H is the stock of human capital in
the host economy, k, is the capital good used by the jth fiml, and A is a fixed
technology parameter. There arc N fimls engaged in the production process, n
domestic llmls, and ;-J-n foreign llrms (MNC). Technological progress takes the fOTl11
of expansion in :\. the number of timls undertaking production. It can easily be shown
that if the units of capital are all employed in the same quantities across fiTl11s, i.e., k
J
= krl = K. then equallon (20) can be written as:
. II ., I ( I L I I -,,, 2
) =AH MI!-'N(3. I)
Equation 021) indicates that production exhibits constant returns to scale in H
and :\ K.I he technological progress is captured by the fact that, for given quantities
of Hand :\K. the tenll N'I" I indicates that output increases with N. Assume that the
price of the capital good is P
J
the price of II is nomlalized to one, and the producers
operate in a compctitl\e market. Since the producers take these prices as given, then
profit maximization entails equating the price P
J
to marginal productivity of capital.
Soh'ing for tht: optimal amount of capital employed by fiTl11 j:
f ) "-u'
K - II \CXA / P . . ................ (3 .. 22)
)
Equation (312) shows tht: quantity demanded ofK, which depends only on the
56
Suppose that each time the firm engages in production, it incurs one unit of output to
use K
J
Then the present value of future cash flows for the jth firm is:
J(r) = I'jp, -1)Ke" .............. (3.23)
\\here r is the steady state rate ofretum of capital. Equation (3.23) shows that the cost
of production can be covered only if the sales price, P
J
, exceeds the marginal cost of
production. I. (i.e, P, > I). It is assumed that the process of adaptation of new
technology of production requires a set up cost (jl (I\-n, N/N\ This cost is inversely
rebtd to the number of foreign tim1s (M1\'Es) and to the ratio of the number of goods
produced in the domestic (developing) economy to the number of goods produced in
foreign (de\elopedl economy. I\ow, the profit of the jth fim1 is n J (t) = V(t) - (jl (1\'-n,
:\ ,,\ The l'ompetitive linn \\ill choose the quantity K
J
to maximize n J (t), where K
J
is gi\en by l'Ljuation (3.22). In fact, equation (3.22) indicates that the choice variable
IS P, and the n:prcssion to maximize is:
(p pl
l
t-a
I
..... (322u)
The optimal ",Iution to the maximization problem is:
p = p = 1/(1 > 1. .................... (324)
Hence, the price 1\ is constant over time and is the same for all capital goods j.
The cost of production is also the same for all goods and each good enters
symmetrically mto the production function (see, Barro and Sala-i-Martin 1995).
Substituting equation (3.24) into equation (3.22) will detem1ine the aggregate quantity
produced of each capital good:
(

K. = K = II AU , ....... (3.25)
57
The quantity KJ is the same for all goods at all points in time (if H is constant).
If we substitute for Pj and K
J
into equation (3.23), expression for the net present value
IS now:
v(r) = H A"'-U)(I-a)Ja. ""-0),,11: -'('-1) (326)
a L.,,=,e ....... .
Assuming free entry in the product market, the equilibrium will indicate that:
'i>=lIA'<I-
U
'(I-a)la. "h.,,,' -/,.-11 ('27)
a L.".,e ....... -'.
As the number N gets large, the summation reduces to IIr and hence. the zero-profit
condition \"( t) = n implies:
,. = (H J <jl ) A' , ) ~ I (I -a )Jaa '"-a 1 (3.28)
That i,;. the rate of return, r, is pegged by the underlying technology and the marginal
producti\il\ of capital. It is further assumed that the households are represented by
the standard. infInitely li\cd, Ramsey consumer who maximize the utility function:
. - '" (e
'
) ( ) I' ,
C - L., =. -1.1-8 e ..... .(3.29)
where C is consumption, p is the subjective rate of time preference, and 0 is the
in\"erse of the intertemporal elasticity of substitution. Households earn the rate of
return on as,;et and the wage rate 1\' (normalized to I) on the fixed quantity H of
human capItal. The key condition characterizing the solution for utility maximization
\\ ill rC\'cal the growth rate:
y = (1.0 XI- p) ............................. (330)
Lquation t3.30) indicates that in steady-state equilibrium, the rate of growth of
consumption" positively associated with the rate of return and negatively related to
the rate of time prdcrence Jml the elasticity of substitution. Moreover, the number of
58
firms, N, and the level of output, Y, will grow at the same rate of growth of
consumption y c.
Substituting equation (3.28) into equation (3.30), the following expression for
the rate of growth of the economy is obtained:
= (118)'(H! )A'II-O'( ) "II-a,
Y 1'<P I-a faa -p} ...... (3.31)
The expression in (3.31) is valid only if the parameters are such that y 2: O.
The expression shows that rate of gro\vth of the eCOn0l11Y is an increasing
function of :\, H and a decreasing function of p, 0 and <P (thus an increasing function of
the number of MNEs and the amount of FOI). The New growth theory emphasizes
precisely those factors, which are supposed to characterize the FDI. In this context,
FDI is belieq:d to transfer technology, promote learning by doing, train labour, and in
!,!cncral result in spillO\'Cfs of human skills and technology and it promotes growth.
Thus, the relation between FDI and the income of the host economy can be stated as:
y, = fIED/"A"H, p,.8 ,,<p) ..... (332)
3.3.4, FDI alld Emplo)'meJlt of the Host Ecollom),
The above discussion shows that income of the host economy is affected by the inward
H)I to that economy. However, income of any economy will go up only when the
unemployed resources of that economy is employed and it could be achieved by a local
content requirement policy of the same countries (Brander and Spencer 1987, Lahiri and
Ono 1998). Therefore, the relation between FDI and employment in the host economy
can be established in the following way:
EMP, = I(FD/"y,)(333)
3,3,5. FDI alld Price Level of the Host ECOllomy
The growth rate of an economy as given by the endogenous growth theory is stated in
equation (3.31). It can be argued that when the set up cost of an economy goes down due
to the adn:nt of 1'01, it puts a downward pressure on the price level of the economy.
59
Thus, if this effect ofFDI is imposed on the quantity theory of money (QTM)", the effect
of FDI on the price level of the economy can be measured in the following way:
WPI, = f(pDI"MS,J." ........... (3.34)
Where WPI is the wholesale price index of the host economy, MS,.
l
refers to the
money supply in the economy with some lag.
3.3.6. FDI alld TB of the Host Ecollomy
The effect of FDI on the TB of the host economy can be presented in a functional form
by using the Keynesian open macroeconomic model. The basic Keynesian open
macroeconomic framcwork is:
y = ('+1 +G+(X -M) ........ (3.35)
where Y = value of the national income. C = value of aggregate consumption
expenditure. I = value of domestic investment expenditure. G = value of aggregate
gov'ernment expenditure. X = value of exports, M = value of imports. By rearranging,
the equation (3.35) could be written as:
(X - At) = Y - (' + 1 + G)"""" .. (336)
The equation (3.36) explains that trade balance (TB), whieh is equal to the
difference between exports and imports (X-M), depends on Y, C, G and I. However, in
the foregoing discussions. it is already stated that Y and I are FDI dependant. It is also
well established in the literature of international trade that the exports and imports of an
economy are largely influenced by the exchange rate. Thus, TB equation can be
expressed as:
TB, = f(PDI,.y,.C"/"G"ERJ",,,,,,(3.37)
where ER is the exchange rate of the domestic currency with the rest of the world.
" For more diSCUSSion on the QT\I1. sec .13ranson 1994,
60
3.3.7. FDI and BOP of the Host Ecollomy
For a developing country, FDI may be considered as a potential additional source of
finance of the balance of payments (BOP) of the host economy. It is also important to
note that FDI can be viewed as autonomous and accommodating capital flows (Meade
1951 ). Suppose a capital flow is autonomous, it is independent of the BOP situation of
the economy and when the capital t10w int1uences the BOP situation of the economy, it
may be referred as accommodating capital flows. Turner (1991) also addresses this issue
that whether or not net FDI inflows are accommodating and hence, constitute additional
BOP financing by regressing the components of the capital account of the BOP of the
host economy. When FDI is accommodating, the BOP position of the host economy wii1
also improve as FDI intlows are credited into the account uf the host country's BOP.
The balance of payments, which consists of buth current and capital accounts, can be
written as:
BOP = C A + K = TB + NFl + NTRA + K .......... (3.38)
where BOP is balance of payments, CA denotes current account, K is the capital account,
NFl is the net foreign income, which is an income acquired domestically owned factors
empluyed in abroad less income acquired by foreign owned factors in domestic country
and NTRA is the net transfers paid by residents to the domestic government. In this
expression, K includes all capital transaction and FDI is a long-term capital flow. Also,
it is already established that TB depends un the FDI inflows. Thus, the BOP function
can be stated as:
BOP, = I(r'DI"TBJ .... (3.39)
3.3.8. FDI and Domestic of the Host Ecollomy
The relation between fDl and domestic saving (S) can be established by uSll1g the
Keynesian linear saving function. The linear saving functiun can be expressed as:
S
=s +sy ............ (3.40)
I () I-I
61
hamework for Analysis
Where 's' is the marginal propensity to save (MPS). Since FDI docs affect the
income (Y) of the host economy, the following functional form can represent the saving
function of the host economy.
s, = s,fpD],_"y,) .............. (3AI)
3.4. Conclusion
It can be cone luded from the above discussion that there are two main effects of FDI on
the host economy, viz., real effects and financial effects. The real effects of the FDI are
both quantitati\'c and qualitative in nature. The main indicators of the quantitative real
effects of FDI are investments, productivity, employment and income, which are
considered for estimation in the present study. The indicators of the qualitative real
effect of FDl are spillover effects, technological change, and structural change in the
economy. It is important to note that these qualitative real effects of the FDI arc not
considered in the present analysis. In addition to the quantitative real effects, the
financial .:ffects of FDI are also considered in the analysis. The main indicators of the
linancial effects of the FDI are effects on the balance of payments and domestic savings.
All these quanti liable real and financial effects are supported by some theoretical
justification and are presented in functional forms through equations 3.15, 3.19, 3.32,
3.33.3.3-\.3.37,3.39 and 3.41.
In an attempt to put the taxonomy of FDI in an estimable functional form, the
study has dcri\ed a set of functions, which describe the determinants and the impact of
the FDI on the receiving economy. The set of functions is:
FDI
= F(z ,y ,K ) (3.9')
I{ 1/ /1 If -I
/ = i,( F D], ' Y" I; )..( 315')
TFP, =/(FD],Q,K,L)(3.19')
Y = I(PD]"A,.H,. p .. 8 ,.cp) ... (3.32')
EMP, = I<FD/, y, Y, ).........(3.33')
WPl, = I(FD/,.MS,J .. .... (3J4')
62
TB, = IfFD/"Y,C,/"G"ERj ........... (3.37')
S, = S,fFDL"yj ......... (34\')
In the subsequent chapters, the study tries to estimate these derived functions
empirically to elicit the determinants and the impact of FDI inflows on the Indian
economy both at the macro level and at the sectoral level. However, thc determinants
and the effects will be different for the sectors than those for the nation as a whole.
Thus, for the empirical analysis, the choice of the variables for the estimable equations
vary according to the need of the study. It is quite pertinent to mention here that the
determinants and the impacts of FDI on the economy mainly depend on domestic policy,
the kinds and nature of FDI that come into the domestic country, the structurc of
domestic political economy and the potency of domestic enterprises. This call for an
analysis of the policy of the host country towards FDI, the behaviour and the nature of
FDI flows and the political economy of the host country, before venturing into an
empirical examination of the detcmlinants and the impacts of FDI inflows. Thus, in the
next chapter, the study tries to review the policy launched by the policy makers, the
nature and the behaviour of the FDI inflows and some stylized facts about political
economy of FDI in India, especially after liberalization.
63
Chapter IV
Policy Measures and Trends in Foreign Direct Investment Flows into
India
4.0. Introduction
World economy witnessed large-scale decolonization during post-war period, which resulted
in an intense desire for development among the newly independent countries. In fact, the
'Big-Push' theoryl gained acceptance during this period and raised the quantum of
investment through greater mobilization of domestic resources and external support in these
countries. There was a common belief that the gains from growth would automatically
trickle down to the lowest rung of the economic ladder. However, the growth rate remained
very low despite huge investment. The structural weaknesses or defective macroeconomic
policies came in the way of the very process of growth. Apart from structural weaknesses
on the domestic front, developing countries had to face severe external shock (Balassa
1981). The soaring international oil prices of 1973-74 and 1979 gave a jolt to the balance of
payments position of the net oil-importing developing countries. All these reasons
hampered the process of economic growth of the developing countries. The economic
measures and efforts of over three decades failed to pull the developing countries like India
out of stagnation. In the mean time, the developing countries were made to believe that
liberalization and globalization of their economies could help to come out of this stagnation.
Thus, many developing national economies were opened for international business.
In this backdrop, India tried to come out of the stigma of a perceived closed
economy and started liberalizing her economy gradually. In the financial year 1990-91,
India entered a period of severe balance of payment crisis and political uncertainty. A rapid
increase in India's external debt coupled with the political instability led international credit
rating agencies to lower India's rating both for short and long-term borrowing. This made
borrowing in international commercial markets di fficult and also led to an outflow of foreign
currency deposits kept in India by the NRIs. Further, the situation was made worse by the
Gulf war and resulted in an increase in petroleum prices and virtual stoppage of remittances
from Indian workers in the Gulf. These developments brought the country almost to the
I For a detailed discussion on BlgPush theory, see, Rodan 1961.
Policy measures and l r e n d ~ In FOI
verge of default in respect of external payments liability, which could only be a\uted by
borrowing from I\1F under standby arrangement and certain emergency measures taken by
the then government to restrict imports. In June 1991, a new government headed by P. V
Narasimha Rao came to power following the mid-term election. This gO\ernment illlllated a
programme of macro-economic stabilization and structural adjustment' supported by the
IMF and World Bank. The programme was substantially different from the earlier ones and
launched a variety of policy reforms. It was believed that FOI had the cheapest and most
effective way of obtaining latest technology from abroad instead of direct purchasing of
capital goods or licensing. Thus, apart from some structural adj ustment both in the internal
as well as external economy, the new economic policy aimed at attracting more FOI into the
economy. In this chapter, an attempt has been made to review the FOI policy> of the
government of India, which came in for a new look in the package of macro-economic
stabilization and structural adjustment programme of 1991 and gradually received
momentum. The chapter also tries to examine the different dimensions of FDI inflows into
India that resulted from the FDI policies initiated by the government of India. However,
FOI was never alien to India even before 1991. The chapter also highlights some of the
relevant and important facets of FOI in India from the year of its emergence as an
independent nation.
Keeping in vIew the foregoing settings, the present chapter tries to address the
following issues:
What was the flow (or stock) of FDI during pre-liberalization period and what was
the sectoral composition')
How did FOI inflows behave in pre-liberalization and post-liberalization periods and
whether the FDI policy launched during different periods in post-liberalization help
to serve the purpose?
What are the different dimensions of the FDI inflows in India during the post-
liberalization period?
The remaining part of this chapter is organized in four sections. The second section
briefs some of the important aspects of FDI inflows (or stock) in pre-liberalization period.
The third section reviews the FOI policy of the government of India in post-liberaliLation
2 For a discussion on the difference between macro-economic stabilization and structural adjustment
rrogramme, see, Appendix 4.1
For a detail on other policy reforms. see AppendIx 4.2
65
followed by some styliLed facts about the FDI Inflow S In the fourth secllon. Summar) and
conclusions of the chapter have been presented In the last section.
4. J. FDI in Pre-Liberalization period
At the time of independence in I ()47, India \\as a host of sigllllicant stock of FDI and It W;I'
largely owed to her colonial master: the UK. Soon aftcr independence. India embarked on a
strategy of industrialization with active governmental intervention. Domestic enterpnses
accumulated considerable capabilities in the process of industriahlation. which influcnced
the paltem of FDI flows to the economy in the subsequent periods. The changes III thc
government policies had also an important bearing on the FDI position of India. The I n d l ~ 1 I 1
government's attitude towards foreign investment evolved mer the post independelKe
period in four distinct phases (Kumar 1995). The period from independence up to the late
I960s was marked by gradual liberalization attitude. The period from the late I %Os through
to the I970s was characterized by a more selective stance. The 1980s were marked by J
certain liberalization policy. In 1991. India liberalized its policy rcgimc with respect to FDI
as a part of the refornl proccss.
The Reserve Bank of India's (RBI) suney on intelllational assets Jnd liabilities in
India shows that foreign investment in the country was only Rs. 2.56 billion In the I11ld 1')48
Cfable 4. I). The bulk of the FDI stock was of natural resource seeking and of trading type.
which had conccntrated on raw materials, extractive or senice sectors It can be obsened
that tea plantation and Jute accounted for a higher share of FDI as compared to
manufacturing and service sectors in mid-194S. It is important to note that the locational
advantages encouraged the market seeking FDI in spite of more protections accorded to
local manufacture as evidenced from the FDI policy in India. In fac\, most of the foreign
enterprises served in the Indian market through exports started establishing manufacturing
affiliates in the country during that period. In the later stage. the westem multinational
enterprises started showing real interest in India especially in late 1950s and early 19605. In
fact, their response was not enthusiastic except in the case of one-shot in\c5tl11ent in oil
refineries in early 1950s (Kidron 19(5). Most of the foreign drug companies exportll1g to
India also set up their manufacturing subsidiaries in India during this period. As a result. the
FDI stock in the country increased more than two times. It accounted for nearly Rs 565.5
66
Policy measures and Trends In FDI
Crores in 1964 as compared to Rs 256 Crores in 1948 (Table 4.1). Though there was
increase in the total FDI stock in 1964, the sector-wisc composition changed during the
period. It shows that the manufacturing and petroleum sectors gained with FO[ stock, whIch
accounted for nearly 40.5 and [4.7 per cent respectively.
The absolute difference of total FO[ inflows between 1964 and 1974 wcre around
Rs.35 Crores. The composition of sector-wise FDI inflows indicates that manufacturing
sector attracted more FO[ during the period. It accounted for nearly Rs.628.6 Crores with a
share of around 68 per cent (Table 4.1). It may be due to the liquidation of FDI stock in non-
manufacturing sector, which was largely through taking over ccrtain government activities
such as general insurance companies in 1971 and of petroleum sector between 1974 and
1976. Within the manufacturing sector, new inflows were directed to technology-intensive
sectors such as electrical goods, machinery and machine tools, and chemical and allied
products (in particular, chemicals, and medicines and phannaceuticals). These three sub-
sectors of manufacturing accounted for nearly 58 per cent of total FDI in 1980 as against 41
per cent in 1964 (Kumar [995). It is also important to note that the rise in technology-
intensive products in the FO[ stock has been at the expense of traditional consumer goods
industries such as food and beverages, textile products and other chemical products.
The restrictions put on FO[ during 1970s had virtually neutralized the internalization
incentives for potential foreign investors in the country. As a result, FO[ inflows into India
did not gain significantly. The total FDI inflow into India accounted for only Rs.933.2
Crores in 1980 as compared to Rs.916 Crores in 1974. The share of manufacturing sector
continued to rise during the period, which accounted for nearly 87 per cent of the total FO[
inflows of the country. The liberalization of industrial, trade and foreign collaboration
policies in 1980s improved the investment climate and helped the country attract more
inflows of FO[ (RBI 1985). The liberalization also eased the near total restriction of FDI
flows to technology intensive manufacturing sector, which resulted in a three-time increase
of total FDI inflows in 1990.
To sum up: there was an absolute increase in the FOI stock during the pre-
liberalization period. The sector-wise distribution of FOI stock shows that manufacturing
sector gained more attention by foreign investors as compared to other sectors (such as
plantation, mining, petroleum and service). This might be due to an import substituting
67
Policy measures and Trends in FDI
policy of the government during this period, as much of the imports were manufacturing
products. Thus, the liberalization in the manufacturing sector helped to attract more FDI into
it. However, the overall picture of FDI flows into India was not encouraging before 1991
with the exception of manufacturing sector.
4.2. Policy Measures for FDI in the Post-Liberalization Period
Broadly speaking, the new policy was initiated to increase the stake of foreign investors in
Indian companies. provided a bigger room for their entry, axed the procedural fonnalities,
provided additive incentive for the import of technology and to the NRIs. Thus, the main
objective of the new FDI policy was to create a congenial environment for FDI inflows in
India. Diluting the provisions of the Foreign Exchange Regulation Act (FERA), the new
policy removes the 40 per cent ceiling for foreign equity participation that existed during the
pre-refonn period. Moreover, it provided for automatic approval of foreign collaborations in
many cases. In case of nine categories of industries, \'/::., mining services, basic metal and
alloys, electric generation and transmission, non-conventional energy generation and
distribution, construction, land and water transport, storage and warehousing services and
some manufactures like industrial and scientific instruments, the RBI granted automatic
approval of foreign collaboration even if foreign participation in equity goes up to 74 per
cent. In case of infrastructural projects of this group, automatic approval would be availed
even with 100 per cent foreign equity participation. In case of three categories of industries,
such as mining of iron ore. metal ore and non-metallic minerals, forcign equity participation
was not to exceed 50 per cent if automatic approval was expected. In addition to this, in
1999-2000, the list of automatic approvals was widened covering important industrial and
services sectors (Secretariat of Industrial Assistance, SIA Newsletter 2(01).
However, if a foreign investor wished to have greater participation in equity than that
mentioned above, documents had to be routed through the Foreign Investment Promotion
Board (FIPB), which was under the Industry Ministry of the Government of India. The FIPB
sanctions even 100 per cent equity participation in cases where Indian companies were
unable to raise funds or in cases where at least one-half of output is meant for export. It was
68
Polic) mca,urc, and I rend, Ul r 01
also done in cases where foreign investors were to bring in proprietary technology (Indian
Investment Centre 1997).
The new policy extended FDI to tracting, hotels and tourism-related companies. units
of export-processing zones, banking and non-banking finanCial services, of course. with
varying degree of foreign equity participation. The non-banking financial selyices now
included credit card and money-changing businesses. The multilateral finanCial institutIOns
were allowed to contribute equity to the extent of shortfall in the holdings of NRls \\ Ithll1
the overall pennissible limit of 40 per cent in the public sector banks. FDI was also allowed
in those areas where the big industrial houses were not previously allowed to invest. The
new policy pemlits for opening of branch/liaison offices of foreign companies, revoking the
prohibition of 1973. The branch office could be set up for conducting research and
development, undertake exportlimport activities and for making available desired
technology. An offshore venture capital company might contribute to an entire equity basc
of a domestic venture capital fund and might also set up a domestic asset management
company (Indian Investment Centre 1997).
FDI does not always involve investment in cash. A purely technical collaboration
involves pennission to usc patents or trademark and transfer of technology for which the
Indian Company pays royalty, technical service fees. In case of technology import, the new
policy also provides for automatic approval if the collaboration agreement ill\'olves royalty
payment up to $ 2 million (net of taxes) to be made in a lump-sum amount or up to 5 per
cent of domestic sale and 8 per cent of export over a tcn-year period from the date of
agreement or seven years foml the date of commencement of business. In hiring of foreign
technicians. there is no bar if the RBI guidelines are followed. There is also no bar on the
use of foreign brand name.
The policy cut the procedural delays significantly. Abolition of industrial licensing
almost in all cases (except public sector units and those units producing hazardous items) is
another example. The Foreign Investment Promotion Council was set up in 1996 to identify
projects within the country that required foreign investment and to target specific countries
fonn where FDI could be brought in (Indian Investment Centre 1997). To foster speedy
69
Policy measures and Trends In FDr
appro\'als. the FIPB had been asked to give its decision within a period of 30 days, For
speedy implementation of the approved investment. the government set up the Foreign
1l1\estment Implementation Authority that convened its first meeting in the last week of
September 1999 (SIA Newsletter 2(00),
The I\Rls making FDI got special treatment. They made direct investments either on
repatriable tenns or on non-repatriable terms. In case of repatriable investments, their share
can go up to 100 per cent of the equity if the project concerns high-priority industry. housing
and real-estate development. air taxi operations. sick unit. 100 per cent export-oriented units
or a unit in export-processing Lone and a trading house. On non-repatriable terms. NRls'
participation could go up to 100 per cent of bonus issues in an Indian company if the
company is not engaged III agriculture or plantation and real estate. Non-repatriable
il1\ estment could also nO\\ into proprietary/partnership concerns engaged in industrial,
trading and commercial activities (SIA I\ewsletter 2001).
The Indian government became quite liberal regarding dividend repatriation abroad.
There vvas no bar if taxes \I ere paid, lIowever. in a limited number of consumer goods, such
outtlow had to be balanced vvith export earnings for a period of seven years. Disinvestments
100 could be made subject to a few RBI fonnalities. Foreign Direct Investment proposals
under the policy arc approved under two routes, viz .. automatic route and foreign investment
promotion board (FI PB) roule, Apart from this. the foreign investment implementation
authonty (FII.A.). foreign IIlvestmenl promotion council (FIPe) and the secretariat of
111dustrial assistancr: (SIA) also helped to facilitate the promotion of FDI in India.
4.2.1. Automat;c ROlltt'
The Reserv'e Bank of India appro\'l:s proposals under this route. A ceiling of equity
participation up to SO per cent in three sectors (i.e, private sector banking,
telecommulllcation and coal and lignite). up to 5 I per cent in twenty-one sectors (i.e.,
petroleum, housing and real estate, trading, cable network, hotel and tourism etc.) and up to
74 per cent in mne sectors (i,e, atomic energy, mining, establishment and operation of
satellite, advertisement and film, drugs and pharmaceuticals, power, broadcasting, township
development and postal services) has been imposed. Existing companies can also enhance
70
PolIcy measures and Trends in FDI
equity up to these prescribed limits. However, non-resident Indians (NRls) and the overseas
corporate bodies predominantly owned by them are allowed 100 per ccnt equity. Foreign
technology agreements are also approved by the RBI subject to the condition that the lump-
sum paymcnt of fee does knot excecd Rs 10 million and the royalty payment is not more
than 8 per cent on exports. The ceiling on lump-sum fee has recently been raised from Rs 10
million to US$ 2 million and a provision for payment of royalty of 5 per cent on domestic
sales has also been made.
4.2.2. FIPB Rowe
Foreign ill\estment promotion board (FIPB) acts as the nodal single-window agency in
matters to FDI approvals. All proposals, which do not fulfil the parameters
prescribed for automatic approval. are considered by FIPB. The board is supposed to ensure
the expeditious clearance of proposals for foreign investment, review implementation of
sectoral policy regimes. undertake promotional activities and interact with industry
associations and organizations. The Industry Minister approves proposals involving
imestment of up to Rs 6,000 million. Other proposals are subject to approval by the Cabinet
Committee on Foreign Investment. Proposals are examined on the basis of investment
prOJections. technology, export potential or opportunity for import-substitution, foreign
exchange balance sheet and employment potential Guidelines for scrutiny on FDI proposals
ha\ e been notified recently.
4.L? Role of FilA
The Government has set up the Foreign Investment Implementation Authority (FIlA) in the
Ministry of Commerce & Industry. The FIlA will facilitate quick translation of Foreign
Director Investment (FDI) approvals into implementations. provide a pro-active one stop
after care service to foreign investors by helping them to obtain necessary approvals, sort out
operational problems and meet with various Government Agencies to find solutions to
problems and maximizing opportunities through a partnership approach.
The FilA takes steps to:
understand and address concerns of investors;
71
PolIcy measures and Trends m FDl

understand and address concerns of approving authorities;
initiate multi agency consultations; and
refer matters not resolved at the FIlA level to high levels on a quarterly basis,
including cases of projects slippage on account of implementation
bottlenecks.
Functions of FIlA:
The functions of FIlA shall be as under:
expediting various approvals/permissions;
fostering partnership between investors and government agencies concerned;
resolve difference in perceptions;
enhance overall credibility;
review policy framework; and
liaise with the Ministry of External Affairs for keeping India's diplomatic
missions abroad infornled about translation of FDI approvals into actual
investment and implementation.
The modalities of functioning of FIlA
The FilA shall set up a Fast Track Committee (FTC) to review and monitor mega
proj ects. It wi II nominate members of the FTC from representatives of various
Ministries/agencies/State Government at the working level. The representative
shall act as the project coordinator and shall head the FTC. The FTC shall
prescribe the time frame within which various approvals/permissions are to be
given on a project-to-project basis. FTC shall also flag issues that need to be
resolved by FilA. Based on the inputs provided by FTC, the FilA will give its
recommendations on each project on the basis of which Administrative
Ministries/State Government shall take action under their own laws and
regulations.
The FIlA will IIlltlate inter Ministerial consultations and make appropriate
recommendations to the competent authority, i.e. M inistryiDepartment concerned
at the Central Government level and the State Government, as the case may be,
on issues requiring policy intervention.
The FilA will act as a single point interface between the investor and
Government agencies including Administrative Ministries, State Governments,
Pollution Control Board, Director General of Foreign Trade (DGFT), Regulatory
Authorities, Tax Authorities, and Company Law Board.
72
The FIlA shall meet once every month to review cases involving investment of
Rs. 100 crore or more, consider references received from the FTC and monitor
the functioning of various FTCs. It would also entertain any complaint regarding
implementation bottlenecks from FDI approval holders regardless of the quantum
of investment.
The FlIA shall also make recommendations from time to time on any issue
relating to the speedy implementation of FDI projects and also to provide
transparency in government functioning with respect to FDI projects.
4.2.4. Role of FIPC
Apart from making the policy framework investor-friendly and transparent, promotional
measures are also taken to attract Foreign Direct Investment into the country. The
Government has constituted a Foreign Investment Promotion Council (FIPC) in the Ministry
of Industry. This comprises professionals from Industry and Commerce. It has been set up to
ha\'e a more target-oriented approach toward Foreign Direct Investment promotion. The
basic function of the Council is to identify specific sectors/projects within the country that
require Foreign DIrect h1\'estment and target specific regions/countries of the world for its
mobil ization .
. 1.2.5. Role of SIA
The SIA has been set up by the Go\'emment of India in the Department of Industrial Policy
and Promotion in the Ministry of Commerce & Industry to pro\'ide a single window for
entrepreneurial assistance, investor facilitation, recei\'ing and processing all applications
which require GO\crnment approval, conveying Government decisions on applications filed,
assisting entrcpreneurs and investors in setting up projects, (including liaison with other
organizations and State Govcrnments) and in monitoring implementation of projects. It also
notifies all Government Policy relating to investment and technology and collects and
publishes monthly production data for 213 select industry groups. As an investor friendly
agency, it provides information and assistance to Indian and foreign companies in setting up
industry and making investments. It guides prospective entrepreneurs and disseminates
information and data on a regular basis through its two monthly newsletters the "SIA
Newsletter" and the "SIA Statistics" as also through its Website address. It also assists
potential investors in finding joint venture partners and provides complete infol1nation on
73
Polley measures and Trends in FDI
relevant policies and procedures, including those, which are specific to sectors and the State
Governments.
4.2.5.1. Elltreprenellriai Assistance Vnit (EAV) of tire SIA
The Entrepreneurial Assistance Unit functioning under the Secretariat for Industrial
Assistance, Department of Industrial Policy and Promotion provides assistance to
entrepreneurs on various subjects concerning investment decisions. The unit also attends to
enquiries from entrepreneurs relating to a wide range of subjects concerning investment
decisions. It furnishes clarifications and arranges meetings with nodal officers in concerned
Ministries/Organizations. The Unit also provides information regarding the current status of
applications filled for various industrial &pprovals.
