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 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 FDI GDP 277 246000 550 276000 973 324000 2144 356000 2426 388000 3577 411000 2635 416000 2169 450000 2657 460000 4334 478000 3030 507000 4118 599000 4429 701000 4740 810000 5051 915000 5362 1180000 5673 1220000 Exports ( US Log of FDI Log of Log of $) GDP Exports 17233 2.44 5.39 21579 2.74 5.44 25538 2.99 5.51 31797 3.33 5.55 33470 3.38 5.59 35006 3.55 5.61 33218 3.42 5.62 36715 3.34 5.65 44076 3.42 5.66 43827 3.64 5.68 52719 3.48 5.71 63843 3.61 5.78 83536 3.65 5.85 103091 3.68 5.91 126263 3.70 5.96 162984 3.73 6.07 182984 3.75 6.09 4.24 4.33 4.41 4.50 4.52 4.54 4.52 4.56 4.64 4.64 4.72 4.81 4.92 5.01 5.10 5.21 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 Log of FDI 3.50 3.75

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 Constant Coef SE Coef T P 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 Log of FDI 3.50 3.75

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

Year 1,990 1,991 1,992 1,993 1,994 1,995

Number Of Sample Firms Total Foreign Firms 1,378 1,754 1,991 2,381 2,987 3,500 126 149 158 171 178 190

Domestic Firms 1,252 1,605 1,833 2,210 2,809 3,310

Share (Per Cent) of Foreign Firms in Total Value Added Total Sales 9.50 11.26 9.77 11.77 9.61 11.69 9.77 11.88 9.91 11.67 9.25 11.03

1,996 1,997 1,998 1,999 2,000 2,001

3,649 3,695 3,695 3,716 3,726 2,959

195 208 216 225 224 193

3,454 3,487 3,479 3,491 3,502 2,766

9.65 10.77 11.20 12.12 12.76 12.63

11.67 12.64 12.85 13.66 14.05 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 1,990 1,991 1,992 1,993 1,994 1,995 1,996 1,997 1,998 1,999 2,000 2,001 All Firms Foreign Firms 0.053 0.114 0.082 0.086 0.148 0.213 0.201 0.365 0.217 0.378 0.272 0.377 0.312 0.376 0.413 0.447 0.341 0.559 0.352 0.477 0.311 0.386 0.343 0.320 Domestic Firms 0.046 0.082 0.139 0.178 0.196 0.259 0.303 0.409 0.309 0.332 0.298 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, exportoriented FDI aims to focus on its global markets. Export-oriented FDI is of higher quality FDI than domestic market-seeking FDI. This is because exportoriented 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 Denmark Sweden Poland Australia Costa Rica Target sector for attracting FDI Sciences, ICT, and Renewable Energy Automotive, life sciences, communications and wood processing industries Automotive manufacturing, business services, and R&D Textiles and wood products 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 (number) 16 8 9 8 9 14 13

Time (days) 120 23 30 13 60 37 30

Cost (% of income per capita) 6.9 7.5 2.7 11.7 26 4.9 66.1

Min. capital (% of income per capita) 0 0 1.8 8.9 59.7 130.9 210.9

Brazil Japan Russia Mexico Indonesia China India

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 AsiaPacific 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

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