IIM LUCKNOW’S MANFEST 2010 TREATISE

FDI FUELING INDIA’S

GROWTH
How long will it last?
 Submitted by
Udaya Bhanu Satapathy, u108116@stu.ximb.ac.in

Sujit Kumar Sahoo, u108111@stu.ximb.ac.in

Xavier Institute of Management,

Bhubaneswar
 FDI FUELING INDIA’S GROWTH: HOW LONG
WILL IT LAST?
INTRODUCTION
Foreign direct investment (FDI) is now widely perceived as an important resource for expediting the
industrial development of developing countries in view of the fact that it flows as a bundle of capital,
technology, skills and sometimes even market access. Most of the developing countries, therefore,
offer a welcoming attitude to multinational enterprises (MNEs) that are usually associated with FDI.
India’s case is a typical in this context. After following a somewhat restrictive policy towards FDI, India
liberalized her FDI policy regime considerably since 1991. This liberalization has been accompanied by
increasing inflows. The liberalization has also been accompanied by changes in the sectoral
composition, sources and entry modes of FDI. The increasing recognition of India’s locational
advantages in knowledge-based industries among MNEs has also led to increasing investments by them
in software development and in global R&D centres set up in India to exploit these advantages.

This paper analyses the question posed “whether FDI has fuelled India’s Growth and whether it is
sustainable”

RELATIONSHIP BETWEEN FDI, GDP AND EXPORTS: A REGRESSION ANALYSIS

Year FDI GDP Exports ( US Log of FDI Log of Log of
$) GDP Exports
1992 277 246000 17233 2.44 5.39 4.24
1993 550 276000 21579 2.74 5.44 4.33
1994 973 324000 25538 2.99 5.51 4.41
1995 2144 356000 31797 3.33 5.55 4.50
1996 2426 388000 33470 3.38 5.59 4.52
1997 3577 411000 35006 3.55 5.61 4.54
1998 2635 416000 33218 3.42 5.62 4.52
1999 2169 450000 36715 3.34 5.65 4.56
2000 2657 460000 44076 3.42 5.66 4.64
2001 4334 478000 43827 3.64 5.68 4.64
2002 3030 507000 52719 3.48 5.71 4.72
2003 4118 599000 63843 3.61 5.78 4.81
2004 4429 701000 83536 3.65 5.85 4.92
2005 4740 810000 103091 3.68 5.91 5.01
2006 5051 915000 126263 3.70 5.96 5.10
2007 5362 1180000 162984 3.73 6.07 5.21
2008 5673 1220000 182984 3.75 6.09 5.26
All values in million US $.

Source: Indiastat.com and Asian Development Bank ( www.adb.org/statistics)

Note: To achieve the stationarity of the data available, natural log of all the variables have been considered.
Some values in the above table are estimated.

Regression Analysis: Log of GDP versus Log of FDI

The regression equation is
Log of GDP = 4.12 + 0.466 Log of FDI
Predictor Coef SE Coef T P
Constant 4.1233 0.2833 14.56 0.000
Log of FDI 0.46627 0.08280 5.63 0.000

Scatterplot of Log of GDP vs Log of FDI

6.1

6.0

5.9

5.8
Log of GDP

5.7

5.6

5.5

5.4

5.3

5.2
2.50 2.75 3.00 3.25 3.50 3.75
Log of FDI

From the Regression Analysis it can inferred that FDI in India has had a positive relationship with GDP
of India and has fuelled the GDP growth of India. From the scatter plot, we can infer that GDP rallied
closely on the with the FDI flow in the initial years of economic reform, however it has mainly grown in
leaps and bounds over and above FDI flow in India. Hence we can assume that FDI has somewhat
fuelled the GDP growth in India. However from this analysis it can be proved to a certain degree of
certainty that FDI is not one of the sole major reasons for the robust GDP figures that India enjoyed
and continues to do so.

Regression Analysis: Log of Exports in India versus Log of FDI

The regression equation is

Log of Exports = 2.40 + 0.676 Log of FDI
Predictor Coef SE Coef T P
Constant 2.4016 0.4318 5.56 0.000
Log of FDI 0.6759 0.1262 5.36 0.000

Scatterplot of Log of Exports vs Log of FDI

5.4

5.2

5.0
Log of Exports

4.8

4.6

4.4

4.2

4.0
2.50 2.75 3.00 3.25 3.50 3.75
Log of FDI

From the regression analysis above it can inferred that FDI has had stronger positive relation with the
exports volume in India than with the GDP of India. This is quite in tune with common knowledge that
FDI has led to the growth of the IT industry and also as a low cost manufacturing hub. The scatter plot
gives a similar story as with (GDP v/s FDI plot). The exports have followed the FDI over many years and
gradually have scored higher that FDI in India.