4.2.5.2. IIII'estmellt Promotion and Infrastructure Development (IP & ID) Cell
In order to give further impetus to facilitation and monitoring of investment, as well as for
better coordination of infrastructural requirements for industry, a new cell called the
"lnV'estment Promotion and Infrastructure Development Cell" has been created. The
functions of the Cell include:-
dissemination of information about investment climate in India;
investment facilitation;
deV'eloping and distributing multimedia presentation material and other
pub lic ations;
organizing Symposiums, Seminars, etc. on investment promotion;
liaison with State Governments regarding investment promotion;
documentation of single window systems followed by various States;
match-making service for investment promotion;
coordination of progress of infrastructure sectors approved for
investment/technology transfer, power, telecom, ports, roads, etc.;
facilitating Industrial Model Town Projects, and Industrial Parks, etc.;
promotion of Private Investment including Foreign Investment in the
infrastructure sector;
compilation of sectoral policies, strategies and guidelines of infrastructure
sectors, both in India and abroad; and
facilitating preparation of a perspective plan on infrastructure requirements
for industry.
74
4.2.5.3. Project MOllitorillg Willg
Project Monitoring Wing, created within the IP & ID Cell in June 1998 is functioning under
Foreign Il1\cstment Implementation Authority section with effect from 27.7.2001. The
functions of the Project Monitoring Wing are as follows:
Coordination with Central and State level Ministries/Departments concerned
and related agencies for tracking and monitoring approved projects and
compilation and analyses such information;
Direct contact, wherever necessary, with entrepreneurs and updation of the
information on projects and provision of necessary assistance.
4.2.6. jor FDI
The package of II1centl\ es offered to foreign investors includes sector specific tax rebates
and concesslonal Import duties. Export earnings are tax free in India and infrastructure
sectors have been accorded high priority. A five-year tax holiday is admissible for
ll1\estment in the power sector. It is proposed to raise it to ten years in any block or fifteen
years for mega projects of I 000 \\. and abovc. Concessional import duty of 20 per cent on
equipment and 16 per ccnt return un equity are also guaranteed. Further, import duty on
capital equipment for mega projects have been waived. In 1995, a five-year tax holiday was
given for investment 111 hlgl1\\ ays, bridges. airports and rapid transportation system under
Build, Operate and Transfi:r (BOT) schemes. The road sector is exempted from payment of
customs duty on equipment for load construction. Some incentives have also been offered
by state governments. which II1clude land, water and power at concessional rates and sales
tax concessions and cash subsidies.
To sum up. It c<ln he said that there have been a gradual, sincere and sustained
efforts on the part of the policy makers to give a boost to the FDI inflows into India in the
post-Iiberali/<ltlon p.:noo. HO\\cn:r. the effects of these efforts need to be analyzed before
making any conclusi\c remark. Thus, the study tries to analyze the impacts of these FDI
policics. by looking into somc stylized facts of FDI inflows into India in the post-
liberalizatIOn perIllO.
75
Policy measures and Trends lfl FDI
4.3. The Impact of New Policies and Some Stylized Facts about FDI Inflows in India
In order to understand the impact of macroeconomic stabilization policy. structural
adjustment programme and the changes in the foreign investment policy on the FDI inflows.
quantitative infornlation is needed on broad dimensions of FDI and its distribution across
sectors and regions. However, there is a considerable amount of ambiguity on the
quantitative data on FDI in India (Srivastava 2003, Nagaraj 2003). The secondary sources.
which publish the FDI data in India (namely, the Reserve Bank of India. (RBI). the
Department of Industrial Policy and Promotion, DIPP and the Secretariat of Industrial
Assistance,( SIA), consider the equity capital as FDI, though the IMF guideline prescribes to
include reinvestments and venture capital in the FDI flows. In view of this, the government
of India redefined the FDI inflows into !ndia in 2002. Accordingly, the new definition of
FDI inflows into India include reinvestments and venture capital along with equity capital.
However, the FDI data, in India according to the new definition. is available only after 2001.
In this situation, it is not possible to use the data for diagnostic checking as per the new
definition and hence the present study has used the FDI data as given by the earlier
definition of the Reserve Bank of India (RBI). There is also inconsistency in the data given
by different sources (Table 4.2). Table 4.2 shows the alternative estimate by Economic
Survey (ES), the Reserve Bank of India (RBI), the International Financial Statistics (IFS)
and the World Investment Report (WIR) of actual FDI inflows into India from 1991 to 2000.
The inconsistency in the data may be because of the discrepancy in defining the FDI data by
different agencies. The Economic Survey (ES) includes American Depositary Receipts
(ADRs) and the Global Depositary Receipts (GDRs) in the FDI inflows whereas the RBI
considers the ADR and GDR as the portfolio investment. Thus, the figures on FDI as given
by the Economic Survey overstate the FDI inflows. Therefore, the present study has
diagnosed the FDI data given by the RBI to assess the impact of the policy changes.
However, the assessment reported here remains a pre-requisite for the following chapters
rather than a straightjacket in itself. The impact of the new policy on the FDI inflows of
India can be explored under the following heads.
76
4.3.1. Growths ami Size of FDf
The growth of FDI inflow to India was not significant until 1991 due to the regulatory
policy framework. However, under the new policy regime, it has expected to get momentum
and assume a much larger role in catalyzing Indian economIc development. It can be
observed from Table 4.2 and Table 4.3 that there has been a steady build up in the actual
FDI Inflows and it has also grown significantly, in the post-policy period.
Actual FDI
inflows have
steadily
increased
I,(}OU
~ 10000
S RO(K)
~ 6000
-
25 4000
Figure 4.1: FDI Inflows from 1980-01
from 1991 to
2001. though
.... ,000
o ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ - - ~ ~ ~ ~ ~
it \\as very
minimal
dunng 1980-
91 (Figure 4.1 ).
However, it reached the
maximum in 1998 to the
tune of 10,895.85 crores
of rupees and then
started fluctuating in the
later periods. The FDI
inflows as a percentage
of GDP and as
percentage of total
~
C'
,
I
;c
r,
X
C' C'
-
... 60
u
'C
C
..
Do
C
(!)
<{
u
'0
;t.
'"
"
2i
50
40
30
20
10
u.. 0
-.
X
C'
-
, ,',-

"T ~ .0 ~
X ox> 00 ox>
C' C'
'"
C'
- - - -
ox> 0-
00 oc
'"
c-
c:
"
-.
g:
c- c-
C' C' C'
-
-
- - -
-
Year
I--+- FOI(Rs.C'r) I
'"
~ .
O' 0-
~ ~
Figure 4.2: FOI as % of CA, GOP and CF
capital fonnation (CF)
L
. - . ~
'II FDI as % of CA OFDI as % o ~ GOP OFOlas % of ~ F J . J
also followed the same
pattern and both of them were at their peak during 1997-98 (Table 4.3, Figure 4.2).
77
Policy measures and Trends m FO[
It shows that FDl as a percentage of GOP was merely 0.03 during 1991 but it reached to
1.11 percentage during 1997. On the other hand, the partial liberalization of the capital
account of the balance of payment seemed to be more effective. This is evidenced from the
ratio of FOI as a percentage to the capital account. Though the ratio was more volatile, it
was as high as 50.30 per cent during 1996 and 29.56 per cent during 1998 (Table 4.3, Figure
4.2). A slow-down after 1998 could be attributed to many factors, such as the US sanctions
imposed in the afternlath of the nuclear tests, the East Asian melt-down and the perceived
swadeshi image of the central government. However, the pace of FOI inflows to India has
definitely been slower than some of the smaller developing countries like Indonesia,
Thailand, Malaysia and Vietnam (World Bank 2002). Jardine and Fleming had earlier
estimated that FDl was likely to touch Rs 45,000 crores by 2000, but it turned out to be Rs.
9338 crores and it could not be achieved as indicated by the slow annual growth rate of the
actual FDl inflows (Table 4.3).
The impact ofnew policy on the magnitude of the FDl inf10w can be analyzed from
a comparative analysis of approvals and of the actual inflows. The total approval investment
was around Rs. 127 crores for the whole decade of 1980s as compared to Rs. 413 crores for
just last six months of 1991 (GOI 1992). It is important to note that India failed to convert
the approved FOI into actual FD!. In 1991, the amount of approved investment was small.
So, it was easy for actual inflow to account for 65.79 per cent of the approved amount. But
with fast growth in
approvals, the actual
inflow failed to keep
pace with the
approved investment
(Table 4.4, Figure
4.3). The percentage
lagged far behind.
The ratio of actual
inflow to approved
80000
e 70000
l 60000
1/1 50000
i ! 40000
.: .: 30000
20000
Figure 4.3: Approved and Actual FDllnflows
from 1991 to 2001
._------_ ...
l
1991 1992 1993 1994 1995 1996 1997 199B 1999 2000 2001
Year
FDI CAclual
amollnt was as low as 17.36 per cent during 1992. The foreign investors have rated India as
the country of their choice in the wake of liberalization.
78
However, the
. .
lOcreaslOg
trend of total approved investments
started decreasing from 1998 as
there was political instability in the
country along with other factors
such as sanctions due to nuclear
test and financial crisis in south-
east Asia (Indian Investment
Centre, 1999). However, it
Figure 4.4: Route-wise FDt Stock from 1991
to 2001
~
JJ'"
l o ~ ; ~ 11"61 DfIPO I
improved to over one-fifth in the following years and was as large as 43.29 per cent and then
it got the momentum afterwards. The realized FDI to the approved FDI reached a new
height in 200 I at 71.68 per cent. This upward movement in the ratio of actual flow in recent
years is a redeeming feature of the FDI flows in India.
Appro\'al does not imply that the follow-up action is immediate. Many formalities
are required after a collaboration agreement is approved. The procedural formalities are not
so cumbersome in the automatic approval through FIPB route. In case of approvals through
the FIPB route, the files move through different ministries and departments that often work
at cross-purposes with each other (Joshi and D'souza 1999). Red-tapism exists at every step,
This is perhaps the reason that the ratio of actual lOflow to the approved amount is much
lower in the case of approvals through FIPB. Since the FIPB approvals account for a lion's
share of the total approved amount (Figure 4.4), the ratio of actual inflow on the whole is
very low (Gupta 1998). However, with the establishment and smooth functioning of Foreign
Investment Implementation Authority (FIlA), this problem was curtailed to a large extent as
seen in the improvement in the ratio of actual to approved FDI during 1999 to 2001. Again,
lack of sufficient infrastructural facilities sometimes comes in the way of implementation of
a project. In the absence of sufficient infrastructural support, the implementation of a project
may be delayed considerably or in some cases, it may even be denied. This has actually
happened in case of the proj ects under foreign collaboration. Moreover, in a federal
structure of administration, the state govemments have to co-operate with the coming up of
the project. But in many cases, it is found that the required response from the state
govemments have been absent (Bhattacharya 1994).
79
4.3.2. Type of FDI II/floll's
In the period of reform,
the number of total
collaborations
agreements has
increased. However, the
growth rate of these
agreements is not very
high (Table 4.5). In 2000,
the number of total
2000
HIOD
!
1600
i 1400
Ie 1200
Fe 1000
eoo
600
<00
200
0
PolIcy measures and Trends In FDI
Figure 4.5: TC and FC from 1991 to 2000
-- ~ --- - - - ------ -- -- .- - ------ "-
_.
.- ---- ----
I
-II
;
i
..... i
.....
---
,...
-.
1991
'9"
1993 1994 1995 1996 1997 1998 1999 :.!OOO
Year
I ~ T C -..._Fe I
financial collaborations was 1,726 as against 418 total number of technical collaboration.
The Table shows that financial collaborations have gradually outnumbered the purely
technical collaborations (Figure 4.5). This indicates that foreigners are more interested in
iinancial collaborations than technical collaborations and this tendency Can be attributed to
the relaxation of the investment nomlS for financial collaborations.
4.3.3. Sources of FDI
An analysis of the origin of FDI inflows into India shows that the new policy has broadened
the source of FDI into India. There were 86 countries in 2000 as compared to 29 countries in
1991, whose FDI was approved by the Indian Govemment.
Thus, the number of countries
investing In India increased
during the period of refoml.
Nevertheless, still a lion's share
of FDI comes from only a few
countries. Figure 4.6 shows the
actual investment flows of top
ten countries (and the respective
growth rates) during the period
Figure 4.6: Country-wise break up of FDI
Stock from 1991 to 2000
80
Policy measures and Trends in FDl
January 1991 to December 2000. The FDI inflow from Mauritius is the largest (39%) even
though the US alone continues to account for nearly a quarter (24%) of the total FDI
inflows. The other five countries, viz., UK, Japan, Germany, South Korea and Australia
collectively shared 28 per cent of the total actual FDI inflows to India. It implies that only
seven countries accounted for well over 90 per cent of the FDI inflows during the above
period (Figure 4.6).
Nevertheless, the geographic concentration of FDI inflows in the post-liberalization
period is lower than in the pre-liberalization period. In 1990, only six countries, viz., the
US, the UK, Gemlany, Japan, Italy and France were responsible for over two-thirds of the
total FDI inflows into India. The country-wise annual growth rate of the FDI inflows shows
that Mauritius, which was not in the p:cture till 1992, has the highest growth rate. As
mentioned earlier, Mauritius alone accounts for around two-fifth of FDI inflows into India in
the post liberalization era. A lion's share of such investment is represented by the holding
companies of Mauritius set up by the US firms. It means that the investment flowing from
the tax havens is mainly the investment of the multinational corporations headquartered in
other countries. Now, an important question arises as to why the US companies have routed
their investment through Mauritius. It is because, firstly, the US companies have positioned
their funds in Mauritius, which they would like to invest elsewhere. Secondly, it is due to the
different tax treaty for different countries to invest in India. For example, the tax treaty
between Mauritius and India stipulates a dividend tax of five per cent, while the treaty
between Indian and the US stipulated a dividend tax of 15 per cent (World Bank 1999).
This is precisely the reason why FDI inflow from Mauritius has been high; on the other
hand, the growth rate of the FDI inflows of the other major countries is declining.
A careful analysis reveals the fact that during the liberal regime beginning from
August 1991, developing countries, such as Mauritius, South Korea, Malaysia, Cayman
Islands and many others made their appearance on the 1 ist of major investors (SIA
Newsletter 1998). The developing countries investing sizably in India can be grouped
broadly in to two sets. The first set is represented by those developing countries that have
developed their industrial base with the help of technology imported from the industrialized
world and are now in a position to import technology and capital to the Indian enterprises.
81
Singapore, South Korea, and Malaysia are some examples. On the other hand, the second
set of developing countries are those that have not so far developed their industrial base (0
that extent, rather they are tax-haven countries, such as Mauritius and Cayman Islands.
Since the tax rates in these countries are very low, the multinational corporations
headquartered in other countries - developed as well as developing - are found diverting
their receipt of funds on different accounts to these tax haven countries. In other words,
these countries playas a host for cash positioning of the multinational companies. This way
they possess huge investable surplus, a part of which has found its way into India.
43,4, Sector-wise FDI Patrem
All analysis of
sector-wise FDI
stock over the
post -I iberal ization
period shows that
transport,
electrical, servIce,
Figure 4.7: Sector-wise break-up of FDI Stock
1991 to 2000
12%
.Elect riC 011 equipment
oChemlcals(other than fetilisers) .Faoel proceSSing lndustr Ie'>
.ltldustrli!1 Machinery
aT elee ornm unl( at Ions
DDrugsand pharmaceuticals
D5ervlce
;1""
17%
OTr a nsportat Ion Indust ry
DMeta11tJrgic ill
.Textlles
telecommunication, chemicals, and fuel and power sector attracted more FDI and accounted
far more than 50 per cent of the total FDI stock during this period (Figure 4.7). Among
these core sectors, transportation sector accounted for 19 per cent followed by electrical
equipment and telecommunication sector with 17 per cent and 14 per cent respectively,
chemicals (other than fertilizers) sector with 12 per cent of total FDL It is important to note
that though food-processing sector attracted less FDI inflows, it recorded a significant share
In attracting total FDI inflows. However, the growth rate of the FDI inflows to different
sectors is not so much encouraging barring the telecommunication sector (Table 4.7). This
82
Policy measures and Trends in FOr
growing importance of the food-processing sector can be attributed to the agrarian nature of
thc Indian economy.
4.3.5. State-wise Distributioll of tire FDI Illflows Approved
It is imperative to note that data on state-wise actual FDI flows is not available. So. the
study tries to find out the spatial dimensions of FDI flows into India by looking into the
approval of FOr in each state. Details of the distribution of FDI approvals from 1991 to
2000. among all the states are given in Table 8. The state-wise approvals in value terms up
to 2001 indicate high concentration in Maharastra (17.13 per cent). Delhi (12.22 per cent),
Kamataka (7.82 per cent), Tamil :--.'adu (8.37 per cent). Gujurat (6.33 per cent) and Orissa
(3.09 per cent). which together accounted for more than 50 per cent of approval during
19912000 (SIA Newsletter 2001). This concentration of FDI in some specific states is
because of a host of reasons like the political scenario of the state and the centre and the
basic infrastructure facilities available in the state.
4.4. Evaluation of India's FDI Policy Measures
The liberal policy measures towards FDI designed in the wake of structural adjustment and
macroeconomic refomls in India since mid1991 have helped attract foreign investors
significantly. The amount of approved investment has grown enormously. Though the actual
inflow of FDI has not picked up so fast, it has improved and significantly strengthened the
capital account of the balance of payments of the country. Nevertheless, India is still on a
lowcr ladder among some major FDI receiving countries of Asia.
The new policy has attracted investors from di fferent comers of the globe -
developed and devcloping. Nevertheless, only six or seven countries claim well over one-
half of the total FDI flows. \1oreovcr, it is evident that the foreign investors are interested
more in investment than in merely supplying technology. This is why the financial
collaborations have outnumbered the purely technical collaborations.
The Sectoral pattern has come to be greatly broad-based. The traditional recipients
have figured large in the approvals as well as in tenns of actual inflow of FDI. Yet with the
opening up of new areas for foreign investors, a huge amollnt of approval and actual inflow
83
Policy measure:.. a l h ~
is also found in non-traditional areas, such as fuel and power, ser.lces and ,UI1:c c< "l"dIIC:i"
goods.
Though the automatic approval route was Introduced for speedlcr clearancc of FDI
proposals, its reach and role have been marginal. The policy lacked thrust on attractIng
investment in sectors that offered comparative cost advantage. Well-dc\'cloped and
strategically located platforms in the form of Export Processing Zones (EPZs) or technology
parks have not been provided for mobilizing investment into these sectors. The thrust was
not on export orientation due to conservative sector-specific policies. Rigid labour laws had
been other serious impediments to FDI inflows. Besides, there was lack of transparency and
clarity about micro-level procedure at the state level.
Approvals under automatic route accounted for only 10 per cent of FDI appro\als in
value terms during 1991-2000. They covered a limited number of sectors of the economy
comprising mainly of heavy manufacturing sectors, which were considered crucial for
transfer of technology. Sectors with inherent comparative cost advantage are not included
in the list. A Majority of approvals outside the automatic route have granted on a case-by-
casc basis, thereby strengthening an impression that the approval mechanism \\as
discretionary. There were unwarranted delays in some cases due to the indecisiveness and
alleged political interference in the decision-making process. Though guidelines about the
approval procedure under FIPS route have been issued, it has not yet so well
institutionalized as to provide investor-certainty and clarity of policy.
It is time to realize that increasing global inter-dependence is leading to quick shifts
in the comparative advantage. East Asian economies are graduating from first stage labour-
intensive export-orientation to the second stage skill-intensive export-orientation.
International subcontracting for labour-intensive export sectors can playa major role in
promoting export growth in segments, which are competitivc for India. Flexible policies
should be formulated for encouraging international sub-contracting in view of the diversified
nature of India's economy and availability of a wide variety of skills at low cost (Sebastian
1994). However, sector- specific policies presently do not favour such an arrangement. An
illustration is the garments sector. As this sector is reser.ed for the small scale, joint
84
Poilcy measures and Trends In I'D I
ventures can be set up only if they undertake export obligation for 75 per cent of production.
The existing policy thus inhibits the flow of domestic and foreign investment in the
garments export sector. It is desirable to lower the export obligation norms for sectors that
offer comparative cost advantage to makc the policy more acceptable (Somnath and Mohan
1993 ).
FDI in India is confined to heavy, complex and technology-intensive industries,
labour-intensive electronics/ electrical, and textile and clothing industries have been the
thrust sectors in East Asian economies and China. These sectors have high expOrt-
orientation and their potential for employment generation is enormous. The East Asian
cxperience suggests that the development of a dynamic manufacturing export sector helps in
sustaining industrialization. Exports have emerged as a strategic instrument for economic
and social dcvelopment and need not be treated as a residual activity. There is an imperative
need to fine-tune FDI policies and incentives for raising export-orientation of foreign
investment. Giving MNCs a fair share of domestic market in these sectors can be a
significant step in this direction.
FDI has mainly been lured by the size of domestic market. To counter the pull of the
domestic market, FDI policies need to provide attractive incentives for export-oriented
industries. Besides, for attracting investment into these sectors, enclaves with developed
infrastructure need to be set up at strategic locations. Labour-intensive industries are
avoided in India due to inflexible labour laws. Since these laws provide excessive job
security, capital-extensive technology is preferred to labour-intensive industries. The
labour regimes for designated areas should be make flexible. Regulatory regimes at the state
level continue to be extremely cumbersome. Investors perceive public administration as
inefficient. A World Bank discussion paper has slimmed up that:
While fetters on industrial investment and promotion have been sharply reduced at
the central government level, they are still pervasive in many states. The requirements for
licenses, permits and inspections at the state level continue to be onerous and entrepreneurs
continue facing di fficulties in procuring land, water and electricity connections.
85
Approval procedures at the state level are inefficient and need to be refornled on
priority. An attitudinal change in the state bureaucracy is necessary for expediting the
decision-making processes. Rapid policy changes are not percolating down fast enough to
the functional level. Implementation of policy has been tardy on account of tedious
procedures and corruption. It has becn aptly observed that the statute books in India are one
of the heaviest in the world. but the level of implementation is the lowest.
4.5. Conclusion
To sum up, it can be said that the Indian Government has created a healthy atmosphere for
FDI inflow by introducing Structural adjustment and Stabilization policy. It is now a
member of the Multilateral Investment Guarantee Agency (MIGA), which has infused
confidence among foreign investors against dispossession of assets. What is important is that
despite change in government in the country, economic refornl process has never been
neglected. The present Government is also moving in the same direction and it has
welcomed foreign investment in sectors of national interest, such as infrastructure, core
industries and export-promoting sector as well as in the case of some consumer-good
industries if it requires improved technology. It has become clear that the intentions of the
government arc no longer in question, though its ability is in doubt and again, where policies
are not in question. the implementation is questionable. In order to give a boost to the FDI
inflows, it has become quite essential to trace out the deternlinants of FDI inflows into India,
which are explained in the next chapter.
86
Policy measures and Trends III FDI
Table 4.1: Sectoral Distribution of the Stock of FDI in India from 1948 to 1990
(Rs In Crores)
Sectors Mid-1948
March-I 964 March-974 March-I 980 March-1990
(Value %)
(Value %) (Value %) (Value %) (Value %)
Plantation 64 105.9 107.2 38.5
256
(25) (11.7) ( 11.7) (4.1 ) (9.5)
Mining 35.84
4.7 6.4 7.8 8
(IS)
(0.9) (0.8) (0.8) (03 )
Petroleum 23.04
143.3 137.9 36.8 3
(9.0) (14.7) (14.7) (3.9) (0.1 )
Manufacturi 51.2
229.3 628.6 811.6 2,298
ng (20.0)
(40.5 ) (68.4) (86.9) (84.9)
Services 81.92 82.3 39.8 38.5 140
(31.0) (14.6 ) (4.4) (4.1 ) (5.2)
Total 256 565.5 916 933.2 2.705
( 100.0)
(1000) ( 100.0) (100.0) ( 100.0)
Source: Kumar 1995
Note: Figures in parenthesis show the percentages.
Table 4.2: Alternative Estimates of the Actual FDI, 1991-2000
Year ES (Rs. CL) RBI (Rs. Cr.) IFS ($ Mil.) WIR ($ Mil.)
1991 351 316 155
1992 675 965 276.5 261
1993 1,787 1,836 550.1 586
1994 3,289 4,126 973.3 947
1995 6,820 7,172 2,143.6 2,144
1996 10,389 10,015 2,426.1 2,591
1997 16,425 13,220 3,577.3 3,613
1998 13,340 10,358 2,634.7 2,614
1999 16,868 9,338 2,168.6 2,154
2000 19,342 10,686 2,315.1 2,315
Source: Nagaraj, 2003
87
Table 4.3: Actual FDI Inflows from \990-9\ to 2000-0\
(Rs in Crores)
AGRof FDI as FDI as % FDI as
Year FDI
% ofCA ofGDP %ofCF
1991
51.23 1.85 0.03 0.14
1992 145.97 6.16 0.08 0.33
1993 151. 95 12.41 0.20 0.88
1994 101.68 9.78 0.38 1.58
1995 103.56 21.07 0.72 3.32
1996 29.57 50.30 0.87 3.58
1997 37.73 26.68 1.11 4.04
1998 0.84 29.03 1.07 4.49
1999 -4.94 29.57 0.96 3.84
2000 -9.85 19.41 0.81 3.38
2001 14.44 27.33 0.88 3.33
Source: Computed.
Table 4.4: Actual FDI as a % of Approved FDI
Actual FDI as %
Year of Approved FDI
1991 65.79731
1992 17.3678
1993 20.16755
1994 23.18486
1995 21.26493
1996 28.74168
1997 29.92335
1998 43.29219
1999 59.46371
2000 52.2193
2001 71.68497
Source: Computed.
88
PolIcy measures and Trends in FDI
Table 4.5: Types of Foreign Collaborations Approvals
Year TC AGR FC AGR Total AGR
1991 661 289 950
1992 828 0.253 692 1.394 1,520 0.600
1993 691 -0.165 785 0.134 1,476 -0.029
1994 792 0.146 1,062 0.353 1,854 0.256
1995 982 0.240 1,355 0.276 2,337 0.261
1996 744 -0.242 1,559 0.151 2,303 -0.015
1997 660 -0.1 13 1,665 0.068 2,325 0.010
1998 595 -0.098 l,l91 -0.285 1,786 -0.232
1999 498 -0.163 1,726 0.449 2,224 0.245
2000 418 -0.161 1,726 0.000 2,144 -0.036
2001 43 -0.897 146 -0.915 188 -0.912
Note: TC -Technical Collaborations, FC -Financial Collaborations
Tahle 4.6: Source Country-wise FDI Inflows and the Growth Rates
Year 1991 19<)2 1993 1994 1995 1996 1997
0.00 0.03 2.51 1.88 36.59 53.93 23.18
Australia (94.8 ) (-0.3) (\ 8.4) (0.5) (-0.6 )
6.98 61.31 41.11 139.64 265.61 493.95 622.59
Gernlany (7.8) (-0.4) (2.4) (0 9) (0.8) (0.3)
5.94 71.79 82.84 275.83 254.35 314.56 647.33
Japan (11.1 ) (0.2) (2.4) (-0.8 ) (0.2) (1.1 )
1.55 14.93 165.06 149.06 138.61 490.72 573.49
Netherlands (8.6) ( 10.1 ) (-0 I) (-0.1 ) (2.5) (02)
0.00 0.00 3.77 90.37 1835.34 2338.55 4112.22
Mauritius (23 ) (19.3) (0.3) (0.8)
South 0.00 8.38 6.59 33.58 58.40 166.09 1344.55
Korea ( -0. 2) (4.1 ) (0.7) ( 1.8) (7.1 )
50.63 87.25 247.90 497.06 250.48 189.10 363.73
UK (0.7) ( 1.8) ( 1.0) (-0.5) (-0.2) (0.9)
29.19 115.02 463.48 373.11 758.48 974.25 2893.36
USA (2.9) (3.0) (-0.2) ( 1.0) (0.3) (1.9)
6.46 26.72 32.32 29.18 269.48 100.66 122.95
France (3.1 ) (0.2) (-0.1 ) (8.2) (-0.6) (0.2)
0.00 0.00 0.63 9.41 23.57 12.58 56.17
Malaysia
(14.0) (1.5 ) (-0.5 ) (3.4)
Source: SIA Newsletters, varIOUS Issues, Government of India
Note: Figures in parenthesis indicate annual growth rates
(Rs In Crores)
1998 1999
63.72 90.02
( 1.8) (0.4)
674.16 205.27
(0. I) (-0.7)
839.40 658.00
(0.3) (-0.2 )
400.16 371.84
(-03 ) (-0.1)
3121.01 1957.48
(-0.2) (-0.3)
471.95 171.79
(-0.6 ) (-0.6)
237.46 410.11
(-0.3 ) (0.7)
1474.48 1875.29
(-0.5) (0.3)
170.77 271.81
(0.4) (0.6)
40.78 20.44
(-0.2 ) (-0.5 )
2000
36.00
(-0.6 )
362.78
(0.8)
740.99
(0.1 )
351.56
(-0.1 )
3402.47
(0.7)
82.75
(-0.5)
279.57
(-0.3)
1568.46
( -0.2)
328.19
(0.2)
49.09
(1.4 )
89
Policy measures and Trends m FDI
Table 4.7: Sector-wise FDI Inflows from 1991 to 2000
(Rs In Crores)
Sectors 1991 1992 1993 1994 1995 1996 1997 1998 1999
8.96 70.37 79.75 325.79 1085.34 9798 835.86
Fuels 2.60 (2AS) (6.85 ) (0.13) (3.09) (233) (-0.10) (-0.54) (085)
Ekctncal 125.98 21344 295.06 622.93 770.97 1271.85 908.6 531.52
Equipments 20.48 (5.15) (0.69) 0.38) ( 1 . 1 I ) (0.24) 0.65 ) (-0.29) (-042 )
115.72 7251 115.8
r
32
.
37 457.41 1795.21 1702.92 1141.82
6. II (17.94) (-0.37) (060) (2.73) (0.06) 292) (-0.05) (-0.33)
159.93 18853 1411.45 326.1 750.37 80786 1100.78 247.02
Chemicals 4642 (245) (0.18 ) (1.18) (-021 ) (130) (008 ) (0.36) (-0.78)
82.22 14131 199.61 285.17 832.29 342.09 94.75
14
44
.
06
Food Processin\.!. 2.12 (37.78) (0.72) 0.41 ) 0.43 ) ( 1.92) (-0.59) (0.72) 3.69)
27.14 16.37 40.52 110.93 58.88 15113 74.05 204.42
\letallurgical 0.33 (8124 ) (-0.40) 1.48 ) (174) (-047) (1.57) (-0.51 ) 176)
Industnal LU6 15.29 388-' 61.29 38.64 84.75 27.43 91.37
.\Iachmery 135 875) 0.16) 154) (0.58) -0.37) (1.19) (-0.68) 233)
Drugs and 9.6 155.3 31.71 176.92 172.03 118.55 103.98 220.32
Phannaceuticals 1133 ( -0.15) (15.IS) (-0.80) 458) (-003 ) (-031) (-0 12) (I. 12)
14.01 93.69 11271 161.42 175.98 109.54 38.31 119.37
trextiles 4.93 ( 1.84) (5.69) 0.20) 0.43 ) 009) (-0.38) (-0.65 ) (2.12)
1l.5 137
14239 1008.2 852.8 588 849.10 250
Service 4.80 ( 1.40) 1091 ) (209) \ 138) (-0.15) (-0.31) 0.44) (-071 )
I eleCOnmlUnICatl 0.72 2705 28991 658.56 1736.98 1149.23 18475
ons. 0.00 0.95 (-0.24) (3657) (972) ( 1.27) (1.64) -0.34) (-OS4 )
Source: SIA Newsletters. vanous Issues, Government of India
Note: Figures in parenthesis indicate annual growth rates, CGR- Compound
Growth Rate.
2000 CGR
392.83
(-0.53) 77.78
1363.7
(1.57) 43.60
864.78
(024) 67.04
14
97
.
