Fdi and Its Impact on Indian Economy

Foreign Direct Investment (FDI) plays a pivotal role in the process of economic development particularly in the capital scarce country, where the domestic base of created assets like technology, skills and entrepreneurship are quite limited. It provides financial resources for investment in a host country and thereby augments domestic saving efforts. It also plays an important role in accelerating the pace of economic growth. FDI provides the much needed foreign exchange to help the bridge the balance of payment or trade deficit. FDI brings complementary assets such as technology, management and organizational competencies and there are spillover effects of these assets on the rest of the economy. FDI is treated as a main engine of economic growth and technological development which provides ample opportunities in accelerating economic development. Foreign investment flows, broadly, can be classified into i) FDI and ii) Portfolio Investment from Foreign Institutional Investors (FII). FDI means investment made by a non-resident/entity in the capital of an Indian company under schedule 1 of Foreign Exchange Management Regulations 2000. Dunning (1993) states that FDI, when compared to portfolio investment, involves the transfer of resources other than capital viz., technology, management, organisational and marketing skills etc. from a foreign country to the host country. It is the expected return on these resources, rather than on the capital per se, which prompts firms to become Multi-NationalCorporations. Further, in case of FDI, resources aretransferred internally within the firm rather thanexternally between two independent parties; de jurecontrol is still retained over their usage. This however, is not the case in respect of portfolio investment. Foreign investment was introduced in 1991 underForeign Exchange Management Act (FEMA), driven bythen finance minister Manmohan Singh. As Singhsubsequently became a prime minister, this has beenone of his top political problems, even in the current(2012) election. India disallowed overseas corporatebodies (OCB) to invest in India. It is observed that FDIrose swiftly form 2006-07 onwards, as India allowed100% FDI through automatic route. Extensive researchhas been conducted throughout the world on ‘ForeignInvestment Flows’ for the last two decades. Many ofthe studies focused on the determinants of FDI andvery few scholars studied the impact of FDI on the host economy. In India, research studies in this area arerather limited. In view of the above, the objective of the present study is to study is to study the impact of FDIon Indian economy since April 2005 i.e., after whichFDI has been growing rapidly in India. Further, thestudy also delineated the trends and progress of FDIinflows into India before and after the eruption ofGlobal Financial Crisis. The present study has been divided into six sections.The second section deals with the Survey of Literature. The third section narrates the research methodology of

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the study. The fourth section delineated the trends and progress in FDI across the world as well as in India. The impact of FDI inflows on India with a theoretical perspective is discussed in the fifth section. The main conclusions emerging out of the study are presented in sixth section.

Many empirical studies have been undertaken to analyze the impact of Foreign Direct Investment (FDI) on India, few of them are as follows:- Montiel and Reinhart (1999) found that a combination of push and pull factors affect capital flows; while the push factors can explain the timing and magnitudes of foreign investments, the pull factors determine the geographic distribution of the flows amongst the recipient economies. Mucchielli and Soubaya (2000) investigated the determinants of the volume of trade of the French Multinational Corporations (MNCs). The major findings suggest that inward FDI has a positive influence on Foreign trade (including exports and imports), and this positive influence is stronger for exports compared with imports. Charkraborty and Basu (2002) explore the co-integration relationship between net inflows of FDI, real GDP, unit cost of labor and the proportion of import duties in tax revenue for India with the method developed by Johansen (1990). They find two long-run equilibrium relationships. The first relationship is between net inflow of FDI, real GDP and the proportion of import duties in tax revenue and the second is between real GDP and unit cost of labor. They find unidirectional Granger Causality from real GDP to net inflow of FDI. Naga Raj (2003) discusses the trends in FDI in India in the 1990s and compares them with china. The study raises some issues on the effects of the recent investments on the domestic economy. Based on the analytical discussion and comparative experience, the study concludes by suggesting a realistic foreign investment policy. Salisu A.A. fees (2004) examined the determinants and impact of FDI on economic growth in developing countries using Nigeria as a case study. The study observed that inflation, debt burden, and exchange rate significantly influence FDI inflows into Nigeria. The contribution of FDI to economic growth in Nigeria was very low even though it was perceived to be a significant factor influencing the level of economic growth in Nigeria Nandita Dasgupta (2007) examined the effects ofinternational trade and investment related macro-economic variables, namely, exports, imports and FDIinflows and the outflows of FDI from India over 1970through 2005. Unidirectional Granger Causality wasfound from export and import to FDI outflows, but nosuch causality exists from FDI inflows to thecorresponding outflows from India. Burak Camurdan and Ismail Cevis (2009) developed anempirical framework to estimate the economicdeterminants of FDI inflows by employing a panel dataset of 17 developing countries and transitioneconomies for the period of 1989-2006. Sevenindependent variables were taken for this researchnamely, the previous period FDI, GDP growth rate,wage, trade rate, inflation rate and economicinvestment. The empirical results conclude that theprevious period FDI is important as an economicdeterminant. Besides, it is also understood that themain determinants of FDI inflows are Inflation rate, the interest rate and trade (openness) rate. Dua and Ranjan (2010) in their study on ‘Exchangerate Policy and Modeling in India’ explained thatthough capital flows are generally seen to be beneficialto an economy, a sudden surge in inflows over a short span of time in excess of the domestic absorptivecapacity can, however, be a source of stress to theeconomy giving rise to upward pressures on theexchange rate, overheating of the economy andpossible asset price bubbles. Further, foreigninvestment may have a negative impact on a country’sBoP due to repatriation of returns over a period of time, in the form of interest, dividends and royalties which,sometimes, exceed the foreign investment itself. Dr. Y. V. Reddy, former governor of RBI endorses thisview in his latest book on ‘Global Crisis: Recession anduneven recovery’, 2011 and confirms that can not beconstrued as permanent capital. FDI, at best, is lesstemporary. FDI in green-field projects may be treatedas permanent source of foreign capital.