The net inference is that FDI in India has fuelled more exports in India first and then indirectly
impacted the GDP of India. FDI more related to exports than GDP.

QUALITY OF FDI INFLOWS IN INDIA AND CHINA: A SECTORAL COMPARISON

India’s post reform experience ( since 1991) suggests that a major chunk of FDI has gone services ,
infrastructure relatively low technology intensive consumer goods manufacturing industries compared
to high concentration in technology intensive manufacturing industries in the pre-reform period. In
China and other south-east Asian countries on the other hand and, the bulk of FDI is concentrated in
manufacturing. In the pre reform period FDI was channeled to technology intensive manufacturing
through a selective policy. In the post reform period however due to opening of services and
infrastructure to FDI has led to a lot of FDI going to them thus bringing down the share of
manufacturing. Within the manufacturing too, now that there is no policy to direct the FDI to certain
branches, consumer goods industries that did not have so much exposure to FDI have risen in
importance.

On the other hand while following in general a liberal policy towards FDI, China and other south-east
Asian countries have directed FDI to manufacturing with export-obligations and other incentives such
pioneer industry programs. Hence, FDI also accounts for a relatively very high share of manufactured
exports in these countries. It suggests that a broad direction needs to be given to improve quality of
FDI and make it contribute more to the industrialization and building export capability. Specific
promotion of more export-oriented FDI may also be fruitful. This goes in tune to the Regression
Analysis done in the previous section.

FDI, GROWTH AND DOMESTIC INVESTMENT

FDI inflows can contribute to growth rate of the host economy by augmenting the capital stock as well
as with infusion of new technology. However, high growth rates may also lead to more FDI inflows by
enhancing the investment climate in the country. Therefore, the FDI-growth relationship is subject to
causality bias given the possibility of two-way relationship. What is the nature of the relationship in
India? A recent study has examined the direction of causation between FDI and growth empirically for a
sample of 107 countries for the 1980-1999 period. In the case of India, the study finds a Granger
neutral relationship as the direction of causation was not pronounced [Kumar and Pradhan 2002].

However, it has been shown that sometimes FDI projects may actually crowd-out or substitute
domestic investments from the product or capital markets with the market power of their well-known
brand names and other resources. Therefore, it is important to examine the impact of FDI on domestic
investment to evaluate the impact of FDI on growth and welfare in host economy. Our research to
examine the effect of FDI on domestic investment in a dynamic setting, however, did not find a
statistically significant effect of FDI on domestic investment in the case of India [Kumar and Pradhan
2002]. It appears, therefore, that FDI inflows received by India have been of mixed type combining
some inflows crowding-in domestic investments while others crowding them out, with no predominant
pattern emerging in the case of India. The empirical studies on the nature of relationship between FDI
and domestic investments suggest that the effect of FDI on domestic investment depends on host
government policies. Governments have extensively employed selective policies, imposed various
performance requirements such as local content requirements (LCRs) to deepen the commitment of
MNEs with the host economy. The Indian government has imposed condition of phased manufacturing
programmes (or local content requirements) in the auto industry to promote vertical inter-firm linkages
and encourage development of auto component industry (and crowding-in of domestic investments). A
case study of the auto industry where such policy was followed shows that these policies (in
combination with other performance requirements, viz, foreign exchange neutrality), have succeeded
in building an internationally competitive vertically integrated auto sector in the country.The Indian
experience in this industry, therefore, is in tune with the experiences of Thailand, Brazil and Mexico.
[Moran 2002]. The table below highlights the findings.