54
(-1.01) 24.43
188.08
-0.58) 37.77
106.34
(-0.48) 59.44
217
-0.76) 30.06
73.6
(-067) 27.97
8.89
(-0.93) to.07
293.9
(0.18) 51.48
1126.9
(5.10) 146.97
90
Table 4.8: State-wise Break-up of Foreign Direct Investment & Foreign Technical
Collaboration Approved (from 1991 to 2000)
State-wise Break-up of Foreign Direct Investment & Foreign Technical Collaboration
(from 1991 to 2000)
i
(Rs. In Crores)
-- ----- - -
---
--
IState/Vts
I
- -
No. of Approvals
I
Amount of %age with
I
FDI: total FDI
Approved Approved
,
Total Technical Financial
-----
iAndhra Pradesh 883 224 659 124,701.31
4,
68
i
I Assam
--- --- ---- -
17 13 4 14,95 0
Bihar 46 22 24 7,395,28 0,28
I Gujarat 995 495 500 168,555.48 6,35
'---'--'-"---- ----
Haryana 731 280 451 31,947.46 1.2
Himachal Pradesh
93 55
-38[
3,630,9 0,14
Jammu & Kaslunir 5 3 2 84,1 0
-- -- - -
1,2451 --
-- - --
Karnataka 1,676 431 208,156.32 7,82
Kerala 225 60 165 14,360,83 0,54
----
,Madhya Pradesh 214 70 144 91,542,2 3.44
--- ---
Maharashtra 3,406 1,078 2,328 456,286,23 17,13
---
---
,Mampur 1 0 1 31.85 0
>-- -- ---
002J
Meghalaya 4 0 4 5296
1
Nagaland 2 1 1 36_8, 0
---
Orissa 135 49 86 82,289,14 3,09
__ 173 54 119 19,519,22' 0,73
Rajasthan 306 99 207 25,916,69 0,97
---- --- --
Tanul 1,888

1,374 222,804 8,37
f--- -
2:npura
2 I
6,8 0
i Uttar Pradesh 699 257 442 42,047,76 1.58
jWest Bengal 543 189 354 84,234.59
3,16
jChhatisgarh 42 29 13 6,166,94 0,23
11harkhand
ilr--47
24 1,438,15 0,05
1.:ittm11C hal
---
1,256.49 48 22 26
--
Andaman & Nicobar Islands 8 0 8 137,87, 0,01
,Arunachal Pradesh 2 0 2 110,6 0
Chandigarh 40 9 31 I
0,05

0,05
1
Nagar Haveli 69 46 23 1,256.49
+
1222
Deihl 1,550 173 1,377 325,502,98
---
Goa
157 56 101 8,635,52 0.32
--- -
0
jLahhadweep 1 0 I 5
Mizoram I 0 I 15,22 0
101 38 63 3,987,74 0,15
LDaman & Diu
39 14 25
552,2 0,02
-
(State Not Indicated)
5,645 2,501 3184 728,760,7 27,36
--
100
,India
19,858 6,830 13,028 2,663,356.41
---
Source: SIA Newsletters, various issues, Government of India
91
Chapter V
Determinants of FDI Inflows into the Indian Economy
5.0. Introduction
Global outward and inward FDI flows continued to be high in the 1990s despite the financial
crisis and di fficult economic scenario in most part of the world especially towards the
developing countries. In fact, in order to supplement their domestic investment. there is a
competition for morc FDI among these developing economies. India is yet to be a front-
runner in this crucial competition though it has been able to attract foreign firms to her land.
As a result. the FDI inflows into India have gone up especially in the post-refonn pcriod.
Indeed, the share of FOI inflows to India, as compared to the other developing economies, is
not significant. However. India is a competitor in the market for FOI inflows, with the other
developing economics. In this context. it is pertinent to assess the detem1ining forces of the
FOI inflows into India so as to take policy initiative to create a conducive atmosphere for
FOI. Thus. in the present chapter, the study tries to explore the host specific determinants I
of FDI inflows into India at the macro level, which are also known as the pull factors ofFOI
inflows.
5.1. Framework for the Empirical Estimation
The macroeconomic variables of the Indian economy are considered as the pull factors of
the FOI inflows into India at the national level. In this context, FDI is treated as an
aggregate entity. It implies that FOI inflows into India at the national level can be
considered as the function of the macroeconomic variables (i.e. GOP, growth rate of GOP,
export. trade balance. degree of openness of the economy and the domestic capital
fom1ation, inflation rate. interest rate and exchange rate) of the Indian economy. These
macroeconomic variables constitute the demand and cost determinants of the FOI inflows.
Thus. the function for the determination of FOI of the Indian economy at the macro level
can be written as:
FDII, = rp(Z, y,) ............... (S.I)
I These detennmanls are also tenned as the pull factors (at the macro level) of FDI inflows.
Determinants of FDI
where FDIIt is the FDI inflows into India at time period t, Zt is the vector of host specific
demand determinants of FDI; Y
t
is the vector of host specific cost determinants of FDI
inflows to India. Zt includes GDP, growth rate ofGDP, export, and trade balance, degree of
openness of the economy and the domestic capital formation. Y
t
includes inflation rate,
interest rate and cxchange rate. For the purpose of empirical estimation, the FDI equation
5.1 is specified as:
FDlJ, = a + /J,GDPFC, + /J,GRGDp, + /JJEX, + /J,TS, + /JiGPEN,
+ /J"CF, + /J,JVPJ, + /J,REER, + /JJR, + /JII,D + /JilT + E', ...... (5.2)
where subscript 't' denotes the time period. FDII, GDPFC, GRGDP, EX, TB, OPEN, CF,
WPI, REER and IR are the Gross domestic Product at Factor cost, annual growth rate of
GDP at factor cost (GDPFC), export, trade balance, degree of openness of the economy,
gross fixed domestic capital fom1ation, wholesale price index, real effective exchange rate
and interests rate respectively. T is the time trend and D is used as a dummy for
liberalization, i.e., D=O before liberalization of 1991 and D=1 after liberalization. Since the
data are of time series nature, the variable T is used to remove the trend component of the
dependent variable FDII. The error term 'e' in the above equation is assumed to satisfy all
the assumptions of the classical regression analysis. In the Ii terature of the determinants of
FDI inflows, there exist {/ priori relationship between FDI and the explanatory variable
(Chapter 2). The relation is such that cFDWc(GDPFC) > 0, oFDIIIo(GRGDP) > (Wang
and Swain 1995, Sianesi 1995, Aristotelous and Fountas 1996, Chen 1996, Jun and Singh
1996, Liu, Song Wei and Romilly 1997, Hasnat 1997), cFDIIIc(EX) > Lucas (1993) and
Jun and Singh (1996), 8FDlllc
'
(TB) > Kravis and Lipsey (1982) and Chen (1992),
cFDIlIc(CF) > 0, (UNCTAD 1993), cFDIIIc(WPI) > (Schneider and Frey 1985),
cFDIlIc(REER) > Aliber's (1970, 1971) cFDIIIc(IR) > 0, (Agarwal 1980, Lucas 1993).
93
5.2. Variables and Data Description
5.2.1. Explallatory Variables
Determinants of FDI
GDPFC: It is used as one of the explanatory variables to reflect the market size of India.
There are two variables, which could have been used for this purpose, i.e., gross national
product (GNP) and the gross domestic product (GDP). GNP refers to the tinal valuc of all
the goods and services produced plus the net factor income earned from abroad. The word
'gross' is used to indicate the valuation of the national product including depreciation. GDP
is an unduplicated total of monetary values of product generated in various kinds of
economic activities during a given period, i.e., one-year. It is called as the domestic product
because it is the value of final goods and services produced within the domestic country of a
nation. Hence, GDP=GNP-Net factor income from abroad.
The GOP can be at market price or factor cost. GOP at market price is the sum of
the market values of all the final goods and services produced in the domestic territory of a
country in a gi\en year. Similarly, GOP at factor cost is equal to the GDP at market prices
minus indirect taxes plus subsidies. It is called GOP at factor cost because it is the
summation of the income of the factors of production.
Further, GOP can be estimated with the help of either (a) Current Prices or (b)
Constant Prices. If domestic product is estimated on the basis of market prices, it is known
as GOP at current prices. On the other hand, if it is calculated on the basis of base year
prices pre\'ailing at some point of time, it is known as GDP at constant prices.
In a dynamiC economy, price level keeps fluctuating. In order to isolate the
fluctuation, the estimates of the domestic product at current prices need to be converted into
the domestic product at constant prices. Any increase in domestic product that takes place
on account of increase in prices cannot be called as the real increase in GOP. Real GOP is
estimated by con\'erting the GOP at current prices into GOP at constant prices, with a fixed
base ycar. In this context, a GOP deflator
2
is used to convert the GDP at current prices to
GOP at constant pnces. The present study uses GOP at factor cost (GDPFC) with constant
prices as one of the explanatory variable to the FOI inflows into India for the aggregate
analysis. The data as constant prices are used to net out the cffect of inflation and GOP at
factor cost is used, as it does not include net indirect taxes. Although data are available on
1 A GOP deflalor IS cakulateJ by multiplYlllg 100 to the ratio of GOP al currenl prices to real GOP.
94
Detenninants of FDI
all the measures of national income, GDPFC in constant prices is used in the analysis since
it is conventionally accepted as realistic indicator of the market size and the level of output.
The proponents of the market size hypothesis argue that higher the market size higher will
be the FDI inflows. In the same argument it can be argued that an economy with higher
GDPFC will attract more FDI. The relevant data have been collected from the 'Economic
Survcl", 2003, Govemment of India.
GRGDP: It refers to the growth rate of GDPFC as constant prices. This is one of the
explanatory variables to the FDI inflows into India because sometimes it is assumed that it is
the growth rate of a market, which attracts more FDI to a particular location rather than the
market size. In the present study, the annual growth rate (AGR)3 of GDPFC as constant
prices is used as one of the explanatory variables for the FDI inflows at the aggregate level.
EX: The data on export on value tenns are available in India from the Director General of
Foreign Trade (DGFT) and on Balance of Payment (BOP) basis from the Reserve Bank of
India (RBI). There is a considerable discrepancy on the data from these two sources. Thus,
it requires a judicious choice between export data based on BOP as given by RBI and the
export data based on trade account as given by OGFT. This choice depends on the kind of
study is being undertaken. The present study tries to explore the detemlinants of FDI
inflows into India at an aggregate level. The FDI inflows into India fonn a part of the
capital account of the BOP and thus, it is quite relevant to take the export data based on BOP
as one of the detemlinants ofFOI inflows into India at the aggregate level. Hence, the study
uses the export data given on the basis of BOP and the data are collected from the
'Economic SlIrvcl" (ES), 2002-2003, Government of India. In addition, data on export at
current prices are deflated by using the GOP deflator to get the export data at constant
prices. The GDP deflator is used because of the lack of proper export-related deflator.
J The AGR ofGDPFC in constant price is given by (GDPFC,- GDPFC'_I ) / GDPFC'_I
95
Detenninants of FDI
TB: Trade Balance is the balance of exports free-on-board (f.o.b.)4 and imports f.o.b. A
positive trade balance indicates that merchandise exports are larger than merchandise
imports while a negative trade balance reflects the reverse. There is also discrepancy on the
trade balance data given by RBI and DGFT. However, in the present context, the study uses
the data given the basis of BOP and the data are collected from the 'Economic Survey' (ES),
2002-2003, Government of India. In addition, the GDP deflator is used to deflate trade
balance data at cUlTent prices.
OPEN: This variable is used as the degree of openness of the economy. The degree of
openness of an economy is defined as the ratio of total trade to the real GDP of that
economy. In the present analysis, the degree of openness of the Indian economy is
calculated by dividing the total merchandise trade with the GDPFC. It means, OPEN=
(Export f.o.b.+ Import fo.b)/GDPFC.
CF: The variable CF represents the gross domestic capital fonnation (GDCF) of India.
This variable is uscd as a proxy for gross investment. The capital fonnation in durable
goods is called as the fixed capital fonnation and the capital fonnation in the non-durable
goods is accounted for the changes in the stock of inventories. Thus, GDCF is the sum of
gross fixed capital fonnation and change in the stocks in an accounting year. The change in
stocks take into account the change in the stock of raw materials and finished product held
by the producer, stock of food grains in the possession of the government and the livestock
raised for slaughter by the commercial households. The change in the stock is calculated by
comparing the stocks at the beginning of the accounting year with the stocks available at the
end of the same year. The balance amount is capital fonnation in the country. In the present
analysis, GDCF is being used for the year 1979-80 to 2000-01 from Economic Survey. It
includes the total capital stock added to the country by way of change on asserts through
construction, machinery and equipment and the change of stocks. For the analysis, the GDP
deflator is used to convert the GDCF at cUlTent prices into GDCF at constant prices.
4 f.o. b IS a term, which descnbes a pnce for valuation of a good, which is calculated on the baSIS of the process
of manufacturing and does not mclude the cost of transporting the good to the consumer.
96
Detenninants of FDI
WPI: In the present study, the wholesale price index (WPI) is used as an indicator of the
price level. The study uses the new series of WPI with 1993-94 as the base year. The base
year was choosen carefully by the working group as WPI is sensitive to the movements of
prices and weighting pattern. The new series of WPI has 435 items in its commodity basket
as against 447 items III the 1981-82 series. The number of price quotation has also
decreased from 2,3 71 III the earlicr series to 1,918 in the new series of 1993-94. The
relevant data have been collected from the 'Handbook of Statistics on Indian Economy',
2001, published by the RBI.
REER: Since the present study tries to explorc the dctem1inants of FDI inflows into India
and such FDI inflows vary with different source country, it is appropriate to take weighted
exchange rate index rather than bilateral exchange rates. So, the study uses real effective
exchange rate (REER) as one of the explanatory variables. The REER is a weighted average
of nominal effectiw exchange rates (NEER) adjusted by domestic to foreign inflation rates.
The NEER is defined as a weighted geometric average of the bilateral nominal exchange
rates of the home currency in tenns of the foreign currencies. The RBI gives the calculation
of the two rates i.e. REER and NEER
5
and the study uses REER given by the RBI as one of
the detenninants of FDI inflows into India. The relevant data are collected from the
'Handbook of Statistics on Indian Economy', 200 I, published by the RBI.
5 The calculation of these two indices (REER and I\EER), accordlllg to Reserve Bank of India (RBI)
procedure IS as follows:
" Ei PI
REER = (NEER) (ERP) = n[(-)(--,.)]'"
,0 I EJ PJ
"
ERP = n (P,. P
J
And
, I
x,
w, =- -,-,-
"
and L \\", = I
LX,
,,,,I
i=1
Where ERP IS the effective relative prices, E, = exchange rate of Indian rupee against a numeraire (SDRs) in index
form, E = exchange rate of coullIry J against the numeraire (SDRs) III index form, E,IE, = exchange rate of the rupee
agarnst j's currency in index form, P, = India's wholesale price index, P
J
= Consumer pnce index of country J,
w, - weIghts attached to currency of country J rn the index form, Xj = India's merchandise trade with country J, n =
number of countnes III the rndex other than IndIa.
97
Oetenninants of FDI
IR: Interest rate is one of the explanatory variables in the study. The study uses the call
money rate of the major commercial banks as the interest rate. The call money rate of India
is the weighted arithmetic average of the rate at which money is accepted and reported by
select scheduled commercial banks at Mumbai. The weights are being proportional to the
amounts accepted during the pcriod by the respective banks. The data on this call money
rate is collected from the 'Ham/hook of Sialislics 011 illdian Ecollomy', 2001, published by
RBI
5.2.2. Depelldelll J 'ariable
FDII: It is the foreign direct investment inflows that come to India via different routes (like
RBI, FIPB and SIA) and through different fonns (like financial collaboration and technical
collaboration). Though there is no consensus on the definition of FDI, the present study
uses the definition accepted by RBI on the guideline of the IMF with effect from March 31
1992. As per the guideline, 10 per cent ownership of ordinary share capital by an overseas
investor in any iJ1\cstment is treated as FOI in India. The present study uses this definition
of RBI The rele\ant data are collected from the Handbook of Statistics on Indian Economy,
published by RBI in 2001 and from the report of the Boston consulting group on the FDI in
India. However, the FDI inflow values are subject to the price fluctuation. In order to net
out the effect of the price fluctuations, GOP deflator is used to deflate the FDI data.
5,3, The Selection of Explanatory Variables
In the light of the existing theoretical and empirical literature, it is always imperative to have
the right combination of variables to explain the variation in the flows ofFDI into a specific
locatIOn. In order to have the best combination of the explanatory variables for the
detenninants of FOI inflows into India, different alternative combination of the variables
were estimated. The alternative combinations also include the famous specification given
by UNCT AD (1993 t The study also applies the simple Ordinary Least Square (OLS) step-
" The specIficatIon of the model as used by U\:CT AD IS:
FDl, = fl" + flIGNp" + fl/,CNP, + flP / GNP),_, + fl4
XR
, + fl,oP, + II,
Where. FDI,. IS the mflow of FDI m period '\', Gl':P,_, IS the level of GNP in year 't-1', "'GNP, is the change in
GNP between '\' and 't-1', (I/GNP),., IS the ratIo of domestic mvestment to G!\'P III year 't-\', XR, is the
98
Dctern1lnants of FDI
wise regression method to find out the explanatory variables of the FDI inflows at the macro
level. The regression has been carried out in two steps. In the first step. It takes Illto
consideration all variables in the estllnable model. In the second step. the inslgl1lficant
variables are dropped to avoid the problem of multi-co linearity and thus the variables arc
selected. However, alier a thorough analysis of the different combination of the explanatory
variables, the present study uses the following specification.
FDf!, = a + /J,GDPFC, + /J,WPJ, + /JJREER, + /JiR, + /J5EX + /JJ + e, ...... (5.3)
Where 'T' represents the time trend and all other variables are as explained earlIer.
5.4. The Selection of Functional Form
In order to avoid the mis-speci fication of the functional form, which may lead to spurious
result, the present study uses either linear or log-linear as the functional forn1. The
functional forms are as follows:
FDf!, = a + /J,GDPFC, + /J,WP!, + /JJRFFR, + /J,IR, + /J,EX + /JJ + e, ...... (5.4)
LFDf!, = a + /J,LGDPFC, + /J,LWP!, + /JJRFER, + /J,LIR, + /J,LEX + /JJ + e, ...... (5.5)
where the prefix 'L' in equation 5.5 means the logarithmic value of the series, u.s' and ~ s '
are the parameters of the models. In order to choose between the alternative functional
fonns as specified by equations 5.4 and 5.5, the study uses the Sargan's Criterion as given
by Godfrey and Wickens (1981). The Sargan's Criterion can be established as:
S = [RSS (L)/{RSS (LL)*GM (DV)}]" ............. (5.6)
exchange rate in year 't'. defined as the ratio of domestic currency to US dollar. OP, IS the degree of openness
of the domestic economy in year 't'. measured as the ratio of total trade to GNP and 'u,' IS the usual error term
that satisfies the assumptions of the OLS estimation.
99
Oetenninants of FOI
where, RSS (L) is the residual sum of squares from the linear eSlImatlOn, RSS (LL) is the
residual sum of squares from the log-linear estimation, GM (OV) is the Geometric Mean of
the dependent variable of the linear estimation and 'n' is the number of observations.
According to the Sargan's Criterion, if the calculated'S' value is ~ r e a t e r than one
(i.e., S> I), the log-linear functional fonn is preferred over the linear functional foml. On the
other hand, when the calculated'S' value is less than one (i.e., S<I), the linear functIOnal
fonn is supposed to be the appropriate functional fonn between the two.
5.5, Results and Discussions
The main thrust of this chapter is to find out the main detenninants of FOI inflows into India
at the macro level. The study period for this analysis was from 1979-80 to 2000-01. The
rationale for selecting the period is two-fold. Firstly, this is the period when India opened
her economy to the overseas investor partly in the mid eighties and mainly in 1991.
Secondly, the FOI inflow data of India is not available before 1979-80, though FOI stock
data at some point of time is available. In order to analyze the determinants, the study
identified the main macroeconomic variables such as GOPFC, WPI, IR, REER and EX and
the relation of these variables with FOI is specified in equation 5.3. In this context, it is
important to asscss the trcnd pattern of all the variables used in the detemlinant analysis.
The FOI inflows into India was very low before 1991 but shows a sharp increase after 1992,
though it has fluctuated a bit towards the late nineties (Figure I). This trend is con finned in
the least-squares growth trends (LGT)7 as it is 41 for the whole period, but 2.5 and 39.86 for
the two sub periods 1986-91 and 1992-01 respectively. However, the GOPFC has
maintained a steady trcnd over the study period (Figure 5.2 and Table 5.1). Thus, the
ample variation of FOI inflows could not be explained by GOPFC alone. In this context, a
close look on the variations of other detcnninants reveals that there is huge disparity in the
variation of IR, REER and EX as evidenced from the LGT (Table 5.1 and Figure 5.3
7 LGT is a commonly used growth indicator having the following advantages:
It takes mto account each of the observations under consIderation, unlike geometric growth rates,
which only consider the first and the last observation.
It measures the stability of observed growth.
Unlike the arithmetIC average of annual growth rates, it takes mto account the sequence of dIfferent
growth rates over time.
100
Detenninants of FDI
through Figure 5.5) during the study period, though the other determinant WPI has a quite
steady growth trend (Table 5.1 and Figure 5.6). In the light of this, the study tries to explain
the variation in FDI inflows into India due to the variation in the variables like GFPFC,
WPI, IR, REER and EX by using the Ordinary Least Square (OLS) method.
The Sargan's criterion shows that the'S' value is greater than one (Table 5.2).
Therefore, the study uses the log-linear functional fom1 of the FDI equation as was specified
in equation 5.4. The lise of the log-linear functional form would facilitate to interpret the
coefficients in elasticity. The results of the OLS regression are presented in Table 5.3. Since
the data in the analysis are of time series nature, it is expected to have autocorrelation in the
specified model. In order to take care of autocorrelation problem, all the estimation in the
analysis followed the Cochrane-Orcutt (C-O) The use of CoO Algorithm has
enabled to come out of the problem of alltocorrelation as the Durbin- Watson (0-W) statistic
is close to 2 (i.e. 2.18 in the present case). It is also important to note that the model shows a
good statistical fit as evidenced from the high adjusted R-square.
The regression results in Table 5.3 show that the important macroeconomIc
determinants of FDI inflows into India arc the GOP at factor cost, real effective exchange
On the negatl,e side, the LGT IS very sensitive to extreme values and thus, requires the exclusIOn of values
those are unrelated to the growth process.
In the presence of autocorrelation, the original series Y, is transformed using the following method:
Y,* = }; - pY,-,
Where.
Y, * Transfomled data
Y, Onglllal data at time period t.
Y,., Original data at time period t-l.
p Autocorrelation coefficient
(U, U,,)' I [ U/
After the data are transformed according to the above formula, a new equatIOn is estimated by the
OLS method and the new regression equation IS
FDfI," = a + fJ,GDPFC; + fJ,WPf; + fJJR; + fJ4REER; + fJsT + v:
Where.
FDII,' FDlI, - pFDIl,.,
GDPFC,' GDPFC, - pGDPFc,.,
WPI,' WPI, - pWPI,_,
IR,' IR, - pIR,.,
REER,' REER, - pREER"
T,me Trend and
U, P U,., is the new error term, which satisfies the OLS assumptions.
101
Detenninants of FDI
rate, interest rate and the wholesale price index. It can be observed from the result that GOP
and interest rate are the deterrent force while REER and WPI are the attracting forces for
FDI inflows into India. The elasticity coefficient between FDI inflow and IR is ~ 1 . 1 9 ,
which implies that one per cent increase in interest rate causes 1. 19-percentage decrease in
FDI inflows into India. This may be because of the reason that the overseas investors try to
extract fund Ii-om the local market and the foreign finns are purchasing the finn specific
assets in the Indian currency. In this situation, when the opportunity cost of domestic assets
is made high (as marked by hiking the interest rate), it becomes a hurdle for foreign finns to
raise more funds. In this case, the FDI inflows go down. Thus, the interest rate has a
negative impact on the flow of FDI. This is also the predicted relation between interest rate
and FDI inflows as interest rate is considered as the opportunity cost for any kind of
investment (Lucas 1993). GOP, which reflects the market size of the host country, is
assumed to have a significant positive influence on the FDI inflows. This proposition is
amply supported by the theoretical and cmpirical litcrature on the detenninants of FDI
(Dunning 1988, Lucas 1993 and Hasnat 1997). However, a remarkable result from the OLS
regression is observed that GOP of India is a significant negativc detem1inant of the FDI
inflows into India. The result shows that the elasticity coefficient between FDI and GOP is
~ 18. 96. This implies that a percentage increase in GOP causes nearly 19 percent reductions
in the FDI flows. This may be because of the reason that the FDI flows to India has mainly
been towards the manufacturing sector which constitute a mere 16 percentage of the total
GDP where as the major share of the GDP in India has been by the Agriculture and the
Service sector. Thus, when there is an increase in the GDP, it mainly reflects the increase in
the share of Agriculture and the Service sector, which do not constitute the destination of the
foreign finns. As a result, the total FDI flow goes down.
Further, the OLS result reveals that the real effective exchange rate does not portray
the predicted negative sign. It is argued in the literature that the depreciation of the host
currency against the home currency would attract more FDI inflows into the host country
and thus exchan"e rate is assumed to be a negative detenninant of the FDI inflows (Froot
, '"
and Stein 19(1). On the contrary, the result shows that the elasticity coefficient between
REER and FDI, inflows is, positive, (as against the predicted ncgative sign) and it is 5.41.
This positive impact of REER on the FDI inflows could be attributed to the reason that the
102
Detemlinants of FDI
appreciation of the Indian rupee against the 36 major trade partner countries" of India has
helped the foreign finns to acquire the finn specific assets foml these countries cheaply.
Thus, the foreign finns find it lucrative to invest in India because of two reasons. Firstly.
the appreciated Indian rupee will help them to reduce the cost of fiml specific assets (tIllS
can be done particularly in the case of Brownfield Investment I''). Secondly. the appreciatIOn
of rupee will ensure them higher profit in the long-run (as the value of the assets in
appreciated currency also appreciates).
The other important promotive force of the FDI innows into India IS \\'PI (Tahk
5.3). The positive sign of WPI is in accordance with the predicted sign The elasticit\
coefficient between WPI and FDI innows is 9.21. It shows that one per cent incrcase In
WPI causes 9.21-percentage increase in FDI inflows into India. It implies that the higher
price level of the Indian economy has heen able to attract more foreign fimls to her land.
This is because a higher price in most cases brings higher profit to the investors. Howc\cr.
there may be the apprehension that the increase in \\iPI mav be the result of Cost-Push
inflation I I. In this case, when the increase in WPI is cost driven. profit will come down. In
such a situation, higher price level may not attract more foreign fimls. But. in the literature
of FDI, it is always assumed that the foreign fimls are able to reduce the cost of production.
particularly in the developing economies like India. as foreign firlns bring hetter technology.
managerial skill and induce positive spill over effects (Lahiri and Ono 1998. Sahoo, ClU/.
2002). Thus, it is reasonable to argue that the higher profit to the im'estors due to an
increase in WPI has lured the overseas investors into Indian economy.
The relative importance of the detenninants of FDI can be judged from the absolute
valuc of the elasticity coefficients. It can be observed from Table 5.3 that between the two
positive detenninants, FDI innows into India are more elastic to WPI than to REER. It is
also observable that FDI innows arc more sensitive to GDP than the IR as the elasticity
coefficient between FDI and IR is least, whereas the elasticity coefficient between FDI and
GDP is the highest. This implies that the foreign fimlS are relatively more interested to use
" Because the study bas used REER whlcb IS calculated by the RBI by giving weights to Ihe 36 major trading
partners of India.
10 Brownfield Investments arc Ihe mergers and acquIsitIOns (takeovers) of the eXisting firms In a foreign
country. ThiS IS different from the Greenfield Investment. which IS baSically investment in new properly. planl
and equipment in a foreign country.
II For a detailed discussion, see, Branson 1994.
103
Oetenninants of FOI
their own funds rather than relying on the Indian capital market to raise the fund, though the
percentage change in FOI due to IR is more than hundred. This would ensure these fimls
more absolute profit rather than sharing it. In addition to this, the share of manufacturing
sector needs to be improved to attract more FOI.
In order to decide whether the structural specification of the model is reasonable and
whether the estimated coefficients make any real sense, the study uses the simulation
technique. In the simulation context, one of the best criteria to evaluate a simulation model is
to fit the endogenous variable by simulation. In other words, one would expect the results of a
historical simulation (i.e., a historical simulation through the estimation period) to match the
behaviour of the actual variable in the system. Hence, one way to test the perfonnance of the
model is to perfonn a historical simulation and examine how closely the endogenous variable
tracks its corresponding historical data series. In this context, there is a need for some
quantitative measure along with graphical analysis to examine how closely the simulated value
of an endogenous variable is explained by its actual data series. The quantitative measures that
are most often used are called Root Mean Square Error (RMSE) and Percentage Root Mean
Square Error (PRMSE). The RMSE and PRMSE for FOI can be defined as:
RMSE of LFDl
t
= Il "2JSLFDJ, _ LFDJ,)'
fT,=t
PRc'\1SE for LFDL = Il t( SLFDJ, - LFDJ, 'J'
Vr ,=1 l LFDJ,
where, SLFOI
t
is simulated value of the logarithmic value of FOI, LFDI
t
implies actual value
of FOI, and T ~ number of periods over which simulation has been carried out. In the present
study, the period covers from 1979-80 to 2000-01 and hence, number of observations is 22.
The first method explains the deviation of simulated variable from its actual time path and the
second method states the deviation of the simulated variable from its actual time path but in
pcrcentage tenns. The robustness of the equation of the detenninants of FOI could be found
from the values of RMSE and PRMSE. The value of RMSE is 0.23 where as the value of
PRMSE is 0.05. The results of these two statistics indicate that the error is minimized but the
value of PRMSE is less than the value of RMSE. This implies that the model is th e best fit
for policy analysis.
104
Detenninants of FDI
The historical simulation of the equation of FDI can be evaluated looking at the Figure
7. The simulated FDI equation 5.5 displayed in Figure 7 shows that the simulated series seems
to reproduce the general long run behaviour of the actual series, although short-run t1uctuations
III actual series are not reproduced well and some turning points are missed altogether. The
major turning points are evidenced during the period from 1997-98 and 1999-00. The reason
for the huge decline in the FDI inflows during this period could be attributed to the East-Asian
melt down and the US sanction on India due to the Pokhran test. The discussion of historical
simulation of the equation on the detemlinants of FDI suggests that the simulated series of FDI
explained well its historical data series. Thus, the equation of FDI could be considered as best
fit for the policy analysis. The simulation method has been once again carried out for policy
analysis. Howevcr, there are only two policy variables in the FDI equation, namely IR and
REER. In this context, in order to detennine the effect of the changes in IR and REER. the
simulated series of both the variables are obtained by changing the coefficients of the variables.
It is important to note that both the variables are changed by 15 per cent for simulation analysis.
This percentage may be considered as reasonable for policy analysis.
The simulation result of the decrease in the IR as explained in Figure 8 and Figure 9
gives the result of the increased REER. It could be observed from both the figures that both
the policy variables have same effect on the FDI int1ows. The simulation analysis for IR
shows that FDI t10w goes up when there is a reduction in the IR. It is also notable that an
appreciation of REER increases the FDI t10ws into India as the base line lies above the
actual line.
5.6. Conclusion
The forgoing analysis reveals the fact that the major macroeconomic detenninants of FDI
int10ws into India are WPI, REER, GDP and the IR. It is observed from the result that in
spite of being the fifth largest volume in the world arid a very high potential for growth, the
GDP of India has not been able to mark itself as the green signal for foreign investors rather
it has a deterrent effect on the FDI inflows. This finding goes against the market size
hypothesis of the detemlinant of FDI. The interest rate produced a predicted impact on the
FDI flows. The negative elasticity of interest rate has a policy implication and it is not
surprising that the agenda for the successive refonns in India induces for a lower interest
105
Oetenninants of FOI
rate, The other variables like REER and WPI are the positive detenninants of FDI inflows
into India, In this context, it can be said that the positive contribution of REER towards the
FDI inflow is an encouraging sign for the Indian policy maker (as it requires to appreciate
the Indian currency in the international market) but the positive impact of WPI should not
induce them to take the route, as higher inflation would destabilize the economy, There
should be sincere effort on the part of the policy makers to raise the Greenfield Investment
as against the Brownfield Investmcnt for which it is necessary to reduce the interest rate,
The above finding of the study has helped identify those variables those have been
important to attract FOr. The exercise has also helped draw some policy conclusions at the
macro leveL This exercise will also help explore and examine the detenninants of FOI at
the sectoral lfinn leveL It is mentioned earlier that FDI is the result of the MNC activities
and these MNCs are nothing but invcsring finns of foreign origin, In this context, it is
pertinent to believe that FOI will be more scnsitive to the finn or sector specific variables
than the overall macrocconomic variables, Thus, the study tries to explore these sector
specific deternlinants of the FOI inflows into India in the next chapter.
