Macroeconomic Determinants of Foreign Direct Investment in India

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1 Macroeconomic Determinants of Foreign Direct Investment in India *Dr. G. Bharathi Kamath *Assistant Professor-Economics Area, IBS-Mangalore. Introduction: FDI has been one of the most debated and significant factor in the economic development of the last 3 decades. In Asia, foreign direct investment (FDI) has increased significantly over the past two decades. However, this FDI has been concentrated in a few countries. In the early 1990s, seven East Asian countries China, Korea, Singapore, Indonesia, Malaysia, Philippines and Thailand received more than 60 per cent of the FDI inflows then all-other Asian countries. The BRIC report [1] states that India is going to be one of the most popular destinations for FDI from across the globe. However, the preliminary question still remains whether this inflow of FDI is going to lead to any growth in our domestic economy and exports, if yes how much and will it be significant enough to drive further FDI inside the economy. Increases in FDI inflows exceeded the growth in nominal value of World GDP and international trade, which expanded by around 3.5 percent and 7 percent in 2006 respectively (World Investment Report, 2005). Foreign direct investment can be defined as an investment which involves establishing a long term relationship with the country where the investment takes place and it reflects an intention of lasting interest and control by the country which has made the investment. By making a FDI, the home countries investor expects to get management control and also a major say in the decision making process of the host countries company. The inflow that takes place through FDI is not a one time flow, depending on the interests and extent of profitability and performance the home country may decide to reinvest/expand. The FDI can come from individuals as well as companies. (World Investment Report, 1997). The components included to account the FDI values from country to country. Theoretical Background: There are various theoretical foundations that discuss the FDI: 1

2 (i) Structuralist Paradigm: Foreign investment is to be welcomed and actually encouraged through tax concessions etc i.e. as a source of foreign finance and technology. However, for Rural Prebish, such investment should flow into the branches of production in which it is most needed (Hunt, 1987). [1] www2.goldmansachs.com/insight/research/reports/99.pdf (ii) Over Lapping Generations Model: The overlapping Generations (OG) model is a long run growth model and it gives a different perspective of the effects of foreign direct investment on the home and host countries. The summary of the finding of this model is that when a country takes up the foreign investment it makes the future generations of the country which imports capital(host country) better off and the future generations of the country that Exports capital(home country) worse-off (Bhalla, 1994). When a foreign investment takes place anywhere in the world, the rate of interest increases in the home country and it tends to fall in the host country. The capital stock of the previous generation determines the wage levels of the present generation. It therefore directly affects the savings made by the present and future generations. The wage rate is assumed not to change. Therefore, since foreign investment reduces the rate of interest in the host country, according to the O.G. Model the present generation suffers the effect of low interest rates. The rate of Interest increases in the home country which exports capital, therefore, the present generation of that country enjoys the fruits of high interest rates (Roy, 1979). (iii) OLI Paradigm: The most recent of them all, is the one given by Dunning popularly known as Eclectic or OLI paradigm. It discusses about ownership (O), location (L), internalization (I) advantages of a country s firms differentiates along the country s course of economic development (Dunning, 1994). According to this theory, three conditions have to be fulfilled in order for a firm to become a multinational: the ownership (O) advantages must be such as to make it profitable for the firm to relocate abroad its own production (or at least part of it); there must be some localization (L) advantage, typically linked to the host country s specific characteristics; it must be more convenient the firm to manage its advantages internally (I) rather than trade them through the market. This appeared to be a very useful paradigm in explaining the different characteristics that needs to be fulfilled for a firm to be called a Multi-national and also helped in developing further empirical workings on this topic. (Soci, 2002). 2

3 Review of Earlier Works: Foreign capital inflows play an important role in supplementing and complementing resources of developing countries in their efforts towards higher levels of development. The role of foreign capital has been emphasized in literature on economic development, for instance, the gap models (Hunt, 1988) and the Kindleberger-Hymer Approach to foreign direct investment. It is Abba Learner who discussed at length about of inflow of foreign capital (Lerner, 1944). The general effects of foreign investment on development received a good treatment in the works of MAC Dougall (Dougall, 1966). The work of Kemp (Murray, 1960) can also be mentioned in this respect. However, the question of the possible adverse effects of foreign capital on the levels of domestic saving was first raised by Trygve Haavelmo (Haavelno, 1960). Following Haavelmo, many evinced interested in studies on the relationship between foreign capital and economic growth in developing countries. There was a proliferation of studies on this and the works of Lee, Rana and Iwasaki in the context of Asia is important (Lee, 1986). One of the earliest studies on the relationship between foreign direct investment and growth is that of Papanak (Papanek, 1973). Among country specific studies, the work of Gustav Ranis and Chi Shive on Taiwan (Ranis, 1985) is very exhaustive. In 1970, it is Rober Aliber who raised many theoretical issues like whether FDI is a currency area or customs areas phenomena (Aliber, 1970). W.B. Reddaway s analysis (Reddaway, 1968) of influence of FDI on BOP is a land mark study in the literature on FDI. A more general theory originally propounded in a thesis at MIT by Stephen Hymer is that direct investment belongs more to the theory of industrial organization than to the theory of international capital movements. Hymer s work emphasizes that firms engaged in direct investment have monopolistic elements and the perfect competition model is not relevant. To the literature on FDI, the greatest contribution is made by Charles, P. Kindleberger (Kindleberger, 1958, 1968). His influence on subsequent works is profound that his analysis and approach to FDI along with that of Stephen Hymer is well known as Kindleberger Hymer Approach. However, there are some region specific studies too, which helps in understanding what are the FDI drivers at a very disaggregate level and has useful implications at policy making level (Na, 2006). Others talk about development of successful FDI strategies at national level (Musila, 2006). Some simplistic papers look at just the trends of FDI in various countries- what they expect to measure is the general perspectives without exploring in detail what are the implications of these investments on the national growth 3