Shares of Foreign Firms in Indian Manufacturing during 1990s

Number Share (Per Cent) of

Of Sample Firms Foreign Firms in
Year Total Foreign Firms Domestic Firms Total Value Added Total
Sales
1,990 1,378 126 1,252 9.50 11.26
1,991 1,754 149 1,605 9.77 11.77
1,992 1,991 158 1,833 9.61 11.69
1,993 2,381 171 2,210 9.77 11.88
1,994 2,987 178 2,809 9.91 11.67
1,995 3,500 190 3,310 9.25 11.03
1,996 3,649 195 3,454 9.65 11.67
1,997 3,695 208 3,487 10.77 12.64
1,998 3,695 216 3,479 11.20 12.85
1,999 3,716 225 3,491 12.12 13.66
2,000 3,726 224 3,502 12.76 14.05
2,001 2,959 193 2,766 12.63 13.77
Source : RIS (RESEARCH AND INFORMATION SYSTEM FOR DEVELOPING CONTRIES)Database

R&D Intensity of Indian Manufacturing Enterprises Based on Ownership, 1990-2001

R & D Intensity ( percent)

Year All Firms Foreign Domestic Firms
Firms
1,990 0.053 0.114 0.046
1,991 0.082 0.086 0.082
1,992 0.148 0.213 0.139
1,993 0.201 0.365 0.178
1,994 0.217 0.378 0.196
1,995 0.272 0.377 0.259
1,996 0.312 0.376 0.303
1,997 0.413 0.447 0.409
1,998 0.341 0.559 0.309
1,999 0.352 0.477 0.332
2,000 0.311 0.386 0.298
2,001 0.343 0.320 0.346

Source: RIS (RESEARCH AND INFORMATION SYSTEM FOR DEVELOPING CONTRIES) Database

R&D, LOCAL TECHNOLOGICAL CAPABILITY AND DIFFUSION

From the table above it can be inferred that foreign firms appear to be spending more on R&D activity
in India than local firms although gap between their R&D intensities has tended to narrow down
vanishing by 2001. A study [Kumar and Agarwal, 2000] analysing the R&D activity of Indian
manufacturing enterprises in the context of liberalisation has found that after controlling for
extraneous factors, MNE (Multi National Enterprises) affiliates reveal a lower R&D intensity compared
to local firms, presumably on account of their captive access to the laboratories of their parents and
associated companies. The study also observed differences in the nature or motivation of R&D activity
of foreign and local firms. Local firms seem to be directing their R&D activity towards absorption of
imported knowledge and to provide a backup to their outward expansion. MNE affiliates, on the other
hand focus on customization of their parents’ technology for the local market. As the analysis suggest
FDI should be more diverted towards developing indigenous R&D in India.
RECOMMENDATIONS
For the positive trend of growing FDI investment in India to grow, following recommendations can be
taken:

ATTRACT ‘QUALITY’ FDI

One of the biggest myths surrounding FDI today is that it is always good for the economy’s present and
future. But, in reality it is actually “quality FDI” which works positively for the economy. World
Investment Report published by UNCTAD in 2006 describes “quality FDI” as “the kind that would
significantly increase employment, enhance skills and boost the competitiveness of local
enterprises.” Whether FDI succeeds in these objectives depends on the sector, industry and the
country’s global strengths. It also depends on the industry’s dependence on external capital and the
level of skill of people required.

Not all foreign companies have the same objectives when they invest in a country. Firms may differ in
terms of degree of vertical integration, investment in local R&D, local sourcing and export orientation.

The advantages derived from FDI differ across primary, services and manufacturing sectors. There may
be differences across industries within a particular sector also. FDI in primary sector industries like
mining, agribusiness and raw materials offers lesser scope of technical progress in developing
countries. In contrast, industries in manufacturing sector and other technology-intensive industries
attract high quality FDI. This is because, in developing countries (having a lower technology base), the
probability of domestic firms learning about new technology and new knowledge through collaboration
and reverse engineering is very high. In contrast, in labor-intensive industries (found mainly in
developing countries), technically advanced firms tend to crowd out the lesser performing and
financially weaker domestic firms.

ATTRACT TECHNOLOGY AND LOCALIZE PRODUCTION

The benefits from FDI are maximized when it finds its way into technology-intensive sectors and when
the production is localized in the host country. Localized production causes knowledge and technology
spillover to domestic companies through a high level of vertical integration, local sourcing and local
collaboration. Unless transfer of technology and knowledge happens, there is very little FDI can do for
the growth of the economy. Foreign pharmaceutical firms in India in the period 1940-1960 invested
little in their local manufacturing base and were used to process imported bulk drugs into formulations
to sell locally. This activity did not transfer any knowledge to the local industries; neither did they
train people with any advanced skills. Such FDI is wasteful, as it provides only employment to local
people, but does not train them in new technologies.