106
Detenninants of FDl
Table 5.1: The Least-Square Growth Trends of Macroeconomic Variables of the
Indian Economv

Year
1980-01 1986-01 1986-91 1992-01
FDI
41.73 41.23 2.49 39.86
GDPFC
5.69 5.93 6.48 6.54
IR
0.55 -1.63 8.05 -7.60
WPI
7.73 8.14 8.35 6.3 I
REER -3.3 I -3.95 -5.59 -1.29
EX 9.97 12. I 6 16.01 8.74
Table 5.2: Sargan's Criterion and the Selection of the Functional Form for the
Determinants of FDI Inflows at the Macro level of the Indian Economy
S-Value Selected Functional
Fom1
(7164.72)"22* Log-Linear
Note: The value of(7164.72)"22 is equal to 6.52E-l-84
Table 5.3: Multiple Linear Regression Estimation of FDII Function
(Dependent Variablc: Log of FDl Inflows to India)
Explanatory Variables Coefficients
Con 187.54
(2.26)**
LGDPFC - I 8.96
(-2.73)*
LWPI 12.19
(5.05 )*
LIR
- 1.19
I (-1.87)***
LREER 5.41
(3.38)*
LEX
-1.78
(-1.51)
Time
0.85
(1.97)***
~
-
Adj- R :0.96
D-W Statistics 2.18
Note: Numbers In parentheses are t-statlstlcs
* Denotes that coefficients are significant at I % level
** Denotes that coefficients are significant at 5% level
*** Denotes that coefficients are significant at 10% level
107
Determinants of FDI
Figure 5.1: FDI Inflows into India from 1980 to 2001
FDI Inflows from 1980-2001
12000 ----_._- - ~ - - - - .
10000
'"
~
8000
0
I:
C (10UO
-
-
woo
Q
"'"
-=,OL)O
U
0
;c
~ ~ ,
'" '"
-c c- oo O'
'" 0:
N ~
'"
~ , ",. c- oo <> 0
;3 oo 00 00 00 00 oo 00 00 00
'"
O' O' c- O' O' O' O' <> 0
c- O' O'
':: '::
C'
':: :': ':: '::
0- <>
':: '::
c- c- O'
:': :': :':
0 0
-
-
N N
Year
1 __ FDI(Rs,Cr) I
Figure 5.2: GDPFC of India from 1980 to 2001
GDPFC oflndia from 1980-2001
1400000
'"
OJ
1200000
...
0
... 1000000
U
c
800000
c.,.;
['00000
"'"
400000
Q.
Q
200000
C-'
0
Year
r=- GDPFC-con I
108
25
20
~ 15
- 10
5
Detenninants of FDI
Figure 5.3: IR of India from 1980 to 2001
IR ofindia from 1980-2001
o ~ ~ , - ~ ~ ~ ~ ~ ~ ~ , - , - , - , - ~ ~ , - ~ , - ~ ~ ~
a::
w
w
a::
~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~
~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~
Year
Figure 5.4: REER of India from 1980 to 2001
REER of India from 1980-2001
120
100
80
60
40
"
20
"> ;
{
0
109
Detenninants of FDI
Figure 5.5: EX oflndia from 1980 to 2001
EX of India from 1980-2001
250000
, ,.i
200000
'"
'"
..
=>
150000 ..
U
.:: 100000
>:
r..l
50000
Year
I - - E ~ J
Figure 5.6: WPI of India from 1980 to 2001
WPI of India from 1980-2001
160 ..------,------------------------------""..,.,
140
120
100
==
80
~
611
40
20
0
,,"
,"
,,'>
,"
" ' ~
,"
,,0
,"
"Go
,"
Year
! __ WPI!
110
Detenninants of FDI
Figure 5.7: Actual and Simulated FDI from 1980 to 2001
FDI
12000,-________________________________ ~
10000
8000
6000
4000
2000
I
I
.J
II
I I
I I
I I
I I
I
I
I
I
I
I
I
I
I
I
I
I
/
I
I
I
I
I
I
" I
"
o + - ~ ~ ~ ~ ~ - ~ - - ~ - ~ ~ ~ ~ ~ ~
,
80 82 84 86 88 90 92 94 96 98 00
1-Actual --- FDI (Baseline) I
I
Note: * hased Oil Ihe equatioll" LFDf = (LGDPFC LEX, LfR. LREER, LWPL T)
) ) )
Dcterllllll.lnts of FDI
Figure 5.8: Simulated FDI from 1980 to 2001
FDI
14000,-______________ ---,
1-Actual --- FDI (Baseline Mean) I
NOll': The simulated FDI is obtained by reducing the IR by 15 per cellI in the FDI
equation.
112
Dctcnninants of FDI
Figure 5.9: Simulated FDI from 1980 to 2001
Note: The simulated FDI is obtained by increasing the REER by 15 per cent in the FDI
equatioll
113
Chapter VI
Determinants of FDI inflows into India: A Sectoral Analysis
6.0. Introduction
The main objective of this chapter is to analyze the determinants of FDI inflows at the
micro level i. e., at the firm or sectoral level. This helps not only in understanding the
dynamics of sector specific variation in the FDI flows in India but also gives scope for
necessary p[policy initiative in terms of attracting more FDI at the sectoral level.
These determinants of the FDI inflows at the sectoral level of the Indian economy
could be elucidated by the general model of FDI derived from the theory of the firm
in Chapter 3.
6.1. The Framework for Empirical Estimation
At the sectoral level, FOI is viewed as a disaggregate entity. It implies that FDI
inflows to India at the sectoral level could be considered as the function of the sector-
specific (firm level) variables of the Indian economy. These sector-specific variables
also foml the demand and cost determinants of the FDI inflows in to the sectors.
Thus, the function for the detemlination of FOI inflows at the sectoral level of the
Indian economy could be written as:
FDl1" = <D(z, yJ ...... ,,(6.1)
where FOIL, is the FDI inflows into sector 'i' at time period 't', Zit is the vector of
sector specific demand determinants of FDllil Y" is the vector of sector specific cost
determinants. For the present analysis Z" includes gross out put (GO), profit (PR),
exports (EX). degree of openness (OPEN), gross value added (GY A), labour
productivity (LPR), gross capital formation (GCF) and the wholesale price index
(WPI) of the sectors. The vector Y" includes imports (1M), number of workers (WO),
value of the total inputs used (IN), wages paid (W A) and the interest paid (lR) by the
sectors. For the purpose of empirical estimation, the FDI equation 5, I is specitled as:
FDJ
= a + /3, Z + /3, Y + [; .......... (6.2)
If If ~ II 1/
i= 1,2, ........ N
t= I, 2, ...... T
Determinants of FDI
\\here subscript 't' denotes the time period and 'i' represents the sectors of the Indian
economy those receive a lion share from the total FDI inflows. Thc sectors are power
and fuels (PF), telecommunication (TEL), clectrical equipment (EQ), transportation
(TR), Chemicals (other than fertilizers) (CH), food processing (FP), metallurgical
(1\1E), industrial machinery (IN), drugs and pharmaceuticals (DP) and textile (TE). It
is important to note that TEL sector is removed from the analysis because of the non-
a\ailability of data on certain crucial variables like interest paid, exports and imports.
Therefore, N is equal to 9. T denotes the time dimension and is equal to lOin this
case as it starts from period 1990-91 to 2000-01. a. is a scalar (3, and (32 are Kx I and
l" andY" are the it'h observation on the K'h variable. In order to explore the
determinants of each sector, FDI functions for each of the sectors are required and
thus the following set of equations are formulated for estimation.
FD("f = a + p, Z. + p, y, + c, .......... (6.3)
FDI,F(! = a + P Z, + p, y, + c, ......... (6.4)
FDI," = a .. 11, Z + p, y, + c, ....... (6.5)
FOI.'H =a+ li,Z +p,y +c ......... (6.6)
, I- I ~ I r
FOI,FP = a .. p Z. + p, y, + ~ " ... (6.7)
FD!,'" = a + 11, Z, + p, y, + c, ......... (6.8)
FOl,'" = a .. fl, Z + p, y + c, .......... (69)
FOI.O? =a .. Ii Z, + fl, y, +c,.(610)
FOI,TE = a + II, Z, + p, y, + c, ......... (6.11)
where subscript 't' denotes the time period, superscripts are the sectors and all other
notations are same as described earlier. In the literature, the determinants of FDI
inflows at the sector (firm) level portrayed II priori relationship between FDI and the
sector-specific explanatory variables (Chapter 2). As per the economic priory, the
relation is such that uFDI!o(Z) > 0, and uFDI/o(Y) < 0, because the demand
determinants are assumed to affect the MNCs activities positively, whereas cost
determinants are assumed to be inversely related to the MNCs activities.
115
Detemlinants of FD!
6.2. Variables lTsed and Data Description
The FDI inflows into the different sectors of India are the dependent variable for the
estimation of the sector specific dctemlinants of FD! inflows. It is the disaggregated
FD! inflow into the various sectors of India and the data are collected for a period of 8
years from 1990-91 to 1997-98. The data are for the two years 1998-99 to 2000-01
e:-;trapolated'. All the data except WPI are collected from the Annual Survey of
Industry (ASI) as complied by the Economic and Political Weekly (EPW) research
foundation. The data on different WPI are collected from the Handbook of Statistics
on the Indian Economy, published by the RBI in 2002. The explanatory variables and
their descriptions are given below. These variables are the elements of the Z and the Y
vectors.
GO: The gross output (GO) of the sectors is the demand determinants and constitutes
the element of the Z vector. As per the economic priori, output of the firm is positive
determinants of FDJ. higher the output, higher will be the FD! inflow because
maximizing the output is one of the objectives of the firms. In the present context,
gross output of the selected sectors is taken as one of the demand determinants of FD!
Inflows into those sectors. In this study, gross output is defined to include the ex-
factory value of products and by-products manufactured during the accounting year. It
also includes the receipts for nonindustrial services rendered to others, the receipt for
work done for others on materials supplied by them, value of electricity produced and
sold and net balance of goods sold in the same condition as purchased. The terms
gross output. \'alue of output and total output have been used in the text
interchangeably to mean same thing.
PI{: Profit (I'R) in the sectors is another demand detcmlinants of the FD! inflows into
a particular sector. Higher the profit, higher will be the FDI inflow into a specific
sector as higher profit attracts the foreign fimls to invest more. The different kind of
profits data given by the secondary sources are operating profit, profit before
depreciation, interest and tax, profit before depreciation and tax, profit before interest
and tax, profit before tax and profit after tax. Another profit data is also available
I The extrapolation donI.: either by I!nt.:;.J.r, quadratic. cubic, exponential, logarithmiC
functions depending upon the nature ofthl' dat<.l. It \vas a good statistical fit for all the series as the
"dJustcd Rsquare wa' IIlllle range 01'0.85100.98 for ailihe sencs.
116
Determinants of FDI
which is called as cash profit. This cash profit is the profit after tax plus non-cash
items like depreciation and amortization. The operating profit is equal to the
di fference between the net sales and the total costs incurred by a firm. As in the
literature, the present study uses this operating profit as one of the demand
determinants of the FDI inflows into the sectors because profit maximization has been
a major objecti\e of the finns.
EX: This exports (EX) are the total forex earnings of the sectors. It includes the
earnings from export of goods as well as the forex earning from services. Other
foreign exchange outgo of the sectors on account of royalty, know-how fees,
di\idend, interest, etc. also fOlm part of this total exports. This export is considered
as one of the determinants of FDI infl0ws into the sectors when the foreign firms arc
interested to exploit the production advantages of the sectors in order to cater the
demand of a third country or in order to take the advantage of the trade treaty between
the host country and a third countrv. This is taken as one of the demand determinants
of the FDI inflows into the sectors. As a demand determinant, export is assumed to
have a positi\c impact on the flow of FDI into the sectors.
1:\1: The imports (1M) are the total lorex spending ofa sector. It includes the value of
the imported raw materials, stores and the import of capital goods. This total imports
are considered as one of the cost determinants of FDI inflows into the sectors as
higher dependence on imports by a sector may lead to an increase in the transportation
cost. Thus, it may result in the reduction of profit and hence J disincentive for the
foreign firms and it may be used as one of the cost determinants of the FDI inflows
into the sectors.
OPE:\': Degree of openness (OPEN) of the sectors is calculated by taking the ratio of
the total trade of a sector to its gross outpu{ Higher the openness of the sectors,
higher will be the FDI inflow to that sector. This is particularly lor the foreign firms
those arc interested to exploit the production advantages of the sectors in order to
cater the demand of a third country or in order to take the advantage of the trade treaty
2 Degree ofopenncss of the Exports T Totallmports)!Gross Output.
117
Determinants of FDl
between the host country and a third country. This variable IS more of a policy
variable than the demand or cost variable. However, this IS taken as one of the
demand detenninants of the FDI inflows into the sectors.
IN: Total Input (IN) of the sectors comprises total value of fuels, materials etc.
consumed as well as expenditures such as (a) cost of contract and commission work
done by others on materials supplied by the factory, (b) cost of materials consumed
for repair and maintenance of factory's fixed assets including cost of repairs and
maintenance work done by others to the factory's fixed assets, (c) inward freight and
transport charges, rates and taxes (excluding income tax), postage, telephone and telex
expenses, insurance charges, banking charges, cost of printing and stationery and
purchase value of goods sold in the same condition as purchased. In a functional
relationship, more input is assumed to have more output and more profit, if the firm is
optimally using its production capacity. However, inputs are the cost of the firms and
it could be assumed that higher the input, lower will be the inducement for the foreign
firms. Therefore, the FDI flow will be less, if a sector resorts to more inputs.
GCF: For the empirical analysis, Gross Capital Formation (GCF) is obtained by
adding total addition in stocks of material, fuel, semi-finished goods and finished
goods to gross fixed capital formation (GFCF). The GFCF is defined as addition of
depreciation to net fixed capital formation (NFCF), where NFCF represents the excess
of net fixed capital at the end of accounting year over that at the beginning of the year.
Though GCF is neither a demand determinant nor a cost determinant, it is assumed
that a capital-intensive sector will attract more FDI, as foreik,'I1 firms are more capital
intensive.
WPI: In the present study, the wholesale price index (WPI) is used as an indicator of
the price level. There are a couple of wholesale price indices provided by the RBI,
namely WPI of all commodities, WPI of primary articles, WPI of food articles, WPI
of fuel, power, light and lubricants, WPI of manufacturing products and the WPI of
non-food articles. The study uses the new series of WPI with 1993-94 as the base
year and for analysis purpose, WPI of food articles are used for food processing
sector, WPI of fuel, power, light and lubricants is used for power and fuel sector and
WPI of manufactured goods used for all other seven sectors. As per the economic
118
Detenninants of FDI
priori, it can be argued that higher the price, higher is the profit for the finn. (unless
the price is cost-driven). Since WPI is an indicator ofthe price level, it is assumed to
have a positive impact on the flow of FDI.
GVA: Gross Yalue Added (GYA) is assumed to be a positive detenninant of the FDI
inflows into the sectors. In the present study, Gross Value Added is the increment to
the value of goods and services that is contributed by the factory and is obtained by
deducting the value of total input from value of output.
WO: Workers (WO) or the labour force of the sectors are defined to include all
persons employed directly or through any agency whether for wages or not and
engaged in any manufacturing proces, or in cleaning any part of the machinery or
premises used for manufacturing process or in any other kind of work incidental to or
connected with the manufacturing process or subject of the manufacturing process.
Labour engaged in the repair and maintenance or production of fixed assets for
factory's own use or labour employed for generating electricity or producing coal, gas
etc. are included. However, persons holding positions of supervision or management
or employed in administrative office, store keeping section and welfare section, sales
department as also those engaged in the purchase of raw materials etc. and in
production of the lixed assets for the factory and watch and ward staff are excluded.
Since labour is a cost for the finns, WO is assumed to have a negative influence on
the now of FDI in to a particular sector.
L1'R: This Labour Productivity (LPR) of the sectors is calculated by taking the ratio
of the gross value added of a sector to its number of workers employed in that sector]
3 However, labour productivity can be measured In more than one way. For single product, labour
productivity IS defined as the ratio of output to number of hours worked by individuals. A change In
labour productiVIty bct\\'ccn two periods can be written as:
(q,! Ill, )!(q,,! lIlu)
Where, q ~ units of output.
M = number of man-hours.
The suffixes 0 and I denote the base year and current year respectively. But the measurement of
productivity IS not so Simple, in reality a single industry produces a number of different products
expressed In different phYSical units. In thiS casc, the problem can be solved In two ways:
(I) An Indcx of production as well as an Index of employment or man-hours may be complied for each
of the two pCrlods 0 and I. So, change In productivity at period I with base period 0 can be
measured by the ratio ofproduetlvlly In period I to period O. Symbolically, It can be written as
119
Detenninants of FDI
Higher the labour productivity of the sectors, higher will be the FDI inflow to that
sector. This happens particularly with the foreign firms, which are interested to
exploit the abundant potentially skilled labourer of India to maximize their profit.
WA; Wage (WA) is one of the cost determinants of FDI inflows into the sectors and
is believed to bear a negative impact on the FDl flow. This include all remuneration
capable of being expressed in monetary tenns and also payable more or less regularly
in each pay period to workers (defined above) as compensation for work done during
the accounting year. It includes (a) direct wages and salary (i.e., basic wagesl salaries,
payment of overtime, dearness, compensatory, house rent and other allowances); (b)
remuneration for the period not worked (i.e., basic wages, salaries and allowances
payable for leave period, paid holiday, lay-off payments and compensation for
unemployment, if not paid from sources other than employers); (e) bonuses and ex-
gratia payment paid both at regular and less frequent intervals (i.e. incentive bonuses,
good attendance bonuses, productive bonuses, profit sharing bonuses, festival or year-
end bonuses etc.). It excludes lay-off payments, which are made from trust or other
special funds set up explicitly for this purpose i.e., payments not made by the
employer. 11 also excludes imputed value of benefits in kind, employer's contribution
to old age benefits and other social security charges, direct expenditure on maternity
benefits and creches and other group benefits. Traveling and other expenditure
incurred for business purposes and reimbursed by the employer are excluded. The
wages are expressed in tenns of gross value i.e., before deduction for fines, damages,
taxes, provident fund, employee's state insurance contribution etc.
(P,I E,)/(P"I Eo)
where P stands for production mdex and E stands for employment Index.
(2) Another method is to use the reCiprocal of " output per man-hour" as a measure of labour
productivity Thus, we measure man-hours expended per unl! of output, which IS called "'unit
labour requIrement". An increase In the unit Inbour requirement index of the current year to
produce the base year output will show a decline in productivity and \/cc-\'ersa. But, the unit
labour reqUirement can be allocated in a number of ways to produce different complex of goods,
ie. Base year complex and Current year complex.
Base Year Complex: I '10
1
, I I q ,,/0 = I q "I, I I III"
Current Year Complex:
I q,l,/I q,l" = I III,/I q,l"
Where, q ~ Quantity of output prodllced
L-= Labour input reqUirement
M ~ The man-hours used," the production of q.
120
Determinants of FDI
IR: Interest paid (IR) is another cost determinant of FDI inflows into the sectors. It
includes all interest paid on factory account on loans, whether short term or long term,
irrespective of the duration and the nature of agency from which the loan was taken.
However, the interest paid to the partners and proprietors on capital or loan are
excluded from the calculation.
6.3. Selection of Explanatory Variables and the Estimation Procedure
[t is always important to have the right combination of the variables to explain the
\'ariation in the depcndent variable of a specification. Thus, in order to facilitate the
analysis for the deternlinants of FDI inflows into the sectors, different alternative
combination of the variables were estimated. The present study has used the step-
wise OLS regression technique to tlnd out the suitable combination of the explanatory
\'ariables for the sector specific analysis. The study has also tried to explore the
possible alternati\e combinations for the pooled regression. This is bccause the
selection of explanatory variables bears a lot in any specification and a
misspecification may lead to spurious result. After careful observation and the test of
different combination of the explanatory variables, the present study opted for the
following set of independent variables for the respective sector. However, in the
selection of the explanatory variables, the explanatory power of the variables needs to
be taken care of. Thus, the explanatory power of the variables is also taken into
confidence in selecting them.
Name of the Sector Explanatory Variables
Power and Fuel (PF) Labour Productivity (LPR), Interest Paid
(lR), Imports (1M) and Wages (WA)
Electrical Equipment (EQ) Wholesale Price Index (WPI), Exports
(EX) and Imports (1M)
.. - - -----
Transportation (TR) Number of Workers (WO), Wholesale
Price Index (WPI), Interest Paid (IR) and
Wages (WA)
Chemicals (other than fertilizers) (CH)
Labour Productivity (LPR), Gross Capital
Formation (GCF), Imports (1M), Wages
(W A), and Interest Paid (lR).
Contd ...
121
Determinants of FDI
Food Processing (FP)
Imports (1M), Wholesale Pnce Index
(WPI) and Interest Paid (IR)
Metallurgical (ME)
Wholesale Price Index (WPI), Interest
Paid (lR), Imports (1M), Wages (WA)
and Labour Productivity (LPR).
Industrial Machinery (IN)
I Labour Productivity (LPR), Interest Paid
I (lR), Wages (W A) and Profit (PR).
Drugs and pharmaceuticals (DP) Wholesale Price Index (WPI), Interest
Paid (lR), Imports (1M), Wages (WA)
and Profit (PR)
Textile (TE) Labour Productivity (LPR) Interest Paid
(lR) and Wages (W A).
The relationship between the above mentioned explanatory variables and the
FD! inflows of the respective sectors have been estimated by the OLS method. The
study also has tried to identify the explanatory variables for the pooled regression
analysis. The study has used three alternative combinations of the sectors for pooled
regression. The nine sectors for the study are power and fuels, electrical equipment,
transportation, Chemicals (other than fertilizers), food processing, metallurgical,
industrial machinery, drugs and pharmaceuticals and textile. For the empirical
analysis purpose, this study classifies all the nine sectors into three different groups
viz .. all nine sectors as one group, major sectors
4
and the minor sectors
5
This
classification is done according to the absolute magnitude of I'D! inflows received by
the sectors. The top five sectors constitute the major group and the bottom four
sectors form the minor group. This classification is useful because the magnitude of
the FDI received by these sectors is different and the specific deternlinants for the I'D!
inflows into these sectors may be different. This will help analyse the possible
differences in the results and the sensitivity of some of the determinants to different
sub groups. The explanatory variables for the different groups are:
, The major sectors Include power and fuels, electrical equipment. transportation. Chcmlcals (other
than fertili/ers), and food processing.
S The minor sectors include metallurgical. industrial machinery, drugs and pharmaceLltlcals and textile
122
Detenninants of FDI
Name of the Group
The Explanatory variables
All nine sectors
Interest Paid (lR), Profit (PR), Labour
Productivity (LPR), Wages (W A), Gross
Capital Fonnation (GCF), Exports (EX)
and Imports (l M).
Major Group
Profit (PR), Labour Productivity (LPR),
Gross Capital Fonnation (GCF), Exports
(EX) and Wholesale Price Index (WPI).
Minor Group
Interest Paid (lR), Labour Productivity
(LPR), Wages (W A), Profit (PR), Gross
Capital Fonnation (GCF), Exports (EX),
Imports (1M) and Wholesale Price Index
(WPI).
After the classification of the sectors, three different models, namely, Fixed
Effect (FE) model, Random Effect (RE) model and simple Pooled OLS model are
used to estimate equation 6.2. [n a pooled estimation, it is expected to encounter the
problem of heteroscedaticity and autocorrelation. In order to overcome these
problems, the pooled estimation assumed nine different assumptions with respect to
group-wise heteroscedasticity, cross group error correction and auto correlation. The
nine di fferent assumptions are:
homoscedasticity and no autocorrelation,
homoscedasticity and common autocorrelation,
homoscedasticity and specific autocorrelation,
group-wise heteroscedasticity and no auto correlation,
group-wise heteroscedasticity and common autocorrelation,
group-wise heteroscedasticity and specific auto correlation,
cross group heteroscedasticity and no auto correlation,
cross group heteroscedasticity and common auto correlation and
cross group heteroscedasticity and specific auto correlation.
The main justification for the assumption of heteroscedasticity in the pooled
regression estimation is due to the specific sectors. Since most of their respective
economic variables are not homogeneous, it is sensible to expect that there will be
difference in the error variances. The large bodies of cross-sectional empirical
econometric studies that take care of the heteroscedasticity problem support this fact.
123
Ikten11lnants uf F D)
Likewise, the presence uf auto-correlation in the error term of a given sel:tor ,'ann"t b,
ruled out because observations over time are used while pooling the data.
It is important to note that the pooled data estimation of this kind fomlUlated
with the assumption of homoscedasticity (constant error variance across Clluntri',I.
absence of cross-group error correlation and also the presen<.:e of non-auto correlah:J
errors are too simplistic and misleading. Further, estimation of the models Ignoring
the presence of heteroscedasticity, cross-group correlation and auto-correlation might
also lead to inconsistent as well as inefficient estimates. In order to obtain efficient
and consistent cot!fficient estimates, the estimation procedure needs appropriate
corrections, which is explained in the following manner.
A pooled regressIOn differs from a regular time series ur cross sel:tion
regression in the sense that it has a double subscript un its variables indicating
changes over time and across units/sectors, which may be written as:
X
=a-Z fJl+Y fJ,+c ................ (6.12)
II If II _ (., '/
i= 1,2, ......... 9 (for all the sectors)
i= 1,2, .......... 5 (for major group)
i= 1,2" ........ .4 (for minor group) and
t= 1991. ...... 2000.
Where 'i' denotes the cross-section dimension, i.e., individual units. In this
case, individual sectors are power and fuels (PF), telecommunication (TEL), electrical
equipment (EQ), transportation (TR), Chemicals (other than fertilizers) (CH), food
processing (FP), metallurgical (ME), industrial machinery (IN), drugs and
pharmaceuticals (OP) and textile (TEl and t denotes the time dimension. In this case,
T equals 10 as it starts from 1990-91 to 2000-0 I. a is a scalar 131 and 132 are Kx I and
Z" and Y" are the itth observation on the Kth variable. Z" includes GOP, growth rate of
GOP, export, import, degree of openness of the economy and the domestic capital
formation. Y" includes inflation rate, cost of capital and cost of labour. tariff rate and
exchange rates.
The disturbance term E"
IS assumed to be homoscedastic and non-auto
correlated: that is,
124
Detenninants of FDI
Violation of the assumptions of homoscedasticity and auto-correlation are
explained into different possibilities. It includes: (l) Groupwise heteroscedasticity, E
[E/ I = a" , (2) Cross group correlation, Cov (E" , E
JI
)= a,), for i+j, (3) Within group
autocorrelation, i.e., 6' = P [; + U . These three cases may be explained in the
1/ I 1.1 I rI
following manner.
Let 2: be an NxN, period specific covariance matrix, i.e., L = {ai)}, I,j = 1,2, ....... N.
It is possible to impose some restrictions on L, which may give three possible cases.
The first case refers to the classical homoscedastic regression, representing a naIve
situation, where in:
,
S" : 2: = a I, where I is an identity matrix.
In the second case. it stands for group-wise heteroscedasticity, and thus:
S I : 2: = diag l a II. a!2. .a"" I
In the third case, 2: is assumed to be a positive definite matrix signifying cross group
correlated errors apart from group-wise heteroscedasticity. That is,
S, : L = NxN positive definite matrix.
In respect of autocorrelation, a similar sct of assumptions can be considered.
Let p be an N x I, vector of group specific autocorrelation coefficients. It is possible to
visualize three meaningful restrictions that could be imposed on the p vector. In the
first case. Ro : p=O, representing a situation where disturbances are non-auto
correlated. In the second case, R, p= {p,p, ..... pi, where all the units have
common autocorrelation coefficient. In the third case, R
2
: P={PI.P2, .pt.d, where
individual units have specific coefficients.
125
Detenninants of FDI
By combining these two sets of restrictions on I and p, it is possible to
generate nine combinations leading to nine distinct models. They may be represented
by [SORO.SIR"S2Ro.SoRI.SIRI.S2RI.SoR2.S1R2 and S2R2.]. The first eight models fonn
as imposing appropriate restrictions on S2R2 can generate special cases of the last
one that is the first eight (8) models
A two-step generalized least squares (GLS) and the three step GLS methods
are used for non-auto correlated models and auto correlated models respectively. [n
order to test the assumptions of homoscedasticity and absence of auto-correlation as
restrictions on the most general case, i.e., S2R,. three different statistics such as, Wald,
LM and LR are computed. The test statistics are given by:
WALD= (Ti2) I, [S2/ S,,-I],
LM = (T/2) ~ l ' [S" /S2 - 1]2 and
LR = T ( N In S2 - I, In S,,)
where S2 is the pooled OLS residual variance and S" is the OLS residual variance of
the ith country. All the three test statistics follow the Chi-squared distribution with (N-
I) degrees uf freedum.
6.4. Selection of the Functional Form
[n order to avoid the problem uf misspecification of the functional fonn, which may
!cad to spurious result, the present study, assumes the functional fonn of the variables
be either linear ur log-linear. [n this cuntext, it is essential to choose between either of
the two for all the sectors individually and for the pooled regression. [n order to
choose between the alternative functional fonns, the study uses the Sargan's
Criterion".
According to the Sargan's Criterion if the calculated'S' value is greater than
one (i.e. S> I) then the log-linear functional fonn is preferred over the linear
functional fonn. On the other hand, when the calculated'S' value is less than one
(i.e. S<I), the linear functional form is supposed to be the appropriate functional form
between the two.
(, For, detailed diSCUSSion on Sargan's Criterion. sec the Previous chapter.
126
Determinants of FDI
6.5. Results and Discussion
The present chapter is an endeavour to identify the sector specific determinants of the
FDI inflows in the Indian economy. The study period was chosen from 1990-91 to
2000-01. because this was the period when India opened her economy and the caps
on the sector specific FDI in!lows were relaxed. In addition to this, the sector-wise
FDI !low data of India is not available before 1990, though FDI stock data at a
sectoral level, at some point of time is available. The literature on FDI flows identify
the variables such as WPI, WO, WA, IN, IR, GO, PR, GYA, LPR, GCF, EX and 1M
as the prime determinants of FDI flows at the sectoral level. Thus, the study tries to
analyze the FDlflows with these variables and the least-squares growth trends (LGT)7
and Annual Average Growth Rate (Table 6.1) of the variables is calculated
to strength the analysis.
The Sargan's criterion shows that the'S' value is greater than one in seven
sectors whereas the'S' value is less than one in two sectors namely IN and TR
(Table 6.2). Sargan's criterion for the pooled regression shows that for all nine
sectors and for jive major sectors, the'S' value is greater than one and for the four
minor sectors. the'S' value is less than one (Table 6.3). Therefore, the Shldy uses thc
log-linear functIOnal form of the FDI equation for the seven sectors and the linear
form for the two sectors. For Panel regression, the study uses the log-linear
functional jorm for all nine sectors and for the five sectors group. The linear form is
used for the four sectors group. The use of the log-linear functional form would
facilitate to interpret the coefficients in elasticity. The results of the OLS regression
are presented in Table 6.4 through Table 6.12. Since the data in the analysis are of
time-series nature, it is expected to have autocorrelation in the specified model. In
order to take care of autocorrelation problem, all the estimations in the analysis were
done with the help of Cochrane-Or cult (C-O) Algorithm'). The use ofC-O Algorithm
has enabled to solve the problem of autocorrelation in all the estimation as noticed
from the Durbin-Watson (D-W) statistic in all the estimations. lt is also important to
. For the and the disadvantages of LST. see the last chapter
'Since LGT cannot be culclilatcd for negutlve values. AAGR is used for the variable PR in DP scetor
(PR In DP sector was negative) and AAGR IS equal to:
((PR,PR'.I)!PR,.Jl/n, where 'n' IS the number of Annual Growth Rutes (AGR).