An attempt has been made through the present studyto understand the impact of FDI on Indian economyfrom April 2005 to March 2011 i.e., before and after the eruption of Global Financial Crisis. The components ofFDI, as per Reserve Bank of India (RBI) classification are i) equity investment, ii) re-invested and iii) othercapital (including inter-company debt transactions ofthe firms that received FDI). While the RBI follows the above classificationin respect of FDI flows, The Ministry of Commerce &

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Industry (MoCI), Government of India shows only ‘equity investment inflows into India’ as FDI. In vies of the same, there exists a discrepancy in the data reported by these tow agencies. The present paper considers the data reported by Ministry of Commerce & Industry since equity investment flows represent actual FDI inflows into India (rather than reinvested earnings / inter-company debt transactions). Monthly data in respect of FDI equity inflows (FDI), Index of Industrial Production (IIP which is a proxy to Gross Domestic Product), Wholesale Price Index (WPI), Weighted average call money interest rates (INTR), Foreign exchange reserves (FR) and Average exchange rate of USD / INR (ER) are considered for the purpose of the study. The entire data have been sourced from RBI in respect of all variables except in case of FDI equity inflows, which have been obtained form MoCI. Correlation Coefficients Matrix has been used.

As per the World Investment Report, UNCTAD, 2011, the total volume of global FDI inflows steed at USD 1393 bn. in 2000 and peaked at USD 1971 bn. in 2007 before getting reduced to USD 1244 bn. In 2010 due to gloomier economic outlook, austerity measures, possible sovereign debt crisis and fiscal & financial sector imbalances in the developed economies coupled with rising inflation and signs of overheating in major EMEs etc. The report hints that cross-country FDI inflows into services sector declined in general and financial sector in particular, during 2010. As India embarked on economic reforms in 1991 and liberalized her Capital Account gradually, the country experienced significant growth in FDI inflows during the last two decades reflecting the ‘India’s growth story’. Since 1991, FDI has been allowed into India under two routes viz., i) Automatic route and ii) Approval route with certain sectoral caps. Subsequently in 2000, all industries, except a few, for strategic reasons have been brought under Automatic route. India’s FDI equity inflows were at a low level of USD 167 mn. In 1991-92 which increased later to USD 5.5 bn. In 2005-06 and reached the peak level of USD 27.3 bn. in 2008-09 before declining to USD 19.4 bn. during 2010-11 owing to Global Economic Slowdown as sown below.

It can be seen form the above table that FDI inflowsrose swiftly during 2006-07, as India allowed 100% FDIthrough automatic route for a number of sectors suchas Green-field airport projects, lying of pipelines,export trading etc. Besides, Government of Indiaenhanced the FDI caps in Telecom and Aviationsectors which resulted in a sharp jump in FDI inflowsinto India since 2006-07. over a period of time, FDI inIndia has been allowed up to 100% in sectors viz.,Mining, Chemicals, Pharmaceuticals, Power, Coffeeand Alcohol, Greenfield airports, Courier services,investment companies for the purpose of infrastructure (except telecom), NBFCs and SEZs. FDI inflows into India, however, declined in 2010-11partly due to her macro-economic concerns such asrising fiscal deficit and corruption scandals etc. coupled with global economic uncertainties. As per the latestTransparency International’s survey, India is placed at87th position in Corruption Index out of the total 181countries surveyed. FDI equity inflows into Indiapeaked during 2008-09 by reaching USD 27.3 bn. andlater came down suddenly to USD 19.4 bn. in 2010-11due to the Global Economic Slowdown. WorldInvestment Report, UNCTAD, 2011 states that thevolatility of the business environment after the crisis,particularly in developed countries, makes the foreigninvestors relatively cautious regarding theirinvestments in EMEs. Foreign investments in India are being routed throughMauritius are the highest followed by Singapore andNetherlands in 2010-11 (please refer Table II). Theforeign investment inflows from the USA, Cyprus &Germany, however, declined significantly during the FY2010-11 reflecting unwinding of overseas positions byinvestors due to heightened risk aversion andrepatriation of the proceeds back home. Investors from Netherlands, the UK, France and Japan have beenmaintaining or increasing their investment exposure toIndia during 2010-11 despite the above concerns. Thefollowing table shows the trends and sources of FDIinto India from various countries.