THE ‘SPILLOVER’ ILLUSION

Spillover means the adoption, by domestic companies, of the knowledge, new technologies and best
practices followed by the foreign companies. Spillover may happen in the following ways:

• Learning the best management practices and technology from their foreign partners
• Employees moving from one company to other
• Local suppliers and service providers being told by the company to follow their standards
• Assistance provided to customers by the company

This spillover is the single biggest reason countries go out of their way to attract FDI. But, the degree
of spillover depends highly on the ability of local firms to respond successfully to new entrants, new
technology, and new competition. It also depends on the human capital and degree of dependence on
foreign capital.

There are a few prerequisites which must be satisfied when it comes to take the advantage of
spillovers. Firstly, to compete against foreign entrants, local firms need skilled labor capable of
improving the production efficiency, adopting new technologies and increasing the quality of their
products. FDI affects skill-dependent industries in a positive way and the intensity increases with the
level of skill-dependency.

Secondly, knowledge spillovers work only when foreign companies are willing to bring new technologies
and skills to the host country. It is extremely good for India as long as companies like Intel set up their
R&D bases locally. In fact, it can be mandated by the government to include technology and knowledge
transfer clauses when allowing foreign companies the access to India’s vast markets and manpower.

FOCUS ON EXPORT- ORIENTED FDI

According to market-orientation, an FDI project either be domestic market-seeking or export-oriented.
Domestic market-seeking FDI primarily intends to serve the local market. On the other hand, export-
oriented FDI aims to focus on its global markets.

Export-oriented FDI is of higher quality FDI than domestic market-seeking FDI. This is because export-
oriented companies tend to form micro-level linkages with domestic firms in the form of sourcing and
partnerships. Their objective is to exploit the low cost infrastructure and cheap skill available locally
for export purposes. In addition to knowledge spillovers to local suppliers, export-oriented foreign
firms also cause information spillovers to purely domestic firms to enter into export market. Also, by
providing new competitive assets through export-oriented FDI, the supply capacities of export oriented
firms are increased. The crowding out effect of local firms is also low in case of export-oriented firms.

TARGET SPECIFIC SECTORS

Investment promotion agencies (IPAs) of different countries focus on attracting FDI in only specific
sectors and industries which fit well with their country’s economic characteristics and their strengths.

Country Target sector for attracting FDI

Denmark Sciences, ICT, and Renewable Energy
Sweden Automotive, life sciences, communications and wood processing industries
Poland Automotive manufacturing, business services, and R&D
Australia Textiles and wood products
Costa Rica Medical devices, electronics and a range of services

The table above shows the sectors targeted by some countries for attracting FDI. These are the sectors
in which these countries possess global strengths. India also needs to focus majorly on a few sectors to
attract FDI e.g. manufacturing, services, communications etc.

INCREASE EASE OF DOING BUSINESS

India performs dismally when it comes to starting up a business in India. Doing Business Report, 2010
Published by World Bank gives India a rank of 169 which is way below comparative economies like
China (151), Brazil (126) and Russia (106). India fares badly in number of procedures required, time and
cost of starting a business in India.
 Starting a business in India

Country Procedures Time Cost (% of Min. capital

(number) (days) income per (% of income
capita) per capita)
Brazil 16 120 6.9 0
Japan 8 23 7.5 0
Russia 9 30 2.7 1.8
Mexico 8 13 11.7 8.9
Indonesia 9 60 26 59.7
China 14 37 4.9 130.9
India 13 30 66.1 210.9

India has secured good ranks in parameters of “Getting Credit” and “Protecting Investors”, but in other
parameters, a lot needs to be done. The government needs to emphasize on policy reforms to improve
India’s rank in different parameters to make India the investment destination of the world.
 Doing Business 2010

NEW GROWTH AREAS WHERE FDI CAN BE DIRECTED

IMPACT OF FDI ON BANKING AND INSURANCE SECTOR
Owing to many reforms, the banking sector in India has seen remarkable improvement in financial
health and in providing jobs. Even in the event of a severe economic downturn, the banking sector
continued to be a very dominant sector of the financial system. The aggregate foreign investment in a
private bank from all sources is allowed to reach as much as 74% under Indian regulations.