"For a diSCUSSIOn on the method ofllsing CoO AlgOrithm. see the last Chapter.
127
Detenninants ofFDI
note that all the models show a good statistical fit as evidenced from the high adjusted
R'.
The regression result for the individual sector reveals that LPR is a positive
detenninant of FDI tlows in the sectors like Power and Fuel and Metallurgical sector
(Table 6.4 and Table 6.9). From the result, it can be observed that the clasticity
coefficient of LPR is more in the Metallurgical sector (5.55) than the Power and Fuel
sector (2.17). This positive impact of LPR shows that the foreign tinns are interested
to use the steady growth of LPR of these sectors (See the growth rates of LPR in
Table 6.1) to maximize their profits. As a result, the FDI tlows in these sectors have
gone up. This implies that the higher labour productivity of these sectors is an
attracting force to the foreign firms as higher the productivity of the labour input
higher will be the profit for the finns.
Interest paid on the sectors loan (IR) is a cost for the production and is
assumed to bear a negative impact on the FDI flows to the respective sectors. The
regression result shows that IR is a negative detenninant of the FDI flows into the
sectors like Power and Fuel, Chemical (other than Fertilizer), Metallurgical and
Textile sectors. This may be because of the reason that the foreign finns try to raise
fund from the local market and they are purchasing the finn specific assets in the
Indian currency. In this situation. when the opportunity cost of domestic assets is
high (as marked by higher interest payment), it becomes a hurdle for the foreign finns
to raise more funds. In this case, the FDI inflows go down. Thus, the IR has a
negative impact on the flow of FDI into these sectors. For all these sectors, it can be
observed that the elasticity coefficient of IR is the highest for the Power and Fuel
sector (i.e. -7.80. Table 6.4) and it is lowest for the Chemical sector (i.c. -1.92, Table
6.7). However, IR has a positive impact on the flow of FDI in the Drugs and the
Phannaeeutical sector. The result reveals that one per cent increase in IR causes
16.86 percent increase in the FDI intlows into this sector. This implies that the FDI in
this sector is Greenfield investment because in spite of a reasonably high growth rate
of IR (Table 6.1) in this sector, the FDI flow has gone up. It suggests that the foreign
finns invest the fund in their own currency rather than relying on the Indian capital
market.
Import is assumed to be a cost detenninant of the FDI flow and it has to have a
negative impact on the flow of FDI to a particular sector. This negative relationship is
established for two sectors, namely, Food processing sector and the Drugs and
128
Iktenninants of fDI
Phannaceutical sector. This may be because of the FP sector. which mainly depend,
on the Indian market rather than relying on the foreign market and for the DP se,tor
the higher transportation cost associated with the imports compel the sector not to
depend on imports. It is also because of the Indian Patent Act I 97(J. whil'h alkl\\ s
process patents in the vital areas including drug production, which i, likely to hal C a
bearing on self-reliance of the DP sector. It can be observed that the elasticity
coefficient of 1M is -6.37 in the FP sector (Table 6g) and (J.65 in the DP sector.
However, there is a contrasting sign of 1M for four sectors, where 1M bears a positive
sIgn. These sectors are Power and Fuel (elasticity coefficient is 5.51), Electrical
(elasticity coefficient is 9.50), Chemicals (elasticity coefficient is 196) and
Metallurgical (elasticity coefficient is 1.79). This is also evidenced from the groll th
rates of 1M and FD! that when there is a fall in the growth of 1M in these sectors the
flow of FDI have also gone down. This implies that these sectors are more import
based. This also shows that more openness of these sectors with the reduction in the
import barrier will help to raise the FD! in these sectors. If the foreign firms are
interested in using the domestic production facility to cater the international market,
then the export should be a positive detenninant of I'D! flows. lIowever, when the
foreib'll finns are interested to meet the domestic market but are compelled to meet the
export requirement (as in the case of the Indian economic policy), then FDI flow IV ill
be reduced. The regression result of the Electrical sector shows that the elasticity
coefficient of export is negative and it is -2.46 (Table 6.5). This implies that the
export requirement policy has a deterrent effect on the flow of FDI into this sector.
The Wages paid (W A) figures as a cost to the production process of a fim1 and
is assumed to be a negative detenninant for the MNEs activity. The regression result
shows that W A is a negative detenninant of FD! flows into sectors like Transportation
(Table 6.6), Drugs and Phannaceuticals (Table 6.10) and Industrial machinery (Table
6.12) sector. This implies that when there is an increase in the cost of production
through a higher wage, the foreign finns arc reluctant to invest more in these sectors.
This is also evidenced from the steady growth of the WAin these sectors. However,
the elasticity coefficient is also seen as positive for the sectors like Power and Fuel
(7.80), Chemicals (5.02) and Metallurgical (10.01). This may be due to an increase in
wage in relation to the cost of capital, which leads to a tendency to substitute FDI in
the place of labour. As a result, higher wage will induce the foreign firms to replace
129
Determinants of FDI
the existing labour-intensive technology by the labour-deepening technology and
hence, more FDI will flow to the respective sectors.
Higher prices bring more profit to the firms in most of the cases. Thus, an
increase in the price level is expected to be a positive determinant of the FDI flows. [t
is also evident from the result that there is a positive relation ship between FDI and
WPI for the sectors like Electrical, Food Processing, Metallurgical and Drugs and
Pharmaceuticals. This is because as the price level goes up, the profit for the firms
rises, unless the hike in price is cost driven. However, for the Transportation sector,
WPI has a negative sign Crable 6.6). This implies that one unit increase in WPI
reduces the FDI flow to the tune of 0.27 and vice versa. It implies that the increase in
the WPI for this sector is due to the increase in the cost of production in the sector. It
is also true that when the price rises due to the increased cost of production, the profit
may not go up. As a result, the foreign firms may not be interested to invest more.
Thus, profit is the driving force for any production process and is assumed to be a
positive determinant of the FDI flows. It is established for the Metallurgical sector
and [ndustrialmachinery sector. [n fact, the result shows that a percentage increase in
the profit would increase the FDI flow at 5.55 percentage (Table 6.9) and a unit
change in profit in the positive direction will raise the FDI flow to the level of 0.09
(Table 6.12). This is also supported by the growth rates of the variables profit and
FDI as both of them show high growth rates in these sectors (Table 6.1 J.
The above analysis reveals the fact that the FDI in the sectors are mostly
Brownfield Investment and the import intensity of the firms in the sector is very high.
However, this results need to be complemented in the Panel regression analysis. The
results of the Panel regression are presented in Table 6.13 through Table 6.18. The
present study has estimated two kinds of fixed effect models both with and without
group dummy variables along with the random effect models, for all the three
classification of the sectors. The fixed effect model without group dummy variables
provide a more meaningful result than the fixed effect model with group dummy
variables. Thus, the result of the fixed effect model without group dummy variables
are reported and interpreted here. It is also interesting to note that though the test
statistics like Hausman test favours the fixed effect model over the random effect
model, the direction of the effect of the explanatory variables are same in both the
model for all the groups. The result also shows that the variation in the magnitude of
the coefficients is very minimal. The present study reports and analyses both the
130
Oetenninants of FOI
results. In both the FE and RE model, the present study has corrected for the presence
of autocorrelation. The results of the fixed effect model without group dummy
variables and random effect model show that for the nine sectors as a whole, WPI,
PR, LPR, 1M and W A are the positive detenninants of FOI inflows into the sectors.
The elasticity coefficient of WPI is 1.34 (FE) and 1.20 (RE). It implies that the higher
price that may increase the profit of these sectors is an attracting for of the FOI
inflows into these sectors. The elasticity coefficient of PR is very small and it turned
out to be 0.002 (both FE and RE). This implies that one percent increase in PR would
raise FOI inflows by 0.002 percent. This implies that the higher profit of these
sectors attracts more FOI. It could also be observed from Table 6.13 that a percentage
increase in the LPR of the sectors results in 0.92 (FE) and 0.83 (RE) percentage
increase in the FOI inflows into the se':tors. This positive impact of LPR shows that,
the foreign firnlS are interested to use the higher LPR of these sectors to maximize
their profits. As a result, the FOI flows in these sectors have gone up. This implies
that the higher labour productivity of these sectors is an attracting force to the foreign
finns as higher the productivity of the labour input higher will be the profit for the
finns. The result also shows that 1M is a positive deternlinant of the FOI inflows into
these sectors. This portrays the import intensity of these sectors. In this context, it
could be argued that if the sectors are allowed to import more as per their
requirement, the FDI inflows will go up. The result shows that the elasticity
coefficients of WA arc 0.61 (FE) and 1.55 (RE). This may be because of the reason
that as wages rise rclatiYC to the cost of capital there is a tendency to substitute capital
in the place of labour. As a result, higher wage will induce the foreign finns to
replace the existing labour-intensive technology by the labour-deepening technology
and hence more FOI will flow to the respective sectors.
The negative detenninants in all these nine sectors are IR and EX. The
negative elasticity coefficient for IR is 0.77 (FE) and 1.17 (RE), for EX 0.97 (FE) and
0.38 (RE). Interest paid on the sectors loan is a cost for the production and is
assumed to bear a negative impact on the FOI flows to the respective sectors. This
may be because of the reason that the foreign finus try to raise fund from the local
market and they are purchasing the finn specific assets in the Indian currency. In this
situation, when the opportunity cost of domestic assets is high (as marked by higher
interest payment), it becomes a hurdle for the foreign finns to raise more funds. In
this case, the FOI inflows go down. Thus, the IR has a negative impact on the flow of
131
Oetenninants of FDI
FDI into these sectors. The negative elasticity between FOI and EX implies that the
export requirement policy of the Indian government deters the flow of FOI and the
foreign linns are reluctant to abide by a high export perfomlance in these entire nine
sector as a whole. though these sectors are also import-dependant (as import elasticity
is also positive).
The results of the lixed etTect and random effect model for the live major
sectors ha\c been presented in Table 6.14. The results show that, for the five sectors,
WP\, PR. GCF, EX and the LPR are the positive detenninants of FDI inflows. The
elasticity coefficient of WPI is 2.18 (FE) and 2.15 (RE). This implies that one per
cent decrease in WPI would attract FOI intlows by 3.57 per cent into these sectors.
This may be because of the reason that the higher profit due to higher WPI has
attracted more I'D! into these sectors. This is also conlinned from the positive and
signilicant value of the coefficient of PRo It can also be observed from the result that
there are no negative detenninants of FDI for these five sectors, though the intercept
is negative and it is 10.96 (FE) and 11.05 (RE). The other important positive
detenninant of FDI intlo"s into these sectors is EX. This implies that the foreign
limls in these sectors are interested to u"e the domestic resources to cater the global
market. The positi\c elasticity coerlicients of GCF imply that the higher capital
mtensity of these sectors helps the domestic linns to attract more foreign finns into
these sectors The elasticity coefficients of LPR are 0.35 (FE) and 0.37 (RE). This
positive impact of LPR shows that, the foreign finns are interested to use the high
LPR of these sectors to maximize their prolits. As a result, the FDI flows in these
sectors have gone up. This indicates that higher labour productivity of these sectors is
an mducement to the foreign finns as higher the productivity of labour input higher
wIll be the pralit for the lirms.
The resuits of the lixed effect and random effect model for the four minor
sectors have been presented in Table 6.15. The results show that, for the four sectors,
WI'I, LPR and 1M are the signilicant positive detenninants of FDI inflows. The
positive impact of WPI on the FDI flow assert that the better profit due to higher price
induces the foreign linns to invest more in these sectors. The coefficient of LPR is
very minimal i.e. 0.0005 (FE) and 00006 (RF). So, in this case. it is very hard to
interpret the result, nevertheless, LPR contributes positively to attract more FOI in
these sectors. The positive value of the coefticicnt of 1M i.e. 0.40 (FE) and 0.41 (RE)
implies that. the foreign linns in these sectors are more import dependent. In this
132
Determinants of FDI
context, it can be argued that the foreign firms uses only the location of India, but uses
the resources of other countries to exploit the rising price level of India.
The results of the pooled OLS regression show that for the nine sectors as a
whole, lR, PR, LPR and GCF are the positive determinants of FDI inflows into the
sectors (Table 6.16). The impact of GCF is very minimal since the elasticity
coefficient of GCF is merely 0.003 for GCF. The elasticity coefficient of lR is 1.02.
This implies that one percent decrease in lR would reduce FDr inflows by 1.02
percent. This implies that as the opportunity cost of capital goes up, the foreign firms
tlnds it profitable to replace the domestic capital with the foreign capital as a result
FDI flo\\' increases. It could also be observed from Table 6.16 that a percentage
increase in the PR of the sectors results in 1.03 percentage increase in the FDI inflows
into the sectors. It could be argued that higher profit in these sectors help to attract
more FDr. As far as the positive determinants of FDI inflows are concerned, PR has
the lowest effect. This implies that the higher profits in all these sectors have been the
secret behind attracting more FDr. The positive impact of LPR (2.50) implies that the
foreign fimb usc the high LPR of these sectors to maximize their profits. Thus, the
FDl tlows in these sectors have gone up. This shows that the higher labour
productivity of these sectors is an attracting force for the foreign fim1s.
The negative determinants in all these nine sectors are W A, EX and 1M. The
negati\'e elasticity coefficient for WA is 1.11, for EX 0.32 and for 1M 0.25. This
implies that, the higher wage retards the I'D! inflows into these sectors (Lucas 1993).
This is because wage is a cost of production and higher the cost lower will be the
profit. So the firms will not be interested to invest more. The negative elasticity
between FDI and EX implies that the export requirement policy of the Indian
gO\'emment d ~ t ~ r s the tlow of FDI and the foreign firms arc reluctant to abide by a
high export perfom1ancc in these entire nine sector as a whole, though these sectors
are not import-dependant (as import elasticity is also negative i.c. -0.25). The
negative relation between FDI and 1M implies that as a whole these sectors do not
rely on the import rather they use the domestic resources for the production process.
The results of the pooled OLS regression for the five sectors major group are
presented in Table 6.17. The results show that, for the five sectors, WPI, PR, GCF,
II'R and the LX an: the positiw determinants of FDI intlows. The elasticity
coeillcient of WI'I is 4.27. This implies that une per cent decrease in WPI would
attract FDI inflows by 4.27 per c ~ n t into these sectors. This may be because of the
133
Detem1inants of FD!
reason that the higher profit due to higher WPI has attracted more FD! into these
sectors. This is also confirmed from the positive and significant value of the
coefficient of PRo The result also shows that a percentage increase in the PR of the
sectors results in 0.03 percentage increase in the FD! inflows into these sectors. It
could also be observed from Table 6.17 that there are no negative determinants of FD!
for these five sectors, though the intercept is negative and it is 18.22. The other
important positi\ e detem1inant of FD! inflows into these sectors is EX (1.21). This
implies that the foreign fim1s in these sectors are interested to use the domestic
resources to cater the global market. This positive impact of LPR (2.26) shows that,
the higher profitability in these sectors due to the greater productivity of the labour
input attracts more FDI in these five sectors. The positive elasticity coefficients of
GCF (1.03) imply that the higher capital intensity of these sectors helps the domestic
fim1s to attract more foreign fimls into these sectors.
The results of the pooled regression for the four sectors m1J1or group are
presented in Table 6.18. The results show that, for the four sectors, WPI, IR, PR,
LPR and 1M are the positive determinants of FD! inflows and W A, GCF and EX are
the negative detem1inants of FD! inflows. The positive impact of WPI on the FD!
!low asserts that the better profit due to higher price induces the foreign firms to
imest more in these sectors. This is also supported by the positive impact of PR
(120). which implies that the higher profit to the firms in these sectors helps to bring
more FDI. The coefficient of IR is 0.03 and significant. This implies that the
investment by the overseas investors in Greenfield investment in these sectors as they
try to bring more capital-intensive technique to replace labour-intensive technique.
This proposition is well supported, as W A is a negative significant determinant ofFD!
111 these sectors. The coefficient of W A is -1.02. This implies that W A being a cost
detem1inant afle,ts the FDI inflows negatively. This is because, as W A increases, the
cost of production increases and PR decreases. As a result, the FDI inflow will be
reduced The positi\c value of the coefficient of 1M (1.66) implies that the foreign
firms in these sectors are more import dependent and more openness of these sectors
with regard to the import would attract more I'D! inflows. The positive coefficient of
I.PR (0.06) implies that the foreign fim1s use the more productive labour of India and
supplement thc imported capital goods to maximize their profit. This is well
supported by the result as both the PR and 1M bear a positive sign as the determinants
of FDI inflows in these sectors. The negative coefficients of GCF (-0.08) imply that
134
Deternlinants of FDI
the low capital intensity of these sectors do not induce the foreign firms to invest in
these sectors. rhe result also shows that WA (-1.02) and EX (-1.80) are the negative
determinants of 1'01 inflows in these sectors. Wage being a cost determinant is
expected to hay e a detrimental effect on the FDI inflows, but the negative impact of
EX implies that the export requirement policy of the government of India for the
foreign finns cine, not help to raise the FDI levcl in these sectors.
6,6, Conclusiun
The major conduslun from the above analysis is that the factors like gross output
(GO)' profit (I'Rl. exports (EX), gross \alue added (GYA), labour productivity (LPR),
gross capital fimnation (G(T) and the wholesale price index (WPI), imports (1M),
number of \\ or"-crs (\\'0). va lue of the tutal inputs used (IN). wages paid (W A) and
th.: interest paid (IR) an: th.: main detenninants of FDI inflows into the sectors.
IIll\\e\CT, th.: dlrc'ction of th.: Impac't of these variables in attracting FDI varies with
the sec'tors I he result shows that the higher profit in the major nine sectors attracts
nHln: I'D!. but these FDI are the Brownfield Investment. Thus. efforts should be
made on the part of the Indian planners to raise the Greenfield Investment as it
ensun:s ne\\ technology in the economy. Another important finding is that there is a
high IInpnrt-dependency among the finn. though the export requirement does not
,,:em lueratl\ e tn the foreign tinns In thi, situation. the policy requires to be such
that the domestic' content requirement for the f(,reign tinns (rather than going for
imports) is met and the export receives a boost from the foreign finns. It is often
ubserved that there ha\e been sustained efforts from the planners to raise the FDI
flows in India Ilnwner. the justification of more FDI illtn the Indiall land needs to
be examined in ternlS of its effects on the economy. In this context. this study tries to
analyze the dlech of Hli Oil the Indian econolllY both at the Illacro leyel as well as at
the sectoral k\ el. III the next chapter.
135
Detenninants of FDI
Table 6,1: The least Square Growth Trend of the Variables of Different Sectors
Food I'roccssing Sector
Year 1981-85 1981-90 1986-90 1991-98 1981-98
\\Pl 7871 7 590 7.592 9.271 9.389
\\'0 -7153
-2.699 3.216 2.709 0.684
\'J
8.374 6.275 9.193 3841 5.072
In 5.421 6 oj35 12.593 6230 6.467
If 12.223 5406 9.050 11.619 8.312
co 6.605 0.806 12695 6511 6.570
pr 58.507 23.804 21785 12 892 10.625
C\'J 15443 9537 13.345 8A35 7.326
lp'
20j 336
12.576 9.813 5575 6.597
gef 51.839 13691 39.299 8.375 7.747
Textile Sector
1981-85 1981-90 1986-90 1991-98 1981-98
\\ PI 5.814 6914 9.411 6.928 8051
10 3188 4.9"2 10.450 13.611 9339
IJ 6.270 7.832 11.236 16.765 11.580
III 1.069 7860 12.461 15804 II 849
"
9055 8491 8.676 18507 11.744
co 3 283 8564 14078 15.71 I 12.632
"
27289 17868 52912 8698 21.392
1:\;.1 13.602 I 1835 21 500 15 31 I 15746
[lp'
10U91 6.538 10005 1496 5.860
!.!l'f -0548 17593 79.339 20.809 19023
:\letallurgical Sector
Y car 1981-85 1981-90 1986-90 1991-98 1981-98
\\ pi 5:, 14 6914 9-1 I I 6.928 8.051
10 2 319 0683 0.890 2.349 1081
110 I U 703 4565 2207 9.551 3721
In 7644 7510 9A68 7.399 7479
I, I 089 6577 5498 10 118 9989
'0 7281 7236 9.506 8553 7573
P'
-3.914 2.741 47054 32.783 12.981
'Ia 5903 6 195 9651 12.937 7.873
lp'
:I ,0, ,474 8.684 10344 6.719
'ef
-b .102 4 9.265 3.706 8.565
Industrial Machiner Sector
Year 1981-h5 1981-90 1986-90 1991-98 1981-98
\\ pi
, S 14
6914 9411 6.928 8051
\\0
I X,8 -0077 -0.171 1.391 0464
\\''-1 8862 4.906 1.882 6 193 4 198
In
<;267 6.553 8.333 8.388 7 118
I, 21 243 6.211 2.865 4.558 5.858
'0
6.956 6 162 6.472 8.558
[p'
-0 _,13 0630 -5.978 15.929 7580
'\'J I I 182 5.098 1698 9047 6.064
;11"
9 176 5.179 I 873
75)0 5 575
'ef
-I 225 4481 8286 1.263 5.008
136
Dctenninants of FOl
Electrical E uipment Sector
Year 1981-85 Inl-90 1986-90 1991-98 1981-98
\\Pl 5814 6914 9All 6.928 8051
\'0 2941 1.569 2.172 2240 1.999
\\ a II 120 6.042 3.196 5.341 4.803
In
1674 8663 13.406 9.562 9009
I r II 624 10.505 15.190 6756 9781
go 4.935 8 568 13 189 9.134 8788
pr 16573 6.494 24092 10547 9.298
g\;1 13438 8.3 74 12.573 7.858 8.215
lpr 10 197 6.700 10.181 5.495 6095
gef -1.924 12.412 15.533 5.847 7.878
Transportation Sector
Year 1981-05 1981-90 1986-90 1991-98 1981-98
\\ pi 5 814 6914 9411 6.928 8051
\0 1.050 -0.427 o 198 ,276 0680
\'a 7.719 4.5.\3 2700 7.805 3909
In 6647 8.914 11.676 14406 9.837
I r 12.564 11.074 8 851 6588 9134
gO 7.234 7.753 10.013 14.048 9.133
pi 5.921 -4.185 7.357 26.258 12.233
'\ i.l 8580 4.763 5.424 12.988 7263
lpr 7452 5213 5.215 9404 6.539
ccf 9611 5.581 1096 32.631 10.559
Chemicals (other than fertilizer) Sector
Year 1981-85 1981-90 1986-90 1991-98 1981-98
\ pi 5 814 6914 9411 6928 8.051
\0 I 005 1980 2.028 5.345 2.826
\a 8300 6.846 4.089 7.644 5 867
III 7437 6947 5493 11216 7701
lr 8072 10 152 13.306 7.942 10.141
'0 8041 6953 5.959 11.904 8 169
pr 11964 ~ 901 4.149 30076 12.875
J\a 10024 6979 7.585 13826 9.554
lpr 8929 4.903 5446 8050 6544
'1.:1'
_, 189 98 I g 7 424 17 112 10A06
Power and Fuel Sector
Year 1981-85 1981-90 1986-90 1991-98 1981-98
WPI 6.377 6.227 5.897 9.980 8.778
\0 5904 1.85 I 3 101 3.720 1.638
\\ i.l 10.063 10067 14 167 8.321 5.624
In 15458 13614 12812 11.079 10963
I I 7066 12.340 9405 5 405 8285
'0 140R2 11.093 11 628 I 1.258 10.102
pr -I 418
2.667 -0.577
'\J 121 12 7388 9.569 11.643 8.064
lpr 5 862 5436 6.274 7.639 7 109
ref 5 196 5475 15.210 3.905 4.834
137
Detenninants of FDI
Drugs and Pharmaceuticals Sector
Year 1981-85 1981-90 1986-90 1991-98 Inl-n
WPI 5 814 6.914 9AII 6928 8051
10 3061 2.181 3.745 6002 3 863
\va 11.220 6.927 4.883 5.832 4.941
In 9.986 8.288 9.945 11.508 9822
Ilf
12.915 9213 9.252 12.250 11.240
go 10487 8.014 9.262 12675 9.835
lor 6.939 5.365 7 189 25 993 13.000
Igva 11654 7302 7.368 15 783 9.852
lior 8.337 5.012 3493 9.228 5.766
gcf 5012 11.302 23.316 12.106 13.230
Table 6.2: Least Square Growth Trend of the Variables of Different Sectors
Food Processing Sector
1991-95 1996-00 1991-00
Fdi 165.219 -28.112 27138
Ex 59.980 -7400 17520
1m 97.913 0.269 28.186
Textile Scctor
1991-95 1996-00 1991-00
Fdl 12521 I -40 285 4008
Ex 12.922 2.933 9777
1m -2263 -II 853 -2366
Metallurgical Sector
1991-95 1996-00 1991-00
Fdi 20:1199 12238 50659
Ex I 1.331 -0.143 4.530
1m -4.631 -6.965 -3443
Industrial Machinery
Sector
1991-95 1996-00 1991-00
Fdl 117479 -13.139 22.892
Ex -16.729 4.763 -6.1 J7
1m 17849 -5 771 0.272
Electrical Eq uipmcnt
Sector
1991-95 1996-00 1991-00
Fdl 96 154 -0.615 35687
Ex -0 126 5.925 In5
1m -2.112 -10.254 -I 416
Transportation Sector
1991-95 1996-00 1991-00
Fdl I 13.308 5.037 57.842
Ex
(, 033 -7.998 -3.848
1m 3254 130.108 24928
138
Determinants of FDl
Chemicals (other than
fertilizer) Sector
1991-95 1996-00 1991-00
Fd,
47701 -20.836 17.580
Ex -.1315 -10868 -5.349
1m -6.963 -4 162 -5356
Power and Fuel Sector
1991-95 1996-00 1991-00
Fd,
194.289 -28.141 60.994
Ex -17.914 -31074 -21.787
1m -11094 -12360 -12 372
Drugs and Pharmaceuticals
Sector
1991-95 1996-00 :991-00
fdl 77671 - L1 135 20.923
Ex 2.186 1545 3.889
1m -2.672 -4.591 -2.05 I
Table 6.3: Sargan's Criterion and the Selection of Functional Form for the
Sector-specific Determinants of FDI Inflows
Sectors s- Values Selected Functional Form
EP 120234.3202 Log-Imea
TE 1538106.712 Log-linea
ME 1.19056E+20 Log-linea
IN 2.9026E-06 Linea
EL 8.5281 E+ 32 Log-llIlcal
TR 244066E-09 Linea
CH 721887E+13 Log-linea
PF 2875718878 Log-linea
DP 5.27178E+17 Log-Imea
Table 6.4: Sargan's Criterion and the Selection of Functional Form for the
Determinants of FDI Inflows at the Sectoral Level of Indian Economy
Selected Functional
Sectors S-Values Form
pall I 48274E+46 Log-Imca
pml 18993E-19 Linea
pm] 1.1 9748EdO Log-Imea
139
Detenninants of FDI
Table 6.5: Multiple Linear Regression Estimation of FDII Function of PF Sector
(Dcpe d V bl L f FDI I fl ector) n ent ana e: og 0 n ows to PF S
Can 3.25
(0.28)
LPR 2.17
(I.\S)
IR 7.80
(3.44)**
1M 5.51
(4.40)**
WA 7S0
(2.05)***
Time 0.29
(096)
,
-
AdJ- R 0.74
D- W Statistics: 2.16
~ o t e : Numbers In Parentheses are t-statlstlcs
.* Denotes that coefficients are significant at 5% level
*** Denotes that coefficients are significant at 10% level
Table 6.6: Multiple Linear Regression Estimation of FDII Function of EL Sector
(Dependent Variable' Log of FDI Inflows to EL Sector)
Explanatory Variables Cocfficlents
Con 39.34
(-2.65)***
WPI 10.55
(3.41)**
EX -2.46
(-2.90)***
1M 950
(10.43)*
Time -0.22
(-0.34 )
,
-
AdJ- R 0.S6
DW Statistics 2.17
Note: Numbers In Parentheses are the t-stalistlcs
>I< Denotes that coefficients are significant at 1 % level
** Denotes that coefficients are significant at 5% level
."'. Denotes that coefficients are significant at I OO/u level
140
Table 6.7: Multiple Linear Regression Estimation of FJ>II Function of lR
or)
(D d epen enl Vanabk FDI Inflows III I R SeCI
Explanatory Variables Cocffi(lcnts
Con -lq4
! 21 )
WO 2327 6b2
(1328)'
WPI -0.27
(-4.75)"
IR 027
( 113)
WA -327
(-6.44)'
Time -3.24
(-5.74)'
,
-
AdJ- R : 0.91
D- W Statistics: 209
Note: Numbers In Parentheses are the t-statlstlcs
* Denotes that coefficients arc signIficant at I % level
** Denotes that coefficients arc significant at 50/0 level
... * Denotes that coefficients are significant at 10% level
Table 6.8: Multiple Linear Regression Estimation of FOil Function of CH Sector
(Dependent Variable Log of FDI Inflows to eH Sector)
Con 16.09
( 1202)'
GCF 203
(1864)'
1M 196
(1465)*
LPR 1008
(2084)*
WA 5.02
(922)'
IR
-192
(-735)*
,
-
AdJ- R
0.91
D- W Statistics 2.08
Note: Numbers In Parentheses are I-statistics
'" Denotes that coefficients arc sign! ficant at I level
141
Detenninants of FDI
Table 6.9: Multiple Linear Regression Estimation of FDII Function of FP Sector
(Dependent Variable' Log of FDI Inflows to FP Sector)
Explanatory VarIables Coefficients
I
! Con
7750
(3.06)**
1M 637
(381)**
WPI 15.66
(3.89 !**
IR 1.99
(1.13)
Time 048
(1 10)
-
,
Adj R . 0.93
D\\" StatisticS: 2.36
Note: ~ u m b c r s 111 Parentheses arc I-stallstlcs
** Denotes that coefficients arc slgnltlcant at Y);;) level
Table 6.10: Multiple Linear Regression Estimation of FDII Function of the ME
Sector
(Depend V' bl L f FDI I fl t ME Sector) ent ana e: og 0 n ows 0
:
ExplanatOfv Variables Coefficients
Con -53.50
(-4.97)**
IR -4.36
(-4.33)**
WPI 0.32
(292)**'
1M 1.79
(346)*'
.--
\VA 1001
(16.64)*
LPR 5.55
(5 I I )*
T1nlC -0.20
(-156 )
-
,
AdJ- R
. 0.99
D-W Statistics. 2.43
Note: Numbers In Parentheses arc t-statlstlcs
Denotes that coeffiCIents are slgmficant at 1 % level
.* Denotes that (,,;oefficlcnts arc significant at 5% level
Denotes that coefficients are sIgnificant at 10;;) level
142
Detcnninants of FDI
Table 6.11: Multiple Linear Regression Estimation of FDII Function of DP
Sector
(Depe d tV bl L f FDI I tl t DP Sector) n cn ana e: og 0 n ows 0
E.xplanatory V.nables Coefficients
Can
338.05
(2096)'
WPI 79.31
(21.14)'
1M 0.65
(2.51)'"
IR
16.86
(16.31)'
WA 48.84
(19.04)'
PR 3.08
( 1788)'
,
-
Adj R .0.99
DW Statistics 2.72
~ o l e : Numbers In Parentheses arc I-statIstiCS
,. Denotes that cocmcients afC signl ticant at 1 % level
Denotes thJt coefficients arc sIgnificant at 5% level
*.* Denotes that coefficients arc significant at 10% level
Table 6.12: :\lultiple Linear Regression Estimation of FDII Function of TE
Sector
(Depe d tV bl L f FDI I fl t TE Sector) n en ana e: og 0 n ows 0
Explanatory Vanables Coefficients
Con 13.81
(2.03)'"
LPR 3.27
( (97)'"
IR -4.03
(3.98)**
WA 009
(102)
Time 0.71
(5.84)'
,
Adj R 096
D-W Statistics Ig4
Note: /'I\umbcrs In Parentheses arc I-statIstICS
Denotes thJt coefficients arc Significant at I % level
Denotes th .n coefficients are significant <.It 5% level
Denotes that coefficients arc significant at 10
%
level
143
Detenninants of FDI
Table 6.13: :\Iultiple Linear Regression Estimation of FDII Function of IN Sector
(D d or) epen
ent Variable: FDI Inflows to IN Sect
Ex planatory Variables
CoeffiCients
Con
087
(3 80)**
LPR
000 I
( 1.07)
IR
0.12
(067)
'vVA
-008
(-2.58)***
PR
0093
(345 )**
Time 0.10
(4.51)**
. -
,
-
AdJ- R 0.83
D-W Statistics: 2.44
Note: Numbers m Parentheses are t-statlstlcs
** Denotes that coeffiCients arc significant at 5% level
... H Denotes that coefficients arc slgmflcant at 10
u
/o level
Table 6.14: Results of Panel Regression Estimation of the FOIl Function (for all
the nine sectors)
--
Coemelents
Explanator) Variables
FIXed Effect Model (Without Random Effect Model
-
Group Dummy)
-
Constant -1499 (-300)* -13.29 (-451)*
\liPI 135 (179)*** 1.20 (187)***
IR -0.77 (-2.23) ** -1.17 (-276)*
PR 0.17 (271)* 0.15(370)*
LPR 092 (2.17)" 0.83 (190)**
EX -0.97 (-441)* -0.38 (-189)**
1M 0.20 (1.73)*** 0.12 (112)
WA 0.61 (157)*** 1.55(281)*
Numbers In Parentheses arc t-statistics
Denotes that coeffiCients arc Significant at I % level
Denotes thut coeffiCients arc Significant at 5
u
/;, leve!