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The above FDI inflows into India mostly channeled into sectors such as Manufacturing including engineering goods and chemicals; Construction and Real Estate, Power, Financial Services and IT & IT enabled Services over the years. The following table depicts the trends and uses of FDI in India sourced from the above mentioned countries.

Note: the above data exclude FDI inflows under theNRI direct investment route through the RBI andinflows due to acquisition of shares under section 5 ofFEMA 1999. The data, however, includes FDI throughSIA / FIPB and RBI routes only. While ‘Manufacturing’ sector garnered the lion’s sharein FDI inflows into India as evident from the abovetable, infrastructure segments such as powertransportation, ports, airports, roads, railways,education facilities etc. also attracted major share ofoverseas investments. While FDI inflows have not ledto an export-oriented manufacturing revolution in India,as happened in case of China, they have contributed inmore subtle a ‘global manufacturing hub’ for certainproducts such as ‘automobiles and auto components,telecom products and metal castings and emerged as amain contender to China in the overseas markets. For the last one decade, India is considered as one ofthe major long-term investment destinations by theforeign investors because of her reform-orientedeconomy, macro-economic stability, gradual openingup of the Capital Account, investor friendly policyregime, lower costs of factors of production, increasingthrust on infrastructure Tax Treaties with certaincountries such as Maritius, favourable interest rate and growth -differentials (with average GDP growth rate of,7-8 % p.a.), largest English-speaking population thatserve international BPO / KPOs, conductive time zonefor the US and other advanced economies, substantialexpertise in IT and ITES etc. The prospects for furtherforeign investments in India appear brigs as severalpolicy initiatives are on the anvil.

When a country receives enormous amount of foreigninvestment inflows, a question arises as tosustainability of such flows if majority of them are ofvolatile or temporary in nature. Research indicates that FDI inflows, unlike portfolio flows from FIIS, are morepermanent in character and have a positive impact onthe real and financial sectors. All the variables aretransformed to natural logarithm and correlationcoefficients have been worked out to know therelationship between FDI and other macro-economicvariables, as displayed in Table IV. It is found thatthere is a co-movement between FDI inflows and IIP,which supports the underlying theory – ‘As more andmore FDI flows into various sectors of the economy,there would be a spurt in manufacturing of goods andservices across the country’. This would help inmaintaining price stability in the economy, which canbe seen from the negative correlation coefficientbetween IIP and WPI. Besides, it is observed that thereis an indirect relationship between FDI and WPI s

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foreign investment flows are mainly meant for capital expenditure of firms that promote production of goods and services further and reduce the demand-supply gap, thereby restraining the inflationary pressures in the economy. It is noticed that FDI and foreign exchange reserves have a positive correlation coefficient, in lime with the theory. It is also found that accumulation of foreign exchange reserves result in depreciation of USD against INR (negative correlation between FDI and exchange rate since USD is the base currency).

Foreign capital supplements and complements domestic capital to accelerate the pace of an economy’s growth apart from offering benefits like transfer of technology, best international management practices, creation of new employment opportunities and costs such as increase in asset prices, appreciation of exchange rates thereby losing domestic export competitiveness which ultimately may lead to Current Account Deficit in the BoP. The empirical study, conducted for the period from April 2005 to March 2011, revealed that FDI equity inflows accelerate the pace of industrial production in India and it will have a salutary effect on general price level in the economy. It is found that accumulation of precious foreign exchange reserves attract FDI inflows further. It is also found that FDI inflows do not affect the interest rates and exchange rates significantly. Hence, the Indian policy makers are encouraged to attract more and more FDI inflows into the country so as to accelerate the pace of industrial production thereby addressing supply side gaps to contain inflationary pressures in the economy and also to accumulate foreign exchange reserves so that international credit worthiness of the country can be enhanced.

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