The insurance sector has also been fast developing with substantial revenue growth in the non-life
insurance market. Though despite its enormous population, India only accounts for 3.4% of the Asia-
Pacific general insurance market’s value. The cap on foreign companies’ equity stakes in insurance
joint ventures is 26%, but is expected to rise to 49%.

Despite the surge in investments, the stringent regulatory framework governing FDI has proved to be a
significant hindrance. However the stringent policies in this field need to be re considered for banking
and insurance sectors as foreign investment, brings with it technological innovation and expertise. It is
also important to recognize that FDI in banking can address several issues pertaining to the sector such
as encouraging development of innovative financial products, improving the efficiency of the banking
sector, and ensure better capitalization of banks and better ability to adapt to changing financial
market conditions.

Having said that FDI norms have been relaxed to a considerable extent with respect to certain sectors.
Private banks, for instance. These measures are a welcome change and promise to fuel India’s banking
and insurance sectors which are significant sustainable growth wagons of the country.

FDI IN PHARMACY RETAILING

According to the India Retail Report easing of foreign direct investment norms in pharmacy retailing in
India can lead to exponential growth in the sector, which may reach a size of Rs43,000 crore in the
next two years. Pharmacy retail is growing at the rate of 20-25% annually. The organised pharma retail
market size has the potential to grow to $9 billion by the year 2011.

The size of India’s pharmacy retail market is estimated at $4.5 billion, which is dominated by 12-15 big
players.

As of now pharmacy chains are highly regulated and there is restriction on FDI investment in the retail
sector. However, if government removes the restriction, there exists huge potential to grow.

There are more than 3,500 organised retail pharmacy outlets in India. This is expected to grow nearly
three times to 10,000 outlets by end of next year, the report said. Growth in pharmacy will lead to
better livelihoods and is expected to bring down costs and improve the supply of drugs which in turn is
expected improve the human developed index of India.

FDI TO BUILD UP THE TRANSPORTATION NETWORK IN INDIA

India is likely to attract foreign direct investment of about $10 billion for the roads sector in the next
two years according to transport minister Kamal Nath (livemint news report, August, 2009)

According to Mr Nath, we would get about 10$ billion of foreign investment in the next two years. The
ministry is positive about all impediments to the FDI flow would removed and FDI would be used for
building of Roads and highways.

Better infrastructure in terms of better roads will ensure a more efficient supply chain system in India
and reduce the operational costs of companies in India. Better roads will lead to better network for
marketing and distribution of food grains and reduce in transit food wastages.

CONCLUSION
To conclude, India has the potential to be the investment hub of the world if the government has
complete focus on the same. Over the last decade, Indian government has been doing positive things to
promote India as an FDI destination. But, India needs to emphasize on the right sectors and industries
which can utilize the spillover effect and reduce the crowding out effect. The next decade will
probably see India rise up the ranks and attract more and more FDI.
REFERENCES
• “Quality of foreign direct investment, knowledge spillovers and host country productivity”,
Jaya Prakash Pradhan, ISID Working Paper, No. 2006 /0 9, Institute for Studies in Industrial
Development, New Delhi , 2006
• “Growth and the Quality of Foreign Direct Investment: Is All FDI Equal?”, Laura Alfaro (Harvard
Business School and NBER) and Andrew Charlton (London School of Economics), May, 2007
• Doing Business Report 2010, World Bank
• Kumar, Nagesh and Jaya Prakash Pradhan (2002): ‘Foreign Direct Investment,Externalities and
Economic Growth in Developing Countries: Some Empirical Explorations and Implications for
WTO Negotiations on Investment’, RIS (RESEARCH AND INFORMATION SYSTEM FOR DEVELOPING
CONTRIES)Discussion Paper #27/2002
• Moran, Theodore H (2002): Foreign Direct Investment and Development,Institute for
International Economics, Washington, DC.– (2001): Parental Supervision: The New Paradigm for
Foreign Direct Investment and Development, Washington, DC.
• Kumar, Nagesh and Aradhna Agarwal (2000): ‘Liberalisation, Outward Orientation and In-house
R&D Activity of Multinational and Local Firms: A Quantitative Exploration for Indian
Manufacturing’, RIS (RESEARCH AND INFORMATION SYSTEM FOR DEVELOPING
CONTRIES)Discussion paper #07/2002.
• India Retail Report 2008
• www.livemint.com, last accessed on 25th December, 2009
• Data derived from Indiastat.com, ris.org.in,adb.org.in and google.com