Denotes that coeffiCients arc slgmtict.lnt at 1 level
Hausman Test Statistic :- 1905 (0008)
144
I
Dctem1inants of FDI
Table 6.15: Results of Panel Regression Estimation of the FDII Function (for live
major sectors)
E wlJnJtor) \ .1rtJblcs
Coefficlcnts
FIXed Effect Model ( Without Random Effect Model
Group Dummy)
Constant
-10.96 (-343)- -11.05 (-397)-
WPI
218(318)- 2.15 (323)-
PR
0.002 (4 17)- 0.002 (4.28)'
LPR 035 (149) 037(1.56)
GCF 00014 (1.97)-' 0.001 (2.03)**
EX 0.33 (192)--- 0.31 (1.84)--'
I\:umbcrs 111 Parentheses are t-statlStiCS
Denotes that coefticlents are significant at I % level
.* Denotes thai coeffitlcnts are significant at 5% level
Denotes that coefficients are significant at 10% level
Hausman T cst Stallstlc- 025 (I 00)
Table 6.16: Results of Panel Regression Estimation of the FDII Function (for
four minor sectors)
E ,planatory Vanables Coefficients
FIXed Effect \1odcl (Without Random Effect Model
Group Dummy)
Constant 043(067) 0.51(013)
----
WPI 0.01 (249)' 0.009 (21 3 ).-
WA -001 (-I 60)"- -0006 (-044)
LPR 00005 ( 159) 0.0006 (199)"
1'-'1 004 (256)' 041 (1.56)-"
10 P'.lrcnthcscs Jrc the I-statistic
Denotes that coeffiCients arc slgmficant at 1% le\'el
Denotes that coctliclcnts arc Significant at 5% level
Denotes that coeffiCients arc slgnlfic,mt at 10%) Ic\. cl
Hausman Test Statistic - 1.751078)
145
Detem1inants of FD!
Table 6.17: Results of Pooled Regression Estimation of the FDII Function (for all
the nine sectors) with model SzR
z
(Dependent Variable: Log of I'Dl Inflows into nine different sectors of the Indian Economy)
Explanatory Vanables
Coefficients
Constant
-1.67
(-1122)'
IR
I 02
(3485)'
PR
1.03
(18.77)'
.---
WA -1.11
(-13.57)'
LPR 2.50
(91.21 )'
GCF 0.003
(10.88)'
EX -0.32
(-88.67)'
1M -0.25
(-28.65)'
'r'ote: Numbers in Parentheses are t-statistics
Denotes that coefficIents are SIgnificant at I % level
LR StatlStlc ~ 224.35
Table 6.18: Results of Pooled Regression Estimation of the FDII Function (for
five major sectors) with model SzRz
I Dependent \'anable: Log of FDllnflows into five different sectors of the Indian Economy)
bplanatory Van abies CoefficIents
Constant -1822
(-9.21)'
WPI 4.27
(10.51)'
PR
0.03
(866'
LPR
2.26
( 11.87)'
GCF
1.03
(379)'
EX
1.21
(7.55)'
Note: Numbers in Parentheses afC t-statlstics
Denotes that coefficients arc slg01ficant at 1 t% level
LR StatIstIc ~ 18.30
146
Determinants of FDI
Table 6.19: Results of Pooled Regression Estimation of the FDII Function (for
four minor sectors) with model SzRo
(Dependent Variable: FDI Inflows mto four different sectors of the Indian Economy)
Exolanatory Vanables Coefficients
Constrtnt 12.64
lJ
OI
)
WPI 0.03
--
(911 )*
WA -102
(-188)**
IR 003
(5.14)'
PR 1.20
(8.71)*
LPR 006
(329)
GCF -008
(-3.85)'
EX -180
( 1.97)
1M 1.66
(734 )'
Note: Numbers In Parentheses arc t-statlstlcs
*Denotes that coefficients are significant at I % level
Denotes that coefficients are slgmfil'ant at 5% level
LR Stalistie = 33.64
147
Chapter VII
Impact of FDllnllows on the Indian Economy
7.0. Introduction
There has been a growing interest and huge competition to strengthen the respective
attracting forces of FDI as a part of globalisation agenda in most of the developing
countries like India. The main interest for such agenda is to use these FDI in the
development process of the economy as FDI may provide intangible asserts including
technology, potential spill over and externalities, which are highly beneficial for host
country's economic growth. In the race for seeking more and more FDI inflows, the
countries have overlooked the fact that all the FDI do not benefit their host countries
similarly (Kumar 2000) The impact of FDI on the domestic economy mainly depends
on the domestic policy, the kinds of I'DI the domestic country receives and the strength
of domestic enterprises. The question of measuring the impact of FDI inflows in India is
pertinent, as FOI has become a prefened finance for growth than the fonnal contractual
agreements for foreign loans. FDI appears attractive to India because it involves a risk
sharing relationship with the investors from the home countries. Such risk sharing does
not exist in the fornlal contractual agreements for foreign loans. In fact, FDI appears
particularly attractive, as existing stocks are low in India. Low stocks of foreign owned
capital imply low flows of repatriated profits. However, the success in attracting FOI
will increase this counter flow over the years, which could exceed the alternative flow of
interest payments in the long run. The question of the cost of FDI to reduce risk must be
addressed, in any evaluation. in tenns of the benefits to be derived from substituting FDI
for foreign bonowings. These conflicting arguments make the measurement of impact
of FDI more challenging as it has a lot of policy implications. In chapter 3, the expected
measurable impacts of FDI on a host economy were modelled in a mathematical
framework. The cunent chapter is an endeavour to test empirically the hypothized
impacts of FDI on the Indian economy.
It is evidenced from the literature that the impact of FDI on the host economy can
be adjudged from two effects of FDI on the economy. These two effects include the real
effect and the financial effect. The real effect includes both qualitative and quantitative
effects. The quantitative effects of FDI include the effects on the domestic investment,
productivity, price level, income, and employment and export growth. The qualitative
effects of FDI include the effects on technological change, spillover effects and the
Impact of FD!
effects on structural change of the economy. The financial effects of FD! on the host
economy are the impact (measurable) on balance of payments. The direction (forward or
backward) of all these effects (both real and financial effects) as mentioned earlier,
depends upon domestic policy, the kinds of FD! that a country receives the strength of
domestic enterprises and the structure of the domestic economy.
In the backdrop of the foregoing discussion, the present chapter tries to address
the following issues:
What are the impacts of FD! inflows on the Indian economy at the macro
level')
How the FD! affects the economic behaviour of the sectors, which are
open to and receive FD! inflows?
In addition to this, the study also tries to evaluate the dynamic relationship of the
variables at the sectoral level. In order to estimate the impact of 1'01 on the Indian
economy, the study has considered only the impact on the macroeconomic variables like
investment, GOP, export, trade balance (TB), WPI and real effective exchange rate.
Indeed, these \ariables also constitute the set of major determinants of FD! inflows into
India. In this context, it is appropriate to test whether there is any feedback relationship
of these macroeconomic variables with the FDI inflows into India.
7.1. Measuring the Impact of FDI on the Indian Economy at the Macro Level:
The Methodology
In order to test the feedback mechanism between the FDI inflows and the
macroeconomic variables in India, this study uses the Granger causality technique. The
Granger approach to causality is based on the premise that predictability is analogous
with causality. It explains that the relationship between cause and effect is temporally
such that an effect cannot arise before its cause. A time-series X is said to Granger-cause
another series Y if the inclusion of lagged valucs of X improve the forecast of Y (i.e.
evident in a smallcr mean square error) compared to the forecast derived from the use of
lags of Yalone. As per the economic priori, the macroeconomic variables such as Gross
Domestic Product (GOP), Gross Domestic Capital Formation (CF), Export (EX), Trade
Balance (TBj, Real Effective Exchange Rate (REER) and Wholesale Price Index (WPI)
are said to cause FDI inflows. In tum, FDI is assumed to cause variation in these
macroeconomic variables. It implies that if the prediction of macroeconomic variables is
improved by using past values of For inflows, given that the relevant infonnation is
149
Impact of FDI
totally contained in the present and past values of these variables, the FDI inflows is said
to cause the macroeconomic variables, The rationale is similar to the test for causality
ti'Olll macroeconomic variables to FDI inflows,
The simplest approach to test for a short-term causality relationship between
macroeconomic variables and FDI inflows is to run a two-way Granger-causality tests,
Gi\'en the e<.:nnomic reasoning nn causality between macroeconomic variables and FDl,
there is no (/ {'riori reason tn exclude anyone of the causal directions, It analyses the
bivariate weakly stationary stochastic processes of all the macroeconomic variables and
FDI intlows, It is expeded that all the macroeconomic variables and the FDI inflows be
stationary, If not. the non-stationary variables need to be transferred into stationary
series. which is carried out by differencing tbe variables until they are stationary, It is
possible to npe<.:t that the <.:ausality stru<.:ture may be affected as the variables are
transferred tll stationary series. Thus. the Granger-causality tests describe only short-run
relationships bet\\ een FDI and macroeconomic variables as the long-run relationship
b.:tween the trend <.:omponents of the original series is removed by differencing the data.
Ilowever. it is possible to establish additional long-run relationships between the
\ ariables by standard Granger-causality tests augmented with error-correction terms
derived from the long-run coinlegrating relationships, Such tests are undertaken on I (0)
stationary \anabks to ensure \alId Illkrences. The error-correction temlS offer an extra
channel through \\ 11I<.:h causality may be observed, It is important to note that the error
com:ction cocrticlcnts are expected to capture the adjustments of the variables to their
long-run equIiilma. \\ hik the coefticients on lagged variables are expected to capture the
,hort-run dynamiCs or the models In contrast to the standard Granger test. the error-
correction model alit)\\" s for the tinding of two variables Granger cause one another. once
the coefficient on lhe rele\ant error-correction term is significant and even if the
coefficients on lagged output are not signiticant.
l:se of the cointegration and error-correction approach becomes more elaborate
and complex as the number of cointegrating vectors increase in line with an incrcase in
the number or \ariables used in analysis. When more than two cointegration vectors are
identified. the identitication of the paramekrs associated with causality is not
"practically simple". Thus, the approach presented in the following section specifics the
use of a set of simple and straightforward bi-variate Granger causality procedure (i,e,
between FDI and macroeconomic variables) to produce robust results:
150
Impact of FOI
Specification 1:
FOI, = a!O + a!! FOI,.! + .... + al! FOI,.! + b!! CF,.! + .... + b!! CF,.! + e!,
CF, = a!O + a!! CF,.! + .... + a!! CF,.! + b!! FOI,.! + .... + b!!FOI,.!+ e2,
Specification 2:
FOI, = a20 + a" FOI,.! + .... + a2! FOI,.! + b
2
! EX,.I + .... + b
2
!EX,.! + el,
EX, = a20 + a2! EX,.! + .... + a21 EX,.! + b" FOI'.I + .... + b
2
! FOI,.! + e2,
Specification 3:
FOI, = a'0 + al! FOI,.! + .... + a)! FDI,.! + bliGOP,.! + .... + bl!GOP,.! + elt
GOP, = a'll + a,! GOP,.! + .... + a)2 GOP,.! + b
l
! FOI,.! + .... + bJ!FDI,.! + e2,
Specification 4:
FOI, = 341l + a4! FOI,! + .... + a4! FOl,.! + b
4
! REER,.! + .... + b
4
! REER,.! + elt
REER, ~ a41l + a4! REER'.I + .... + a4! REER,.! + b
4
! FOl,.! + .... + b
4
! FOl,.! + e2,
Specification 5:
FOI, = a<1l + a<! FOI,., + .... + a5! FOI,.! + b
SI
SA,.! + .... + bs!SA,.! + e!t
SA, = aSIl + a5! SA,.! + .... + as! SA,.! + b" FOI,.! + .... + b" FOI,.! + e2t
Specification 6:
FOI, = a"" + a'd FOI,.! + .... + au! FOI,.! + b,,! WPI,.! + .... + b,,! WPl
t
.! + elt
\VPI, = a,," + a,,, \\'PI,.! T .... + au! WPI,.! + b'd FOI,.! + .... + be,! FOI,.! + e2t
Specification 7:
FOI, = a'il + a7! FOI,.! + .... + a7! FOI,.! + b71 1M,.! + .... + b
7
! 1M,.! + e!t
1M, = a'il + a"! 1M,.! + .... + a71 1:V1,.!+ bet FOI,.! + .... + b
7
!IM,.!+ e2,
Specification 8:
FOI, = aXil + aX! FOI,.! + .... + aK! FOI,.! + b
x
! CA,.! + .... + b
8
! C A,.! + elt
CA, = aXil + aX! C A,.! + .... + a8! C A,.! + b
s
! FDI,.! + .... + b
s
! FOI,.! + ez,
Where, FOJ. CF, EX, CiOP, REER, SA, WPI, 1M and C A are the foreign direct
investment inflows, gross fixed capital formation, export, gross domestic product at
factor cost, real effective exchange rate, total savings, wholesale price index, imports and
capital account of India respectively, t is the time period and e's are the error temlS in the
specifications. All the variables used in the model are estimated in their logarithms.
Thus, the series those contain a negative value are excluded from the analysis. These
series are the trade balance (TH) and the balance of payment (BOP) However, the uses
the Important variables of TB and BOP like the EX, 1M and C A to draw some inferences
on TB and BOP. It is important to note that the variables need to be stationary for a
151
Impact of FDI
Granger Causality test and accordingly the variables are made stationary after
differencing and a bi-directional causality test is conducted.
7. I. I. Selectioll of the Lag-Lellgth of Variables
Correct lag-length selection is critical for a causality test since excessively short lags
may fail to capture the causality. lead to omitted variables. bias in the remaining
cocfticients and likely to produce serially correlated errors. Meanwhile, too long a lag
leads to a rapid loss of degrees of freedom and to overparametarization. Considering all
equations in the system jointly in order to preserve the symmetry. the multivariate
generalization of the Akaike lnfonnation Criterion (All') and Schwarz Criterion (SC)
have been used as indicators of the correct lag-length, since the standard likelihood ratio
test is based on asymptotic theory and by itself is not very useful in small samples.
7,1.2. Statiollarity of Variables
The Granger-Causality test requires that all the variables should be stationary. In order
to test the stationarity property, all the variables have been checked for unit root using
Augmented Dickey-fuller (ADF) and Phillips-Perron test. The test covers the most
general specification for all the variables, which include a constant, a trend and lags.
The study uses the Granger causality test to examine the causal relationship between FDI
and the macroeconomic variables. The data used in this study are annual observation
ranging from 1979-80 to 2000-0 l. It is important to observe that the data on the FDI
flows into India are not available. as FDI was not a separate entry in the capital account
of the balance of payments (BOP) of India before 1979-80. As per the economic priori,
the variables included in the analysis in order to explain the causal relationship are FDI,
CF. EX. (iDP at factor cost. REER, SA. WPI. 1M and CA.
Before applying and interpreting the results of Granger causality, as general time
series procedures do, the study first examines the stationary nature of all the variables
(Table 7.1). It is evidenced from the unit root test that all variables except EX and WPI
are non-stationary at their log level. However, they are stationary at their log first
difference and arc integrated of order one, i.c., I (I). The series EX and WPI are
stationary at their second difference and thus, are I (2). The All' and SC show that the
152
Impad 011 1)1
optimum lags for each model would be different. The Granger-causality models an:
estimated after getting all the variables stationary and with the suited lag structure
The result of the Granger causality test has been presented in Table 7.2. Ih,
result reveals that there is a bi-directional causality between FOI and GOP. This implIes
that the FDI flow into India has helped to raise the GOP, and vice versa. Howewr. the
growth rates of FOI and GOP for the study period are 41.23 and 5.95 respectively. "hlch
implies the huge growth of FDI flow during the period cannot be explained by the
growth of GOP alone. As mentioned in the determinant analysis. the major factors
influencing the FDI flows in to India positively are the WPI and the REER. This is also
supported by the Granger causality test. The result of the test shows that there is a uni-
directional causality from REER to FDI and from WPI to FOI. These results are
consistent with the results of the macroeconomic determinants of FDI I. The results of
the detelminant analysis showed that REER has a negative impact on the FDI inflows,
whereas, the WPI has contributed positively towards the increased FOI inflows into
India. This may be due to the fact that FDI inflow has helped to exert a downward
pressure on the real effective exchange rate. It can be argued that FOr inflows into India
have raised the demand for the Indian currency in the international currency market and
thus have resulted in an appreciation of the Indian rupee. On the other hand, the
unidirectiotliill causality from WPI to FDI could be interpreted, as the upward movement
of the price level in the domestic market is able to lure the foreign firms to invest in India
as a result of which the FOr inflows into India have gone up2 This implies that India has
become a profitable land for investment for the foreigners as the appreciated Indian
rupee will help them to reduce the cost of firm specific assets (this can be done
particularly in case of the Brownfield Investment) and the appreciation of rupee will
ensure them higher profit in the long-run (as the value of the assets in appreciated
currency also appreciates). This is because a higher price in most cases brings higher
profit to the investors. However, the assumption of lower cost due to the advent of
foreign firm is clearly rejected here. This is because the WPI has gone up during the
study period (Table 7.3) and also the hypothesis of FDI does not Granger cause WPI is
not rejected in the Granger causality test. Thus, the set up cost of production cannot be
reduced with the entry of foreign firms in the Indian economy.
I For a diSCUSSion, see, Chapter 5.
l For a detailed diSCUSSion on the relation between FDI and WPI, see. Section 56 of the Chapter V
153
Impact of I'DI
There is a striking relation between CF and GDP, The result shows that there is a
ulll-direction relation from GDP to CT, but not the reverse, This implies that domestic
capital formation has not helped to raise the level of growth in the economy, This may
be bel'ause of the dominant role of the public investment as compared to private
i!1lestment during the study period, Further, the poor perfomlance of the public sector
has also led to the discouraging dkct on the GOP, Therefore, it is no surprise that the
gmemment of India IS gOll1g for disll1\estments in the public sector. However, the
result shows that there is a bi-directional causality between FDI and CF. It implies that
the FDI intlows into India ha\e been successful in raising the upstream and downstream
i!1lestment through its tUT\\ard and backward linkages, There is positive growth rate of
domestie capita I fOmlallon 0\ er the period from 1979-80 to 2000-0 I Crable 7.3), This
positive growth of the CF can be attributed to the twin reason of the steady decline in the
II1teresl rale ll\ er tl1L' stud\ period (re, interest ratc has a negative growth rate from
1979-8010 :!OOU-IIII and a hIgh gTl)\\th rate of the FDI 110ws (Table 7 JI When interest
rate goes down the investment I' a"umed to go up and "ic!! ,',T.\'(/ and when the toreign
tirms exert spillover effects, Ihe il1\estment in the domestic tirms goes up. The Granger
l'ausality test also supports this \ ie\\ that IR does not Granger causes CF as the null
hypothesis has been rejected at I per cent significance Inet This implies that the
IIKrease 111 the domes\lc In\ estment IS a result of a reduction in the interest rate
Jnd the spill 0\ er cfkct of the I 1>1 In 11<\\\ s The causality from CF to FDI could be
\ lewed as the result of lIlL'rea,ed Infrastructure fal'ilities in IndIa. It is argued earlier that
the major component of domestic investment has been the public investment and when
these investments are made tll a\'ail beller infrastnrcture, the Il,reign lirms arc interested
to invesl more, As a result, the FDl tlows go up
The result shows that there is a uni-dlrectional causality timn SA to 1'01 but not
the reverse, The trend pallem of SA shows that there has been a signiticant growth of
SA during the study pCTlod ( I he growth rate of SA during the period is 6.91, Table 7.3).
I his growth in SA may be due to the positi\e gn\\\th of the (i1W, as to the
Keynesian psychological la\\' of consumption, people knd tll sa\e a portion of their
IIlcome as II1come grows. Ihis is also supporlt:d by granger causality test as the
result shows that there IS uni-dlrl'l,tion causality from (j])\' to SA, IIowc\'cr, the uni-
dIrectional causality Irom SA to 111I may be because of the rcason that the increased
. 'icc, Branson, 19'14
154
Impact of FDl
Ion able fund in the Indian capital market has facilitated the foreign firms to raise the
desired fund flllm the domestic market.
The causality test shows that there is no causal relation from FOr to EX, rather a
causal relation is established trom EX to FOI. During the study period, exports in India
registered a positive growth rate (Table 7.3). This positive growth of export may be
attributed to the continuous glllwth of the Indian economy as evidenced from the high
gro\\th rate of the GDP. It is \\ell supported from the Granger causality test that there is
a bi-directional causal relationship between EX and GOP (Table 7.2). The trade balance
and the capItal account of the BOP of India have improved a lot during the period.
Ho\\eq:r, the improvement of the TB may be due to a relatively higher growth of EX
than 1M (Table 7.3) and the improvement of the CA may be the decline of the REER of
India. This is also supported by the granger causality test as the null hypothesis of REER
does not cause C A is rejected at 10 percent level. This is because when the exchange
rate of an economy appreciates: there will be capital inflow into that economy. This is
because: the appreciation of the domestic currency will ensure the higher return to the
capitaL Ho\\ c\ cr. I'DI has helped neither to improve the TB nor to C A (Table 7.2).
The aboH: analysis reveals that at the macro level, FDI has not been able to affect
the Indian economy to the maximum extent. It implies that the FOI flows have not
succeeded in raising the export though the GOP of India has got some boost from FOI.
As a result of this. the twin objective of using FDI as finance for growth and vehicle for
export promotion i, not fullilled simultaneously. This may be due to the fact that the
Indian economy has not been able to use its all FDl absorptive capacity. It implies that
the spirit in which the economy has been liberalized and exposed to the world economy
at the late eighties and early nineties has not been achieved yet, at the macro level.
Thus, it calls for a study at the sectoral level to examine whether the FOI inflows into the
sectors have contributed positively towards the development of the economy or no(') [n
this context, the following sections analyze the impact of FDI int10ws into the major
sectors of the Indian economy.
7.4. \lcasuring the [mpact of FU[ on the I ndian Economy at the Sectoral Leve[: The
\1 cthodulol:Y
In the pn:\\Ous section, the study t:mpirically tested the bi-directional causal relationship
between 11)1 and the macroeconomic variables. These macroeconomic variables
repn:sented the economy at an aggregate level. However, the results suggest that it is
155
Impact of FDI
very hard to establish any causal relation between FDI and the variables at the aggregate
level. Thus, it may provoke a question: Why does India need to invite foreign finns into
her land') For answering such a question, one needs to study the impact of FDI in depth.
In this context, it is important to find out the role played by the FDI inflows into the
sectors, where the strength of the economy lies. While analyzing the detenninants of the
FDI inflows, the main sectors have been identified. It includes nine sectors such as:
power and fuels, electrical equipment, transportation, Chemicals (other than fertilizers),
food processing, metallurgical, industrial machinery, drugs and pham1aceuticals and
textile. The literature on the impact of FDI inflows on the sectors demonstrates that FDI
affects the output, productivity (both total factor productivity and labour productivity),
\\ age, interest, and export. It is important to note that the sectoral level data of India are
available only from 1990-91 to 2000-0 I. Therefore, in order to measure the impact of
FDI on the sectors with robust estimation, the study pools the data of the nine sectors
O\'er the time period (i.e, 10 years). However, the pooled data sets raise special
problems in estimation. As Pesaran and Smith (1995) show, unlike in static models,
pooled dynamic heterogeneous models generate estimates that are inconsistent even in
large samples. The time period for this study is not high enough to allow individual
sector estimation (i.e. by reducing the number of explanatory variables). The numbers of
cross-section units are also not that big to exploit the cross-section dimension of the data.
While it is implausible that the dynamic specification is common to all sectors, it is at
least conceivable that the long-run parameters of the model may be common. The
estimation can be done either by averaging the individual sector estimates or by pooling
the data, if the data allows, and estimate the model as a system. The estimation of the
model as a system by pooling the data requires the efficiency of pooled estimation while
avoiding the inconsistency problem owing from pooling heterogeneous dynamic
relationships. In this context, the study applies the estimation of the model as a system
by pooling the data.
In order to examine the impact of FDI inflows on the sector specific variables like
labour productivity, output and export the study uses the Panel cointegration (PCONT)4
technique. A PCONT model is best suited because of the fol1owing reasons:
4 For a detailed diSCUSSion SCC, Pedronl, 200 I
156
Impact of FDl
The pooling of the data for nine sectors over ten years will increase the degrees of
freedom and also it will enable to explore the co-movement of the variables.
It will also enable to allow the short-run dynamics to be potentially
heterogeneous.
In order to estimate the PCONT relationship among the sector specific variables, the
PCONT model is described as follows:
FOil" = + V" .......... (7.1)
\Vhere.
Foreign [)irect Investment inflows to sector' i' at time period t.
x" = vector of right-hand side variables at time "t" for cross-section units "i" = 1 to
B, = coefficient vector, and
V" = error vector over N.
In the above equation, FOil and X are co-integrated with slopes which mayor may not
be homogeneous across 'i'. In this case, in order to have the co integrating relationship
among the variables, we require under the null hypothesis that Ho: PI = I for all i. Let,
be a stationary vector consisting of the estimated residual form the cointe!,'Tating
regression and the differences in the X values, and let,
I I
Q "lim. Ell' '(' C )(,c'j
, , __u
r I if (= I
be the long-run covariance for this vector process. It can be decomposed as:
Q, = n;' + r. + (,
where Q," is the contemporaneous covariance and r, is a weighted sum of
autocovariances. Using this notation, the expression for the between-dimension, group-
mean model panel FMOLS estimator is given as:
\' r I
A, If = N-' IlI(p" - p, )'r' xlI (p" - p, )s,: - Ty, ] ........... (7.2)
,=1 /=1 1=1
where
157
Impact of FDI
. "
, -(s -s')-(O I'" )'
'Ii - /I I 21/' UP'II
and
In the similar spirit, a between-dimension, group-mean panel DOLS estimator can be
constructed as follows. The DOLS regression is:
A
s" = a, T /3, p" + I y" !'.p" _, + lI" .......... (7.3)
From the equation 7.3, the group-mean panel DOLS estimator can be constructed as:
\ I I
AT> = [N-' I (I (I ::"s" )], ........... (7.4)
" -,-1 - \ I'" I
where
Z" is the 2(K + I)x I \'ector of regressOls and the subscript outside the brackets indicates
that \\ e are taking only the first element of the vector to obtain the pooled slope
coefficient.
The \ectur X has three sector specific variables namely; gross output (GO),
labuur producti\ity (LPR) and exports (EX). Since the number of observations in the
current study is limited to 90 only, the study has the following combinations of the
\ariabks to test the co-integrating relations among the variables. The combination of the
\ariables is as follows:
PCO:'l'T : (FOil", GO
II
, EX", LPR
II
)
There is a need for the verification of the stationary properties of the variables in
the analysis of a PCONT model and for the present study it has been carried out for all
the pooled \ariabks by the unit root tests as prescribed by Pedrini (\ 999)5 The usual
tests for the unit rout for a panel set of data are Levin-Lin Augmented Dickey-Fuller
(ADF) test. The test covers the most general specification for all the pooled variables,
which include a constant, a trend and lags. It is also necessary to determine the lag
length of the variables in the PCONT model. The Akaike Information Criterion (AIC)
and Schwarz Criterion (SC) are the common test-criterion to fix the lag length in any
model. However, in the current PCONT model, the lag length cannot exceed one, since
thl: time period is small (i.e. 10 years) and the explanatory variables vectur consists of
Fur details, sec, Pcdronl 1 <)99
158
Impact of I'DI
three variables i.c. GO, EX and LPR. Moreover. it is also appropriate to ha\ e a one la!,!
because the analysis is done for the yearly data.
The estimation of the PCONT model first needs to examine the unit-root properties of times
series variables in the system. It is imperative to mention here that the analysis of the
variables is carried out at their logarithmic value. The result of unit root tcsts for all the
variables used in the PCONT is given in the Table 7.4. It shows that all the four variables
namely FDI, EX, Wand IR are non-stationary at their log level. These variables are
stationary at their first difference and are inteb'Taled of order one i.e. I (I). Thus, in order to
carry out the analysis, all the variables are made stationary by differentiating once. The lag
lengths of the variables, as mentioned earlier. are decided by taking into the statistical logic
of the model. Given that the number of variables included in the PCONT and the time
dimension of the time series. the system cannot be tested for a lag length morc than one"-
Confirming the variables are stationary at their first difference, the PCONT model arc
estimated with the first difference of all variables. The analysis included computation of
individual sector-wise Fully Modified OLS (FMOLS) and Dynamic OLS (DOLS), Panel
Group FMOLS and Panel Cointegration.
The results of the individual FMOLS are presented in Table 7.5. The results show
that FDI has a co-integrating relation with GO in five sectors. It shows that there is a negative
relation between these two variables in sectors like PF and TR. This implies that the FDI
inflows into these two sectors have a deterrent effect on the out put of these sectors.
However. the results show a positive co-integrating relation between FDl and GO in the
sectors like FP, TE and IN. This may be due to the advent of better technology through FDL
in these sectors, which has helped them to grow at a faster rate. On the contrary, FDI has a
negative relationship with EX in three sectors namely, TR, CH and FP. However, there is no
positive relation between EX and FDI in any other sectors. This may be due to the export
requirement policy of the government. Thus, if the government is persisting with its policy
of export compulsion at least in these sectors, the goal cannot be achieved, as FDl does not
promote EX in these sectors. As far as the co-integrating relation between FDI and LPR is
concerned, the result shows that two sectors, i.e., TR and ME have a positive co-integrating
o [f lag length IS k, each of the n equation 111 the systcm wil[ contam Ilk-I coeffiCients. [n thc present casco
With 10 data points, the maximum [ag-Iength can be one, 111 which case PCONT "II[ ha\e to estimate 6
l:ocfficlcnts.
159
Impact of FDI
relationship where as two sectors i.e. FP and IN have a negative co-integrating relationship.
The positive relationship implies that FDI has helped to raise the LPR in the two sectors and
thus is will be appropriate to encourage FDI in these two sectors. But the negative
relationship of FDI and LPR in the two sectors calls for a judicious wage rate in the sectors,
since FDI is supposed to raise the LPR.
The result of the individual sector-wise DOLS has been presented in Table 7.6.
The result shows that FDI has a positive co-integrating relationship with the other
variables like GO, EX and LPR in two sectors namely, TR and ME, whereas it has a
negative co-integrating relationship in two other sectors i.e. FP and IN. This implies that
FDI has a positive contribution in transport and metallurgical sectors, but it has affected
the food-processing sector and the industrial machinery sector adversely. There is the
absence of any co-integrating relation in other sectors. The result of the Panel FMOLS
also suggests that the flow of FDI has not helped to raise the GO and LPR, rather it has
an adverse impact on the export of all the sectors (Table 7.7). The panel co-integration
result also reveals that there is no co-integrating relationship among the variables like
FDI, GO, EX and LPR in all the nine sectors (Table 7.8). This implies that when there is
an increase in the output, export or labour productivity of the sectors it is not due to the
advent of FDI. Thus, it could be concluded that the advent of FDI has not helped to
wield a positive impact on the Indian economy at the sectoral level.
In the overall analysis, it can be observed that the flow of FOI into the sectors
has helped to raise the output, labour productivity and export in some sectors but a better
role of FOI at the sectoral level is still expected. It also shows from the result of the
PCONT that a very minimal relation in these variables (output, labour productivity and
export) is established by the FDI inflows into the sectors. This may be due to a very low
flow of FDI into India (the flow of FDI into India is merely 1.2 per cent of the total FDI
flow to the developing countries and the percentage of FDI to the GOP of India is less
than 3). Nevertheless, the flow of FDI has contributed positively in some sectors.
7.6. Conclusion
It can be observed from the above analysis that at the macro level, FDI has been able to
affect the GOP and the CF of the Indian economy. However, it has failed to raise the
savings and to promote exports. It has also not been successful in bringing down the
price level in India. As a result of this, the twin objective of using FDI as finance for
growth and vehicle for export promotion has not been fulfilled. At the sectoral level of
160
Impact of For
the Indian economy, For has helped to raise the output, productivity and export in some
sectors. However, it can be observed from the result of the PCONT that a very minimal
relation in these variables (output, labour productivity and export) is established by the
For inflows into the sectors. This may be due to the low flow of For into India both at
the macro level as well as at the sectoral level. It implies that the spirit in which the
economy has been liberalized and exposed to the world economy at the latc eighties and
early nineties has not been achieved after so many years. This calls for a judicious
policy decision towards For both at the macro level as well as at the sectoral level.
Thus, in the following chapter the study tries to prescribe some policy suggestions for the
India economy so that India could attract more ror and the impact of such For is more
realized both at the macro level as well at the sectoral level.
161
Impact of FD!
Table 7.1: Unit-root test Results for Variables at the :\1aero Level
Variables
ADF
pp
Level First Level First
Difference Difference
LFDl
-2.93(2) -3.92(2) -2.23(2) -4.39(2)
LCF -3.55(2) -5.51(2) -441(2) -758(2)
LGDP -2.38(2) -342(2) -2.11(2) -4.32(2)
LWPI -1.31(2) -3.29(2) -1.34(2) -3.36(2)
LSA -3.07(2) -3.79(2) -4.05(2) -3.99(2)
LEX -2.01 (2) -2.31(2) -244(2) -3.72(2)
lIM . -242(2) -3.65(2) -141(2) -542(2)
LREER i -1.39(2) -344(2) -1.52(2) -3.26(2)
iLeA -2.21(2) -7.10(2) -3.15(2) -7.71(2)
Note: The umt root test regressions Include the Intercept and trend.
The values in the brackets show the lag augmentation on the basis of Ale.
The critical \alues for ADF and PP tests at 1 ' ~ o , 5% and 10% are -3.51, -2.89, and
-2. SX respectively.
Table 7.2: Granger Causality Test Results
Null Hypothesis F-Statistic
(j1W does not Granger Cause FDI 2.53***
I'D! does not Granger Calise GDP 246***
RITR does not Ciranger Cause FDI
5.73*
FDI docs not Granger Cause REER 0.03
1,:\ doc's not Grangn Cause FDI
5.60'
FDI docs not Granger Cause EX 0.14
CF docs not Granger Cause 1'01
2.91***
FD1 does not Granger Cause CF 3.18*'
\\" 1'1 does not (jranger Cause FDI
5.66*
FDI does not Granger Calise WPI 0.16
SA does not (jranger Cause FD!
5.17'
I'Dl does not Granger Cause SA 1.29
(T does not Granger Cause GDP
0.07
(j[)!, does not Granger Cause CF 16.27*
('[. docs not Granger Cause IR
n.02
[R does not Granger Cause CF 5.06'
!\otc: ' Denotcs significant at I per cent level
** Denotes significant at 5 per cent level
.. * Denotes significant at 10 per cent levcl
162
Impact of r DI
Table 7.3: Compound Growth Rate of the Variables
Variables
Least Square
Growth Rate
FDI
41.23
GDPFC 5.93
REER -3.95
IR
-1.63
EX 22 71
TB
-17.23
f--=---
CF 6.12
WPI 8.14
SA 6.91
1M 7.69
CA 11.42
Table 7.4: Unit-root Test Results for Variables for PCONT
Variables
ADF
Level First
Difference
LFDI -4.21 -7.91
LGO -2.72 -5.92
LEX -0.65 -3.24
LLPR -1.33 -3.36
~ o t e : The unit root test regressIOns Include the mtercept and trend.
The critical values for ADF test at 1';0.5% and 10% are -4.06, -3.46, and
-3.15 respectively.
Table 7.5: Individual Sector-wise FMOLS
Sectors Coefficient of GO Coefficient of EX Coefficient of LPR
--------
PF -4.92 (-2.62) 102 (0.05) 3.16 (1.22)
EL -4.33 (-1.09) 6.93 (1.00) -0.08 (-0.33)
TR -1.04 (-2.06) -1.50 (-2.80) 3.29 (230)
CH -2.88 (-1.52) -1.74 (-4.71) 3.35 (0.69)
FP 4.59 (264) -1.77 (-4.00) -3.62 (-2.46)
ME -0.38 (-1.05) -0.26 (-0.79) 4.58 (2.39)
DP 2.13(0.83) 3.22 (1.79) 0.63 (-0.23)
TE 7.33 (2.36) 1.44 (0.67) 1.92 (033)
IN 5.46 (2.66) 0.74 (-0.13) -5.96 (-3.63)
Note: FIgures m parenthesIs are t-statlstlcs
163
Impact of FDI
Table 7.6: Individual Sector-wise DOLS
Sectors
DOLS
PF
3.16 (122)
EL
-0.08 (-033)
TR 3.29 (2.03)
CH 3.35 (0.69)
FP
-3.62( -2.46)
: ME
4.58 (2.39)
-
DP
0.63 (-0.23)
TE 1.92 (0.33)
IN -5.96 (-3.63)
Note: F I ~ u r e s In parenthesIs are t-statlstlcs
Table 7.7: Panel Group FMOLS Result
-
Coefficient of GO I Coefficient of EX Coefficient of LPR
0.66 (0.04)
i 0.90 (-3.05) 0.81 (0.00)
Note: Figures In the parenthesIs are the t-statlstlcs
T bI 77 PIC' a c : ane olllteeratlOn R esu t
Panel rho-stat 0.21
Panel PP-stat -7.0 I
Panel ADF-stat -5.56
..
Note: The cntlcal values for Panel rho-stat, PP-stat and ADF-stat are 1.36, -10.03 and
-7.58 respectively.
164
Chapter VIII
8.0. Introduction
The main objective of this study was to analyze the impact of FDI inflows on the
Indian economy. The study also tried to explore the proximate determinants of the FDI
flows to India. In this regard, the study developed a general framework for analyzing
the determinants and the impact of FDI inflows both at the macro as well as at the
sectoral leve 1, based on theoretical justifications. The main findings of the present
study could be summarized in the following ways.
8.1. Major Findings of the Study
8.1.1. Trelld, Compositioll lIlId Dimellsiolls of FDI
In order to ha\'e some preliminary knowledge on the stocks of the FDI at the beginning of
the 1991 economic policy, the present study, has tried to explore different dimensions of
the FDI in India from the period of Independence till 1991. Further, the study also has
tried to analyze the distribution of the stock of FDI among different sectors. As a part of
the policy, Indian economy was liberalized in the mid 80s'. In order to have a complete
assessment of the policy of the government of Indian on the FDI inflows, a trend analysis
of the FDI inflows from 1979-80 to 2000-0 I has carried out. The study has derived the
following inferences from the trend analysis:
From 1947-48 to 1990-91, there was an absolute increase in the FDI stock.
During the above period, manufacturing sector gained more attention by the
foreign investors as compared to other sectors (such as mining and petroleum).
This may be due to an import substituting policy in India during the said period,
which resulted more imports of manufacturing products. Therefore, the
liberalization in the manufacturing sector helped to attract more FDI into it. The
overall picture of FDI flows to India was very low before 1991, of course with the
exception of the FDI flows to the manufacturing sector.
In the post-liberalization period, the FDI inflows have increased significantly.
However, the flow of FDI is low in comparison to the other developing countries
Summary, Conclusion and Poltcy Suggestions
like China, Thailand, Indonesia and Vietnam. The analysis also shows that there
is a relatively more increase in the financial collaboration than the technical
collaboration because of the relaxation of the nonns in the financial sectors.
The analyses of the origin of FD! inflows to India shows that the new policy has
broaden the source of FD! into India. There were S6 countries in 2000 as
compared to 29 countries in 1991, whose FDI was approved by the Indian
Government. Thus, the number of countries investing in India has increased after
the reforn1. Nevertheless, still a big share of FD! comes from only a few
countries. The analysis also reveals the fact that during the liberal regime
beginning from August 1991, developing countries such as Mauritius, South
Korea, Malaysia and Cayman Is!ands have made their appearance on the list of
major investors.
It is important to note that though food-processing sector attracted less I'D!
inflows in the post-liberalization period, it recorded a significant growth in the
I'D! flows. This may be because of the agrarian nature of the Indian economy.
However, the growth rate of the FDI inflows to other sectors such as
transportation, electrical equipment and metallurgical sectors is not so much
encouraging baring the telecommunication sector.
The state-wise approvals in value tenns up to 2001 indicates high concentration in
Maharastra (17.13 per cent), Delhi (12.22 per cent), Tamil Nadu (8.37 per cent),
Karnataka (7.82 per cent), Gujarat (6.33 per cent) and Orissa (3.09 per cent),
which together accounted for more than 50 percent of approval during 1991-2000.
This implies that the sates having better infrastructure facilities attract more FD!
(States like Delhi, !\1aharastra, Karnataka, Tamil Nadu and Gujurat have a better
infrastructure facility than the all India level).
S.2. Determinants of FDI Inflows into India
The objective of the study in the detenninant analysis was to explore the proximate
detenninant of the FD! inflows both at the macro level as well as at the sectoral level.
166
Summary. Conclusion and Policy Suggestions
For the macro level analysis. the important determinants of FDI inflows into India are
the real effective exchange rate (REER), interest rate OR), the wholesale price index
(WPI) and the GOP at factor cost. The result of the macro level analysis could be
summarized below as:
8.2.1. Macro Level Allalysis
The result shows that interest rate is the deterrent force while REER and WPI
are the attracting force for the FDI inflows into India. The elasticity coefficient
between FDI inflow and IR is 1.19, which implies that one per cent increase in
interest rate causes 1.19-percentage decrease in FOI inflows into India. This
may be because the overseas investors try to extract fund from the local market
and the foreign firms are purchasing the firm specific assets in the Indian
currency.
Contrast to this, the real effective exchange rate does not portray the predicted
negative sign. It is argued that the depreciation of the host currency against the
home would attract more FOI inflows into the host country. However, the
result shows that the elasticity coefficient between REER and FDI inflows is
positive and it is 5.41. This may be because the appreciation of the Indian
rupee against the 36 major trade partner countries of India has helped the
foreign firms to acquire the firm specific assets form these countries cheaply
and it results higher profit to the foreign firms.
The other important promotive force of the FDI inflows into India is WPL The
positive sign of WPI is in accordance with the predicted sign. The result shows
that the elasticity coefficient between WPI and FDI inflows is 9.21, i.e. one per
cent increase in WPI causes 9.21 per cent increase in FOI inflows into India. It
implies that the higher price level of the Indian economy has been able to
attract the foreign firms to her land. It may be the result of higher price as in
most cases brings higher profit to the investors.
167
Summary, ConclusIOn and PolIcy SuggestIons
The GDPFC, which retlects the market size of the host country, is assumed to
have a significant positive intluencc on the FDI intlows. This proposition is
amply supported by the theoretical and empirical literature on FDI. However,
results indicate that GOPFC oflndia is a significant negative detenninant of the
FDI inllows into India. It may be due to the low contribution of the
manufacturing sector toward the GOP as compared to the other major sectors
such as Agriculture and the Service sector.
8. :!. :!. Sc'c(o/'a I Lc'l'l'1 A /Ill Irs is
The sectors considered for the analysis been power and fuels (PF), electrical equipment
(EQ). transportation (TR), Chemicals (other than fertilizers) (CH), food processing
(FP). metallurgical (ME). industrial machinery (IN), drugs and phannaceuticals (OP)
and textIle ITE). Four kinds of empirical analysis have been undertaken in the present
study to know the determinants of FDI inflows at the sectoral level. Initially, the study
explored the sector-specific determinants of FDI inflows. Then, all the nine sectors
\\ as classified into three different groups vi=. all nine sectors as one group, major
sectors group and the minor sectors group. This classification is undertaken to account
for the heterogenetty of the FDI intlows into the sectors. The top five FDI receiving
sectors constituted the major group and it includes power and fuels, electrical
equIpment, transportation. Chemicals (other than fertilizers), and food processing. The
bottom four sectors form the minor group and it included metallurgical, industrial
machinery, drugs and pharmaceuticals and textile. The major determinants of FDl
inflows at the sectoral level was gross out put (GO), profit (PR), exports (EX), degree
of openness (OPEN), gross value added (GY A), labour productivity (LPR), total factor
productivity (TFP), gross capital fomlation (GCF), wholesale price index (WPI),
imports (1M). number of workers (WU), value of the total inputs used (IN), wages paid
I \\. AI and the interest paid (lR). The result of the sectoral level analysis could be
summarised as below:
Ii.:! :! I S('('(()/-.\j)('CI/ic ..tllall'sis
hH the individual sector LPR is a positive determinant of FOI flows in the
sectors like Power and Fuel and Metallurgical sector. from the result, it can be
168
observed that the elasticity coefficient of LPR is more in the Metallurgical
sector (5.55) than the Power and Fuel sector (2.17). This positive impact of
LPR shows that foreign firms are interested in using the steady growth of LPR
of these sectors to maximize their profits. As a result, the FDI flows in these
sectors have gone up. This implies that the higher labour productivity of these
sectors is an attracting force to the foreign firms as higher the productivity of
the labour input higher will be the profit for the firms.
The result shows that IR is a negative determinant of the FDr flows into the
sectors like Power and Fuel. Chemical (other than Fertilizer), Metallurgical and
Textile sectors. This may be because of the reason that the foreign firms try to
raise fund from the local market and they are purchasing the firm specific assets
in the Indian currency. In this situation, when the opportunity cost of domestic
assets is high (as marked by higher interest payment), it becomes a hurdle for
the foreign firms to raise more funds. In this case, the FDI inflows go down.
Thus, the IR has a negative impact on the flow of FDI into these sectors. For
all these sectors, it can be observed that the elasticity coefficient of rR is the
highest for the Power and Fuel sector (i.e. -7.80) and it is lowest for the
Chemical sector (i.e. -192). However, IR has a positive impact on the flow of
FDI in the Drugs and the Pharmaceutical sector. The result reveals that one
percent increase in IR causes 16.86 percent increase in the FDr inflows into this
sector. This implies that the FDI in this sector is Greenfield investment
because, In spite of a reasonably high growth rate of IR in this sector, the FDI
flow has gone up. It suggests that the foreign finllS invest the fund in their own
currency rather than relying on the Indian capital market.
Import is negatively related to FDI in two sectors, namely, Food processing
sector and the Drugs and Pharmaceutical sector. This may be because of the FP
sector, which mainly depends on the Indian market rather than relying on the
t<m:ign market and for the DP sector the higher transportation cost associated
with the imports compel the sector not to depend on imports. It is also because
of th" Indian Patent Act 1970, which allows process patents in the vital areas
169
Summary, ConclusIOn and Policy Suggestions
including drug production, which is like to have bearing on self-reliance of the
DP sector. It could be observed that the elasticity coefficient of 1M is -6.37 in
the FP sector and -0.65 in the DP sector. However, there is a contrasting sign
of 1M for four sectors, where 1M bears a positive sign. These sectors are Power
and Fuel (elasticity coefficient is 5.51), Electrical (elasticity coefficient is 9.50),
Chemicals (elasticity coefficient is 1.96) and Metallurgical (elasticity
coefficient is 1.79). This is also evidenced from the growth rates of 1M and
FDI that when there is a fall in the growth of 1M in these sectors the flow of
FDI have also gone down. This implies that these sectors are more import
based. This also shows that more openness of these sectors with the reduction
in the import barrier will help to raise the FDI in these sectors. If the foreign
firnls are interested in using the domestic production facility to cater the
international market, then the export should be a positive deternlinant of FDI
!lo\\'s. However, when the foreign firms are interested to meet the domestic
market but are compelled to meet the export requirement (as in the case of the
Indian economic policy), then FDI flow will be reduced. The regression result
of the Electrical sector shows that the elasticity coefficient of export is negati ve
and it is -2.46. This implies that the export requirement policy has a deterrent
effect on the flow of FDI into this sector.
The Wages paid (WA) figures as a cost to the production process of a firm and
is assumed to be a negative determinant for the MNEs activity. The result
shows that W A is a negative determinant of FDI flows into sectors like
Transportation, Drugs and Pharmaceuticals and Industrial machinery sector.
This implies that when there is an increase in tht:! cost of production through a
higher wage, the foreign firms are reluctant to invt:!st more in these sectors. This
is also evidenced from the steady growth of the WAin these sectors.
I !owever, the elasticity coefficient is also seen as positive for the sectors like
Power and Fuel (7.80), Chemicals (5.02) and Metallurgical (10.01). This may
be due to an increase in wage in relation to the cost of capital, which leads to a
tendency to substitute FDI in the place of labour. As a result, higher wage will
induce the foreign firms to replace the existing labour-intensive technology by
170
the labour-deepening technology and hence more FDI will flow to the
respective sectors.
It is evident from the result that there is a positive relationship between FDI and
WPI for the sectors like Electrical, Food Processing, Metallurgical and Drugs
and Pharmaceuticals. This is because as the price level goes up, the profit for
the firnls rises, unless the hike in price is cost driven. However, for the
Transportation sector, WPI has a negative sign. This means that one unit
increase in WPI reduces the FDI flow to the tune of 027 and vice versa. It
also implies that the increase in the WPI for this sector is due to the increase in
the cost of production in the sector. It is true that when the price riscs due to
the increased cost of production, the profit may not go up. As a result, the
foreign firms may not be interested to invest more. Thus, profit is the driving
force for any production process and is assumed to be a positive determinant of
the FDI flows. It is established for the Metallurgical sector and Industrial
machinery sector. In fact, the result shows that a percentage increase in the
profit would increase the FDI flow at 5.55 percentage and a unit change in
profit in the positive direction will raise the FDI flow to the level of 0.09. This
is also supported by the growth rates of the variables profit and FDI as both of
them show high growth rates in these sectors.
From the above analysis, it can be observed that JODI in the sectors are mostly
Brownfield Investment and the import intensity of the firms in the sector is very high.
However, this results need to be complemented in the Panel regression analysis.
8.:!.:!.:! Sec/or- \Ii.IT Allalysis
The results of the fixed effect model without group dummy variables and
random effect model show that for the nine sectors as a whole, WPI, PR, LPR,
1M and W A are the positive determinants of JODI inflows into the sectors. The
elasticity coefficient of WPI is 1.34 (FE) and 1.20 (RE). The higher price that
may increase the profit of these sectors is an attracting for of the FDI inflows
into these sectors. The elasticity coefficient of PR is very small and it turned
171
Summary, Conclusion and Polley Suggestions
out to bc 0.002 (both FE and RE). This implies that onc percent increase in PR
would raise FDI inflows by 0.002 per cent. This means that the higher profit
of these sectors attracts more FDI. It could also be observed that a percentage
increase in the LPR of the sectors results in 0.92 (FE) and 0.83 (RE) percentage
increase in the fDI inflows into the sectors. This positive impact of LPR shows
that, the foreign firms are interested to use the higher LPR of these sectors to
maximize their profits. As a result, the FDI flows in these sectors have gone
up. Higher labour productivity of these sectors is an attracting force to the
foreign firms as higher the productivity of the labour input higher will be the
profit for the firms. The result also shows that 1M is a positive determinant of
the I'D! inflows into these sectors. This portrays the import intensity of these
sectors. In this context, it could be argued that if the sectors are allowed to
import more as per their requirement, the FDl inflows will go up. The result
shows that the elasticity coefficients of W A are 0.61 (FE) and 1.55 (RE). This
may be because of the reason that as wages rise relative to the cost of capital
there is a tendency to substitute capital in the place of labour. As a result,
higher wage will induce the foreign firms to replace the existing labour-
intensive technology by the labour-deepening technology and hence, more FDl
will flow to the respective sectors.
The negative determinants in all these nllle sectors are IR and EX. The
negative elasticity coefficient for IR is 0.77 (FE) and 1.17 (RE), for EX 0.97
(FE) and 0.38 (RE). Interest paid on the sectors loan is a cost for the
production and is assumed to bear a negative impact on the FDI flows to the
respective sectors. This may be because of the reason that the foreign firms try
to raise fund from the local market and they are purchasing the firm specific
assets in the Indian currency. In this situation, when the opportunity cost of
domestic assets is high (as marked by higher interest payment), it becomes a
hurdle for the foreign firms to raise more funds. In this case, the FDl inflows
go down. Thus, the IR has a negative impact on the flow of FDl into these
sectors The negative elasticity between FDl and EX implies that the export
requirement policy of the Indian government deters the flow of FDl and the
172
Summary, ConclusIOn and Policy SuggestIOns
foreign firms are reluctant to abide by a high export performance in these entire
nine sector as a whole, though these sectors are also import-dependant (as
import elasticity is also positive),
The results of the fixed effect and random effect model for the five major
sectors show that, for the five sectors, WPI, PR, GCF, EX and the LPR are the
positive determinants of FD! inflows, The elasticity coefficient of WPI is 2.18
(FE) and 2.15 (RE). One percent decrease in WPI would attract FD! inflows by
3.57 per cent into these sectors. This may be because of the reason that the
higher profit due to higher WPI has attracted more FD! into these sectors. This
is also confirmed from the positive and significant value of the coefficient of
PR. It could also be observed from the result that there are no negative
detemlinants of FD! for these five sectors, though the intercept is negative and
it is 10.96 (FE) and 11.05 (RE). The other important positive determinant of
FD! intlows into these sectors is EX. This implies that the foreign firms in
these sectors 3re interested to use the domestic resources to cater the global
market. The positive elasticity coefficients of GCF imply that the higher
capital intensity of these sectors helps the domestic firms to attract more
foreign finllS into these sectors. The elasticity coefficients of LPR are 0.35
(FE) and 0.37 (RE). This positive impact ofLPR shows that, the foreign timlS
are interested to use the high LPR of these sectors to maximize their profits. As
a result, the FDI flows in these sectors have gone up. Higher labour
productivity of these sectors is an inducement to the foreign firms as higher the
productivity of the labour input higher will be the profit for the firms.
The results of the fixed effect and random effect model for the four minor
sectors show that, for the four sectors, WPI, LPR and 1M are the sih'llificant
positive determinants of FD! inflows. The positive impact of WPI on the FD!
flow assert that the better profit due to higher price induces the foreign firms to
invest more in these sectors. The coefficient of LPR is very minimal i.e.
0.0005 (FE) and 0.0006 (RE). So in this case it is very hard to interpret the
result, nevertheless, LPR contributes positively to attract more FDI in these
173
s e ~ t o r s . The positive value of the coefficient uf 1\1 i.e. 0.40 (FE) and 0.41 (RIo,
implies that, the foreign firnls in these sectors are more import dependent In
this context, it could be argued that the foreign fimls uses only the ilK3110n ot
India, but uses the resources of other countries to exploit the rising price Ie\ el
of India.
The results of the pooled OLS regression show that for the nine sectors as a
whole, IR, PR, LPR and Gel' are the positive determinants of FDI inflows into
the sectors. The impact of Gel' is very minimal since the elasticity coefficient
of(jCF is merely 0.003 for Gel'. The elasticity coefficient of IR is 1.02. This
implies that one percent decrease in IR would reduce FDI inflows b) 1 1)2
percent. This implies that as the opportunity cust of capital goes up. the
foreign finllS finds it profitable to replace the domestic capital with the lorelgn
capital as a result FDI flow increases. It can also be observed that a percentage
increase in the PR of the sectors results in 1.03 percentage increase in the FDI
inflows into the sectors. Higher profit in these sectors help to attract more FDI.
As far as the positive detemlinants of FDI inflows arc conccrned. PR has the
lowest effect. This implies that the higher profits in all these sectors have been

the secret behind attracting more FDI. The positive impact of I.I'R (2501
implies that the foreign fimls use the high LPR of these sectors to nIaXlml/e
their profits. Thus, the FDI flows in these sectors have gone up. This shows
that higher labour productivity of these sectors is an attracting force for the
foreign firms.
The negative detemlinants in all these nine sectors arc W A. EX and IM_ The
negativc elasticity coefficient for W A is 1.11. for EX 0.32 and for 1M 0.25.
This implies that, the higher wage retards the 1'01 intlows into these sectors
(Lucas 1993). This is because wage is a cost of production and higher the cost
lower will be the profit. So the fimls will not be interested to invest more. The
negativc elasticity between I'D! and EX implies that the export requirement
policy of the Indian government deters the flow of FDI and the foreign fimls
are reluctant to abide by a high export perfornlance in these entire nine sector
t74
Summary, ConclusIOn and Policy Suggestions
as a whole, though these sectors are not import-dependant (as import elasticity
is also negative i.e. -0.25). The negative relation between FDI and 1M implies
that as a whole these sectors do not rely on the import rather they use the
domestic resources for the production process.
For the five sectors, WPI, PR, GCF, LPR and the EX are the positive
determinants of FDI inflows. The elasticity coefficient of WPI is 4.27. This
means that one per cent decrease in WPI would attract FDI inflows by 4.27
percent into these sectors. This may be because of the reason that the higher
profit due to higher WPI has attracted more FDI into these sectors. This is also
confirmed from the positive and significant value of the coefficient of PRo The
result also shows that a percentage increase in the PR of the sectors results in
0.03 percentage increase in the FOI inflows into these sectors. It can also be
observed that there are no negative determinants of FOI for these five sectors,
though the intercept is negative and it is 18.22. The other important positive
determinant of FDI inflows into these sectors is EX (1.21). The foreign firms
in these sectors are interested to use the domestic resources to cater the global
market. This positive impact of LPR (2.26) shows that, the higher profitability
in these sectors due to the greater productivity of the labour input attracts more
FDI in these five sectors. The positive elasticity coefficients of GCF (1.03)
imply that the higher capital intensity of these sectors helps the domestic fimls
to attract more foreign firms into these sectors.
The results show that, for the four sectors, WPI, IR, PR, LPR and 1M are the
positive detemlinants of FOI inflows and W A, GCF and EX are the negative
detemlinants of FDI inflows. The positive impact of WPI on the FDI flow
asserts that the better profit due to higher price induces the foreign firms to
invest more in these sectors. This is also supported by the positive impact of
PR (l.20), which implies that the higher profit to the firms in these sectors
helps to bring more FOr. The coefficient of IR is 0.03 and significant. This
implies that the investment by the overseas investors in Greenfield investment
in these sectors as they try to bring more capital-intensive technique to replace
175
labour-intensive technique. This proposition is well supported, as W A is a
negative significant determinant of FDI in these sectors. The coefficient of W A
is -1.02. This implies that W A being a cost detemlinant affects the FDI
inflows negatively. This is because, as W A increases, the cost of production
increases and PR decreases. As a result, the fDI inflow will be reduced.
The positive value of the coefficient of 1M (1.66) implies that the foreign firms
in these sectors are more import dependent and more openness of these sectors
with regard to the import would attract more FDI inflows. The positive
coefficient of LPR (0.06) implies that the foreign firms use the morc productive
labour of India and supplement the imported capital goods to maximize their
pro lit. This is well supported by the result as both the PR and 1M bear a
positive sign as the determinants of FDI inflows in these sectors. The negative
coefficients of GCF (-0.08) imply that the low capital intensity of these sectors
do not induce the foreign firms to invest in these sectors. The result also shows
that W A (-1.02) and EX (-1,80) are the negative determinants of FDI inflows in
these sectors. Wage being a cost determinant is expected to have a detrimental
effect on the FDI inflows, but the negative impact of EX implies that the export
requirement policy of the government of India for the foreign firms does not
help to raise the FDI level in these sectors.
8.3. Impact of FDI Inflows on the Indian Economy
The impact of FDI on the Indian economy is hypothized and tested for the macro
economic v'ariables and for the sectoral variables. As per the economic priori, the
macroeconomic variables included in the analysis are Gross Domestic Product at factor
cost (GOP), Gross Domestic Capital Formation (CF), Export (EX), Trade Balance
(TB). Real Effective Exchange Rate (REER) and Wholesale Price Index (WPI). A
Granger causality test is used to assess the relationship between these variables and
FDI inflows at the macro level, the result for which could be summarized below:
176
Summary, ConcluSion and Policy SuggestIOns
B.3.1. Macro Level A/lo/vsis
The result of the Granger causality test reveals that there is a bi-directional
causality between FD! and GOP. This implies that the FD! flow into India has
helped to raise the GOP, and vice verso. But, the growth rates of FOI and GOP
for the study period are 41.23 and 5.95 respectively. The huge growth of FD!
flow during the period cannot be explained by the growth of GOP alone.
The result of the test shows that there is a unidirectional causality from REER
to FDI and from WPI to FO!. These results are consistent with the results of
the macroeconomic determinants of FO!. The unidirectional causality from
REER to FD! may be due to the I'D! inflows into India, which have raised the
demand for the Indian currency in the international currency market. This has
resulted in an appreciation of the Indian rupee (as REER is found to be a
negative determinant of FD!). On the other hand, the unidirectional causality
from WPI to FD! may be because of the upward movement of the price level in
the domestic market, which has been able to lure the foreign firms to invest in
India.
The result also reveals that the FD! flow has not been successfilll reducing the
price level in India. This is because of WPI, which has gone up during the
study period and also the hypothesis of FOI does not Granger cause WPI is not
rej ected in the Granger causality test.
As far as the relationship between CF and GDP is concerned, it is revealed that
there is a unidirectional relation from GDP to CF, but not the reverse. The
domestic capital formation has not helped to raise the level of growth in the
economy. This may be because of the deterrent effect of the public investment
on the growth of the economy.
The result shows that there is a bi-directional causality between FD! and CF.
It implies that the FOI inflows into India have been successful in raising the
upstream and downstream investment through its forward and backward
177
linkages. There is positive growth rate of domestic capital formation over the
period from 1979-80 to 2000-01. This positive growth of the CF may be
because of two reasons; firstly, the steady decline in thc interest rate over the
study period and secondly, a high growth rate of the FDi flows. The Granger
causality test also supports this view that IR does not Granger causes CF as the
null hypothesis has been rejected at I percent significance level.
Further, the result also shows that the causality also runs from CF to FDL This
could be viewed as the result of increased infrastructure facilities in India. It is
argued that public investments are made to avail better infrastructure and thus,
the foreign firms are interested to invest more.
With respect to the relationship between SA and FDI, the result shows that
there is a unidirectional causality form SA to FDi but not the reverse. This
unidirectional causality from SA to FDI may be due to the increased lonable
fund in the Indian capital market, which has facilitated the foreign fimlS to raise
the desired fund from the domestic market.
The causality test shows that there is no causal relation from FDI to EX, rather
a causal relation is established from EX to FDL This result suggests that the
openness of the Indian economy is an essential requirement to raise the FDI
level.
8. 3.:!. Sec/or LeI'eI AI/alysis
For the sector level analysis, all the nine sectors have pooled over the study period of
ten years 1991 to 2000 and a Panel Cointegration (PCONT) technique was used. The
variables included in the PCONT are the FDi inflows, gross output (GO), export (EX)
and labour productivity (LPR). The results for the sectoral level analysis can be
summarized below:
The results show that FDi has a co-integrating relation with GO in five sectors. It
shows that there is a negative relation between these two variables in sectors like PF
and TR. This implies that the FDi inflows into these two sectors have a dcterrent
178
Summary, Conclusion and Suggestions
effect on the out put of these sectors. However, the results show a positive co-
integrating relation between FDI and GO in the sectors like FP, TE and IN. This
may be due to the advent of better technology through FDI, in these sectors, whIch
has helped them to grow at a faster rate. On the contrary, FDI has a
relationship with EX in three sectors namely, TR, CH and FP. But there is no
positive relation between EX and FDI in any other sectors. This may be due to the
export requirement policy of the government. Thus, if the government is persisting
with its policy of export compulsion at least in these sectors, the goal cannot be
achieved, as FDI does not promote EX in these sectors. As far as the co-integrating
relation between FDI and LPR is concerned, the result shows that two sectors i.e.
TR and ME have a positive co-integrating relationship where as two sectors i.e. FP
and IN have a negative co-integrating relationship. The positive relationship
implies that FDI has helped to nise the LPR in the two sectors and thus is will be
appropriate to encourage FDI in these two sectors. But the negative relationship of
FDI and LPR in the two sectors calls for a judicious wage rate in the sectors, since
FDI is supposed to raise the LPR.
The result also shows that FDI has a positive co-integrating relationship with
the other variables like GO, EX and LPR in two sectors namely, TR and ME,
where as it has a negative co-integrating relationship in two other sectors i.e. FP
and IN. This implies that FDI has a positive contribution in transport and
metallurgical sectors, but it has affected the food-processing sector and the
industrial machinery sector adversely. There is the absence of any co-
integrating relation in other sectors. The result of the Panel FMOLS also
suggests that the flow of FDI has not helped to raise the GO and LPR, rather it
has an adverse impact on the export of all the sectors. The panel co-integration
result also reveals that there is no co-integrating relationship among the
variables like FDI, GO, EX and LPR in all the nine sectors. When there is an
increase in the output, export or labour productivity of the sectors it is not due
to the advent of FD!. Thus, it could be concluded that the advent of FDI has
not helped to wield a positive impact on the Indian economy at the sectoral
level.
179
Summary, Conclusion and Poilcy SuggestIOns
In the overall analysis, it can be observed that the flow of FDI into the sectors
has helped to raise the output, labour productivity and export in some sectors
but a better role of FDI at the sectoral level is still expected It could be
observed from the result of the PCONT that a very minimal relation in these
variables (output, labour productivity and export) is established by the FDI
inflows into the sectors. This may be due to a very low flow of FDI into India
(the flow of FDI into India is merely 1.2 per cent of the total FDI flow to the
developing countries and the percentage of FDI to the GOP of India is less than
3). Nevertheless, the flow of FOI has contributed positively in somc sectors.
8A, Conclusion and Policy Suggestions
The major tindings of the study at the macro level suggest that FDI played a vital role
in the economic growth of the country. [t also contributed significantly to raise the
capital formation in India. The global share of the FD[ inflow in India is very low, it is
able to take the overall economy in a positive direction. [n this context, the FDI inflow
is very important and should be encouraged significantly in all spheres of the Indian
economy. [t is also important to note that FDI inflow in the country has also not been
able to fulfill the objective of increasing exports and saving. [n the case of export
promotion through FDI inflow, it is suggested to reduce the tariff rates of the country.
Though external sector reforms call for an effort fur appreciation of the Indian Rupee
against the other currencies in the world, India's tariff rates are still among the highest
in the wurld and continue to block India's attractiveness as export platform for labour-
intensive manufacturing production. [t is also suggested that tariff rates on imported
capital goods used for export and on imported inputs into export production should be
made duty free. It may boost the high inflow of FDI in the manufacturing sector, which
may result in a higher export of the manufacturing sector in India.
[t is also observed that FDI inflows have not helped reduce the price level of
the economy, rather the growing price at the macro level is an inducement for the
overseas investors to invest more in India. [n this context, in order to raise the FD[
inflows, the monetary policy requires to keep the price level high. However, the
gruwing price level at an alarming rate may destabilize the economy. Therefore, it is
180
,
Summary, ConclusIOn and Pollcy SuggestIons
suggested that the price level should bc kept at a threshold level, which does not affect
the economic fundamentals and at the same time it can be a source of inducement to
the foreign investors. This may raise the flow of FDI at the macro level, which may
result in the reduction of the cost of production. [t is also observed from the policy
simulation that another policy variable, i.e., interest rate plays an important role in
raising the FDI flow at the macro level. [n order to increase the FDI, financial sector
reforms call for a reduction in the interest rate, as lower the interest rate, higher will be
the FDI flows. However, the interest rate in India is one of the highest in the world. [n
this context, it can be suggested that interest rate on the fund raised from the market
should be reduced. Of course, the successive governments at the center have the policy
agenda for the lower interest rate. This may help increase the Brownfield Investment
both at the macro level as well as at the sectoral level.
The main findings at sectoral level suggest that the FDI inflows to the major
sectors in India have made a positive impact in increasing the output, labour
productivities, and export. However, FDI flows to the major sectors explain a very
small variation in performance of output, productivity and export. This may be due to
the fact that the Indian economy has not been able to use its all FDI absorptive
capacity. The sectoral level policy in India has a differential treatment for the sectors
and each sector is restricted to receive a certain amount of FOI. The sectoral level
policy necessitates to get rid of this restrictive policy regime. Foreign ownership of
between 51 and 100 per cent of equity still requires a long procedure of governmental
approval in certain key sectors like Transportation, Service, Telecommunications and
Electrical equipments. There does not seem to be any justification for continuing with
this rule. This rule should be reformed in favour of automatic approval for 100-per
cent foreign ownership Fortunately, in the recent plan of 2004-05, the government
has tried to give a boost to the FDI flows to the potential sectors like
Telecommunications, Insurance and Civil Aviliation. The sectoral caps of these
potential sectors have been relaxed to attract more FOl. The cap of 75 per cent FDI
in Telecommunication sector is done away with in favour of a complete 100 per cent
FDI. But, the FDI into the other promising two sectors like Insurance and Civil
Aviliation are kept at a 49 per cent in view of the promised humanitarian face in the
Common Minimum Programme (CMP) of the ruling United Progressive Alliance's
181
(UPA) election manifesto, Moreover, the regulation should not be relaxed totally for
a small list of sectors like Defense and Education that may continue to require
govemment aUlhorization, It can also be seen Ihat the realization of approval FDI
into actual is very low, In this context, it can be suggested that the time-consuming
red-tapism should be removed so that the actual FDI inflows can be raised at the
sectoral level.
The review of the policy shows Ihal reform process so far has mainly
concentrated at the central leveL In a federal set op like India, the state govemments
need to be viewed as potential agents of rapid and constructive change, However, India
has yel 10 free up its state govemmcnts sufficiently so that they can add much greater
dynamism to the reforms, The central government controls most of the key
infrastructure areas or at least sanctions over state actions, The reform policy requires
grealer li'eedom to the states. In this context, it can be suggested that the state
governments need to be entrusted with more power. This will help foster greater
competition among the states to attract more FDI 10 their respective economies, which
may result more FDI at Ihe aggregate level.
To sum up, il can be concluded that the FDI inflows have the potential to give a
boost to the Indian economy, bUI the flow of FDI should be high enough for a large
economy like India. However, as of now, given the size and pOlential of the economy,
the flow of FDI into India is very minimal. India's poor performance in terms of
competiliveness, quality of infrastructure, skills and productivity oflabour makes India
a far less attractive ground for direct investment than the potential she has. Given that
India has a huge domestic market and a fast growing one, there is every reason to
belic\'e that with continued refomls that improve institutions and economic policies,
and thereby create an environment conducive for private investment and economic
growth so that substantially large volumes of FDI will flow to India, It is the deficiency
in the plan rather than the role of FDI is in question as India is not able to attract
sufficient FDI to her land. II requires a judicious and sustained decision on the part of
the policy makers to lure more foreign firms into India, which may bring positive
effects on the Indian economy in the future.
182

APPENDIX 1.1
FDI \\ias never considered as a specIal case before the 20
th
century when its features were IdentIfied and
it became a more Important part of internatIOnal business. However, its conceptIon, or Its defimtlOn is
still not ciear enough "Ithough many studies on this Issue have been completed since then A distinction
could be made between Direct and Indirect Foreign Investment. The fol1O\\!Og types of investment can
be Included in the category of' indirect foreIgn Investment'.
Portfolio investment, which means sale and purchase of eXisting bonds and stocks.
AcqUISition of stock of an enterpnse when the objective 15 solely to obtain dIVIdends or capital
gams.
Investment In new issues of natIonal loans, bonds and debentures.
and long-term loans by financial instItutions and intermediaries.
Thc close association of FDI with the MNEs induced Dunning (! 997) to define MNEs as
'firms that engages in foreign direct investment'. The first person to give spcclal conSideration to FDI
"as Stephen Hymer. In hiS doctoral theSIS, ho argues that direct Investment and portfoliO investment
arc really two different thmgs. First, these two types of mvestment behave differently. For example, the
pace of their growth rate IS not the same: III the thirties, portfolio Investments dropped enormously, but
FDI decreased Just slightly: 10 the post-war penod FDI expanded rapidly while portfolio investment
regIstered a SIllJI! Increase. Second. unlike portfolIO Investment, 'dIrect investment are capital
mo\'emcnts assOCIated \vith the internatIOnal operatIOn of the firms'. Hymer 1I1troduced a crUCIal factor
III order to distingUish these t\.\'o dIfferent Investments, that is. control He states: 'if the investor
directly controls the foreign enterpnse. hiS Investment 15 called a direct 1I1vestment. If he dues not
controllL hiS Investment IS a portfolIO Investment' (1976). Control, Hymer believes, 15 connected With
the eqUity of the tirm or based on the amount of the equity In a local firm that a foreign investor holds.
Accordmg to Hymer, control and eqUity arc the two key determinants In defining FDI. It is a
fact that some questIOns relating to control and CqUlty still remam unclear f !owever, the eXIsting
dctinltlons of FDI arc ambiguous as revealed by the literature on the subject, including the work done
by some of the mfluential FDI experts, sllch as Hymer. Some eXIsting definitIons proposed by several
"nters and organl/atlons equally originated from Hymer's framework. RagaLZI (1984) defines FDI as
'the amount 111\ ested by residents of a country 111 a foreign enterprise over \\'hich they have effectIve
control' Direct investment refers to Investment that IS made to acquire a lasting interest in an
enterpnse operating In an economy other than that of the investor, the investor's purpose being to have
an effectIVe vOice In the managemcnt of the enterprISe (BOP manual 4'" edition)'. It can be seen from
these definitIOns that the determinants of the definitions of FDI are those that have been identified by
Hymcr, namcly, that FDI refers to; control and eqUity. However, there arc some problems With all these
definitIOns of FDI. First, what IS the extent of 'control' required to deCide whether an investment is a
direct mveslment rather than any other form of investment?
I
Appendices
M<lny countfles and organllations define FDI differently. The US government asserts that an
investment is FDJ when the investors have more than 10 per cent of the ownership In the foreign
enterprISes (Chen 1992). In Japan, any lending and Investment, which meets one of the following
rcqUlremcnts, will be treated as FDI. even If the ratio of Japanese Investment does not exceed 2S per
cent (KoJ lOla 1985)

tinanclal aid, supply of manufacturing techniques, raw matenals and Inputs.
the purchase of products from the invested enterprise and the despatch of executives,
the establishment of permanent economic relatIOns With enterprises abroad and
Investment in natural resources development by a loan and purchase contract. This is a system
111 which a foreign corporation provides loans for the development of a natural resource and
the loan IS paid back In kind, thai IS 10 say through Imports ofthc devcloped products
The department of economic and SOCIal affairS of the Ullited Nations defines FDI In two ways:
firstly, as a subsidiary, which should have at least 25 per cent control of the voting stock by the parent
company and secondly. as an associate, whic:l satisfies 10 per cent control of voting stock. In general,
thc proportIon of ownership gIven to the investors varies from country to country. This leads to the fact
that FDI IS unllkcly to be defined precisely. HOIVever, It tends 10 be accepted generally that an
Investment. which amounts to at least 10 per cent control of voting vOIce. IS direct investment \Vith
regard to the equIty. there is a difference between theory and practIce. In theory. equIty is another basic
dcterrillnant of FDI other than control. and requires that the Investor has ownership rights or holds
stock shares 111 a foreign company IGriffiths and Hall 1984) In practice, the World Bank also
rccognl/cs some non-cqll1ty forms of investment. such as contractLJal JOInt ventures as FDI. Casson
also puts the question like: Does 1I1volvcmcnt meilns that the Investor has to be Involved in day-
today management. or holds a hIgh enough position? If not, wh<lt IS It. and why') Therefore, as Hymer
(1976) argues, conlrollS not an easy thing to define', and it IS hard to find 'the dlVldll1g line between
some control and no control' As noted earlier, the data and the defimtlon relating to FDI 111 India has
some 1'l11ltatlons There is huge discrepancy in the actual and the approved data. The secondary
sources, which publish the FDI data 111 India, Inamely the Reserve Bank of India, (RBI), the
Department of I ndustnal Pol,ey and Promollon, I DI PP), and the Secretariat of Industrial Assistance
ISlA)), conSider the equity capital as FDI. though the IMF gLllde"nc preScribes to Include
rClI1vcstmcnts and venture capital on the FDI fiows. In VICW of thIS, the Government of India redefined
the FDI II1nows IIlto India III 2002 Ithe details regardll1g tillS IS avadable on the websites
hnp:llwww.rbi.org.ln! and hltp:!lwww.dipp.nle.in). Accordingly, the new defil1ltion of FDI Innows
Into India Ineludes reinvestments and venture capllal along With the eqully capital.
184
APPENDIX 4.1
The process of economIc reform or economIc adjustment combines macroeconomic rcfonns and
structural adjustment and alms at ensuring better allocation of resources, thereby ImprO\'lng cconomH.-
performance through changes In economIc policIes MacroeconomIC adjustment IOvol\'es an Immediate
change in policIes and alms at achieving short-term objectives Structural adJustment. on the other
hand, Involves more fundamental changes In the way the economy operates It modifies the
structure of the economy towards meeting the long-term obJectIves. It takes anto account reordenng of
prlOritles and reconsideratIOn of polley Instrument. There may be vanatlOns JCross different
adopllng economic adjustment, but. by and l<.lrge. the poliCY package cneomp<.lsscs production. sa\lng
and investment. sectoral development monetary and budgetary targets and the external sector
(Woodward 1992)
Despite differences. macroeconomic stabili/atlOn programmc ;md structural adjustment
overlap c3ch other. For Illstance, dcpreci<.ltl011 of currency by the ordcrs of the monetary authority IS a
structural reform InsofOJ.r as it encourages a shift of prouuctlon towOJ.rds Internallon<ll1y trJdablc goods
But, at the same time. It is considered as <.I part of m<.lcroeconomlC adJustmcnt inasmuch as lis
immediate aim IS to reduce demand for Imports in order to reduce trade defiCit In fact. the structural
adjustment process cannot go on In an environment of macroeconomic instability. Macroeconomll'
adjustment IS 111lkcd with the process of structural adjustment at two levels - one at the beginning.
when a healthy macroeconomic envlronmcnt is needed, and the other. ;].ftcr the structur<.ll adjustment
process IS over and changes In key variables arc called for (Rodrigue? 1989)
The m<l1ll purpose of a macroeconomic adjustment programme IS to reduce a country' sneed
for external finance through Improvement In balance of payments. and to keep lI111atlOn at a 10\\ and
rn<1nageJblc level. ThiS concept rests on the theory of international monetansm. which postulates that
deterioration 1tl balance of payments and a nse In inflatIOn are both symptoms of excessive monel
supply. It thLis calls for a tight credit and monetary policy, cutllng of budgetary defiCits and
rationalIZing InnatlOnary finanCing. All these help in lowering the demand In the economy and hence,
reduces Impon. The goods previously demanded at home arc released for expon. Consequently, the
balance of payments Improves
Improvement In the balance of payments can Jlso be brought about through depreCiatIOn of
currency that Clits the demand for imports and raises exports by mak1llg them more competitIve 111 the
international market. In a long-term framework. It makes the production of exports and Import-
substitutes more profitable thus Improving the balancc of payments
Structural adjustment programmes are more Wide-ranging. The major objectives are to reduce
the role of the State In matters relating to the private sector, to allow prices and Income to respond
freely to market forces, and to open the economy to foreign trade and Investment. The ratIOnale behind
185
reducing the role of public scctor IS prl\atc sector operatIOns arc comparatl\cl) ctliclcnt ..1
1
',,'
that private markets encourage <.In optlm<.ll <.I I 1000:at IOn of rC!iourecs This IS particularly true In m.I!',
lov.'-Incume countries where the role of the State has grown f<.lr beyond Its capacity Again, Ih,
proceeds of prlvatl/atlon represent a non+lntlatlonary source of financing for the budgetary defiCits 1 L
achieve It, government expendIture percentage of nattoniJl Incomc IS reduced, production alh'
provision of servlccsare shifted from the public to the prI\ ate sector. and unnecessary gm ernmcnt .d
mtcrfercnee IS removed from the private sector
Similarly, the structural <JdJlIstmcnt process bl:lteH.'s In the market forces and attempts to bring
prices In line wIth thc market conditions admlnlstered prices ..Hi.: doni.: "may \\lth This In tum. calls
for removal or reduction of subSidies .md price control. and thc Introduction of. and. or Increase In.
user's charges for puhlic services
Last but not the least, opening of the economy to foreign and In\estment Impro\cs thc
perfonmlllce of the economy In thc sense that free access to Imports and the disCipline of foreign
competItIon help Improve the efficiency of domestic productIOn Foreign Investment alleViates pressure
on the balance of payments and bndgcs the technology gap. Structural adjustments m\olve relaxation.
or removal. of restrictions on forclgn trade Investment.
186
Appendices
APPENDIX 4.2
The strategy of reform introduced in India In July 1991 presents a mixture of macroeconomic
stabilizatIon and structural adjustment; or In other words, both the short-term, and the long-term
objectIves gUIde It. In view of the policy-makers, 'stabdlzatlOn was necessary In the short-run to restore
bJlance of payments equilibrium and to control IIlflatlon, although the reform measures were equally
Important in the medium-term if the economy \vas to grO\\' and become competitive in the world' (GOI,
1993). From this \'Icwpomt. a number of reform measures have been introduced in different sectors of
the economy The important ones are mentIoned hereunder.
Let us begin with fiscal reforms that were emphasIzed In view of the hIgh rate of Inflation and senously
distressed balance of payments In the early 1990s The baSICS of economics tcll us, that grcatcr the
fiscal deficll. larger IS the government borrOWing from the Reserve Bank of India (RBI). Thc greater
the amount of borrowing the larger is the muney supply and higher is the rate of InfiatlOn. Similarly,
tiscal deficil IS closely linked wllh the worsening of the balance of payments. ExpanSion In aggregate
moncy supply and aggregate demand results In higher Import demand. On the other hand. InnatlOn and
thcreby. increased cost of produclion reduces the competitiveness of exports rcsulting In a trade deficit.
FIscal deficit also leads to greater external borrOWings and sometImes. commercIal borroWIngs when
offiCial development assistance IS not available to the required levels. Consequently. servicing of the
debt burden becomes increasingly dlmeult. Thc outfiow of foreign exchange has a deleteriOUs effect
upon the balance of payments.
Thc statistics sho\\ that fiscal deficit dUring FY 1990-91 was as large as 84 pcr cent ofGDP.
It was over tv"cc the Icvcl ofmld-1970s and over one and a halftimes the 198182 level (GOI 1993).
Naturally. the aIm of tiscal reform \vas to correct the fiscal Imbalances. It envIsaged a reductIOn In
fiscal deticlt inItIally by two percentage POints. ThiS was to be achieved through contamment of
guvcrnment expenditure and augmentatIon of revenues, curbing conspIcuous consumptIon and
reversing the downward trend in the share of direct taxes to total tax revenuc. The steps were in
the dircctlOn of reduction of fertihzer subsidy, abolition of cash compensatory support for exports,
abolition of subsidy on sugar and disinvestment of a part of the government's eqUity holding in
selected public sector undertakings. The Government accepted In 1991-92 almost all the major
recommendations of the Tax Reforms Committee headed by Raja Chclhah and Implemented most of
them subsequently. The purpose was to raise revenue through better compliance in case of income tax,
excISe and customs as well as to make the tax structure stable and transparent.
Alon('/ary (flU! Financial ')'(;,ctor Reform:
to contain the growth In money supply were taken through both fiscal and monetary
dISCiplines To tillS end. quarterly targets for RBI credit to the central government were set along with
187

Appendices
targets for bank credit to government. Monetary reform aimed at domg away with mterest rate
distortions and ratlOnaii/mg the structure of lending rates. In the pre-reform period, government
borrowJng was done at administered 11lterest rates while the lending rates for the commercial sector
were high. The new policy attempted to apply market-related rates to government borrowings, an
approprIate example of which was the 3M-day Treasury bill. Besides this, 11 tried to reduce the number
of lendmg rates, \\"hich were as many as six at the tIme of launching of the reforms. Imtlally. they were
reduced to three with the ultimate aim of rcdu(;ing them to only two- one being the general rate, and the
other being concesslonal for the weaker sectIons OfSOC1Cty,
Thc monetary poliCY reforms went for reduction In statutory lrqllldity ratio (SLR) and the cash
reser\'c ratIo ~ C R R ) 111 hne With the recommendatIons of the Narsirnham Commlttee Report of 1991.
Durrng the mld-1991, LSR and CRR were vcry high. High SLR helped mobrll7e greater resources for
the central and the state budgets, whrle high CRR helped check the expansionary effect of the budget
deticlt on money supply. But since they pre-empted a sizeable portion of banks' resources and diverted
thcm to IO\\-income earnlllg assets, protitabllrty of banks was badly affected. To ensure profitability,
banks had to raise Interest rats on lending to the commercial sector that created further problems. In
\ lew of t11l5. SLR was to be cut down in stages over a three-year period form 38.5 per cent to 25 per
cent The CRR was to be a,ed to a level below 10 per cent over four years.
Besides the above. the new policy tned In many ways to make the banking system more
effiCient. It brought In greater competition among the three cons9tuents of the banking system - public
sector banks. private sector banks and the foreign banks, and attempted to eliminate administrative
constraints The branch licenSing polrey was liberali/ed to help ratlonaliLe the eXisting branch network.
B<lnks got freedom to relocate branches. open spcci<llized branches and set up controlling offices
SpcCIJI tnbunals for recovery of loans \vere set up. Guidelines were Issued for opening new private
sector banks With the Idc<l of maklllg them 1110re viable. New accounting norms rcgard1l1g classification
of assets and pro\ 1510115 for bad debt ",'ere Introduced in tune with the Narsllnham Committee Report.
The banks were expected to meet capital adequacy norms at par \vlth the internatIonal standard under
"hleh the)' had to malntalll ulllmp .. llred mInImum c;Jplt;J1 at least equal to g per cent of the total ofrisk*
"clghted assets and other otT-balance-sheet exposures. In case the capnal of the banks was found
Inadequate, additional capital was to be mobril/ed from the capital market In the form of new equity, or
In other words. through the disinvcstments of government hold1l1gs in the capital structure.
Reforms were not limited to the bankmg sector alone. They permeated to the capital market as
well An clement of liberalization was Introduced Into the system through the repealing of the Capital
Lssues (Control) Act, 1947 and abolrshlng the office of the Controller of Capital Issues. With thiS.
companies no longer needed government approval for approaching the capital market. The companies
Issuing securities were free to fix price and premium. The reforms went on to permit companies to
approach the International capital market through the Issue of Euro-equilles under the Global
DepOSitory Receipt (GDR)lAmerican Depository Receipt (ADR) mechanism.
188
Howc\cr. reins were not loosened completc1) and sufTlclcnt carc \\35 taken 10 chee!...
malpractices 'The Securities and Exchange Board of India (SEBI). "h,ch had been set up '" 1988 Ie'
rcgulate the capital market. was given statutory pov,,'crs to ratlOnall/c stock exchange. ThiS institution
took a number of steps to mcrC;Jse transparency In (he system \\ Ith J \ IC .... In promoting hcalth\
practices. speedier transactIOns, ;md ensuring Improved scn'lccs and greater protectIOn to Investors
Some additional steps were taken such as the inspection of mutual funds and stock exchanges,
registratIOn of Intermediaries. disclosure of m;)tcnal facts by SCCUritY-ISSUlng companies. adherence to
code of conduct by the merchant bankers, permission to forelg.n Instllutlonal Imcstars (Fils) and
forclgn brokers to operatc in the capll;)1 market
ImluSlfiu/ PO/tel' Rt'./urms
The New Industrial Pulley ('HPJ was announced on July 24.1991 In the parliament ThiS polin reform
stressed thc removal of major hurdles in the way of Industnal production, makmg thiS sector
internJtlonally compctltlvc 111 tcrms of price and quality. Fur purpose. dellccnslllg was II1troduced
on a Significant sc;)le, except for a few industries of stmteglc Importance Dcllcensing. hO\\e\'CL
necessitated filing of an InformatIOn memorandum With the government \\hllc scttll1g up or c,pandlng
an industrial lIll1t
The new II1dustrial policy removed most of the restrictions th;)t had been Imposed on thc
lI1f1ow of foreign tcchnology and in\'('stment through the amendment 10 the Foreign E\change
Regulation Aet (FERA) 111 1973 The cellmg on foreign equity partICipatIOn "'as to 5l per ('ent 111
normal cases Jnd even up to 100 per cent 111 spcclal cases. ProviSIOn was made for Jutumatl(' appro\ al
of foreign collaborations where the foreign equity partiCipation \Vas hmitcd to 51 pcr cent of the total
equity_ BeSides thiS, the area of operations of foreign investors \\';)$ Widened to cO\er trJdmg Jnt!
serVices, power. all production, and refining and marketing, Automatic appro\al was also gl\ en to
techllolog) Jgreclllents 111 hlgh-pnonty industries and those involVing a lump-sulll PJyment of up to Rs
10 mtilion and a royalty payment of up to 5 per cent of the domestic sales and 8 per cent ofe'ports
The policy-mukcrs relJl lied that the Monopolies and Rcstnctlvc 1 rade Practices Al't \\ as ;)
IllJJor hurdle 1!1 the way of industrial production as big II1dustnal houses were not allo\\cd to set up
new units 111 mallY fields. Though the Act has becn abolished m the mterests of mdustrlal dc\'elopml:nt.
there IS a commission to control unfair trade practlccs.
Last but not the least. the new poliCY reinterpreted the role of publiC sector units 111 a \\ay that
IS relevant to the present needs of the economy. Despite the fact that the publiC sector units have had a
role to play in fostering growth and preventing concentratIOn of wealth, a host of accompanymg
probkms ultimately told on their productivity and some Ulllts were cvcn rendered Sick The ne\\ pollc)
took all these facts mto account and prOVided a few guidelines. First. eleven out of seventeen mdustnes
reserved for the publtc sector were thrown open to the private sector. Secondly. the policy encouraged
189
Appendices
disinvestmcnts of government holdings In the equity share capital of public sedor enterprises. This was
1111tl;"lIly In fJ\'our of mutual funds and other institutIOns. but later, 1Il favour of public in general.
Tlmdly, the public sector Units were prOVided greater autonomy of management that could be helpful
for generating reasonable profits. ThiS was to be achieved through a system of Memorandum of
Understanding (MOU j, which prOVided for an agreement between the enterprISe and the concerned
for nlmil1111'ing governmental interference, but at the same time making the enterpnse
accountable to the government at the year-end, Fourthly, the new poliCY showed concern for the revival
of sick units. It brought public sector Units under the ambit of the already existing Sick Industrial
Comp"nles (Special Provision) Act, 1985 and the Board for Industrial and Fmancial Reconstruction
(BIFR) The Sick Industrial Companies Act was further amended in December 1993 to facilitate early
detection of sickness in companies and speedy enforcement of remedial measures on the basIs of the
recommendatIOns of the Omkar Goswami Committee III the months preeedmg December 1993. As per
thL" prOVisions. Sickness was to be reported to the BIFR which, In turn, was to recommend the closure
of non-viable units and for the revival of viable units. The interest of the retrenched workers was to be
protected Ihrough aSSistance from the National Renewal Fund (SIA newsletter 2000).
The external seclor reform IS Ihe main area of concern as it is closely related to FDI. It may be noted
that the poliCY reforms touchcd upon every aspecl of the balance of paymcnls problem. Mosl
slgnlticantly, the e\change rate was rationailled. The rupee was depreciated to remove maladjustment
between the real and the nominal exchange rates. The depreciation of the rupee was followed by Its
com'ertibility on current account. First. it was made partially convertible, and then. after a year, It was
made fully cOll\ertlblc mainly on !rade account. By mid 1994, the rllpee was made fully convertible on
all current account transactions. The rationalization of process illso included a shift to the system of a
managed flo<.ltmg e'(ch<.lnge rate_ All the above steps aimed at encouraging foreign exchange earnings.
Imp0l1s \\,-crc hbl:rail/ed to give a boost to the domestic production. Tanff was axed with a
10 <.Irrcstmg the cost of production \\-'Ithln meaningful limits. These were accompanied by various
cxport promotion measures. In casc of invlslbles, the strategy was to limIt the mflow of external loans,
particularly non-conccsslonal loans. so that interest payments remained Within manageable limits Jnd
then gradually began to shrink. Improving the net earnings from invlslbles. Moreover, overseas
opcrallOns of I ndi3n companies werc encouraged to give boost to investment income. Thus, through
rl'structurlf1g trade and exchange rate and encouraging the invisible earnings, the new policy aimed at
rcduclf1g the current account defiCIt.
The 1M F was appro"ehcd In 1991-92 to meet the defieil and resolve the Immediate CrISIS.
Hu\\c\"cr, from the medium and long-term POlf1ts of view, the new policy stressed on foreign
IIl\Cstmcnt rather than extcrnal assistance. Scrviemg external debt had been one of the key factors
behind the balance of payments CrISIS
190
Appendices
The area for the opcratlOns of foreign investors was widened as also their stake In the Indian
enterprises increased through raismg the ceding on their participation in equity capital. Automatic
ilpprO\'a! or foreign collaboration agreements 111 certain cases was added encouragement for an Inflow
of foreIgn dlfect investment. Besides foreign direct Investment, portfolio equity Investment from
abroad was also given an impetus, Foreign institutional investors were allowed to operate in the Indian
capital market and Indlan companies were allowed to raise capital from the international capital
market All this represented a big move towards opening the economy. One more milestone was set by
rno\ ing towards capital account convertibility based on strategies outlmes by the Tarapore Committee
(June 1997), but In view of the lack ofsustamabilily olthe economy. the monetary authontles followed
a policy of go-slow on tl1l5 count (Sharan and MukherJI 200 I)
191
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