4 and other parameters. There are studies pertaining to firm level analysis of the determinants (Pantelidis, 2005), and the paper deals with specific determinants of US FDI in India (Balasundram, 1998). Objectives of the Present Study: The main objective of this paper is to analyze the major determinants of outward and inward Foreign Direct Investment (FDI) in India, such as income, exchange rate, technology, human capital and openness of the economy and determine which is more significant than others. Hypothesis: It is known through the theories specified above that the any asset of the country keeps evolving over a period of time along with its development and changes in the external environment especially the economic policies. The firms in the economy also keep reacting to the above changes and make suitable strategies of growth. The FDI which flows in and out of the economy therefore must be a reaction and dependent on these country specific parameters. Thus this paper tries to evaluate the hypothesis that the FDI is a function of the factors specific to a country such as Income, exchange rate, technology, human capital and openness in the economy with specific reference to Indian economy. Period of Study: A time-series data is taken for analysis, from 1980 to 2005 for analysis. The model tries to identify the main determinants of FDI in Indian economy. Sources of Data: 4

5 Varied sources are taken for various parameters. Primarily the data on FDI, exports, imports, interest rates, Exchange rates and GDP is taken from Reserve Bank of India (RBI) online database of Indian Economy and other annual publications on Indian economy by Reserve Bank of India. The data for Human capital and the technology is taken from the World Bank Reports and UNESCO s report of various years. Methodology: The model function is given below in the following form: FDI = F(Y; I; ER; T; HC; O; D) Where, FDI = Outward/inward flows of FDI. Y = Real GDP. I = Interest rate. ER = Real Effective Exchange Rate (REER) Index. T = Technology variable. This variable is reflected through the number of patents issued in the home country. HC = Human capital variable. It is approximated by number of education students. O = Openness of the economy. This variable is reflected by the level of exports plus imports. D = Dummy variable for measuring the impact of liberalization process started in 1991 in the Indian economy. It takes the value 0 for the years between 1980 and 1991 and the value 1 for the years between 1991 and The signs given below the variables indicate the expected relation (negative or positive) between the independent variables and FDI outflows. The linear regression analysis is done using the OLS for the period between 1980 and The Model: Variables used and Explanations: The dependent variable in the model is FDI of the given economy for the period specified above. There are several independent variables in the model namely Income, exchange rate, technology, human capital and openness in the economy. A brief explanation as to why these are considered as variables in the model and why they are regarded as independent variables supposed to have an influence on FDI is explained below. 5

6 1. Income: The first independent variable is GDP of the economy. It is generally observed that the pattern of International Trade in terms of the composition and direction changes with development of an economy. There are changes observed in the internal sectors also such as increasing share of industry and service sectors, the capital intensity of production increases, demand patterns move towards the consumption of differentiated products and markets grow. The latter improves the realization of economies of scale through specialization, the introduction of new technology and greater volumes of output (Chenery et al., 1986). As the income of the nation increases there is always a possibility that firms start accumulating advantages which are owner specific or are resource specific. Thus the OLI advantages as mentioned earlier gets created which attracts more FDI within the country as makes the domestic economy more inclined towards the external market (Dunning, 1993). Thus, it can be said that as in case of trade the investment pattern also undergoes a change with the development of the economy. Thus, in this model, the GDP of the nation is taken as a variable to measure the development and structural changes of the economy over the period of study. It is expected as shown in the model that their is a positive relationship expected between the FDI and GDP indicating that as the nation advances towards more development, the FDI inflows and outflows increase. 2. Exchange Rate: The appreciation and depreciation of currency does have an impact on the price of exports and imports making their comparative position and competitiveness in international markets fluctuate sometimes towards advantage to the home country and sometimes disadvantage. It was argued by (Aliber, 1970) that firms which come from countries that have strong currency are able to financially support their foreign direct investments in a much better manner than those firms which come from countries that have a inherently weak currency. The link between the interest rate and exchange rate also makes it more beneficial for a firm to go in for a FDI as the currency appreciates. Similarly the reduction in competitiveness of exports also may make the country look for better ways of entering international business. Thus, there appears to be a sure link between the exchange rate and outward FDI, and the relation is expected to be positive for outflows and negative for inflows as shown in the model. The real effective exchange rate index of the Indian economy which is calculated as a weighted average of top currency basket is taken as a representative of the variable exchange rate 3. Interest Rate: Foreign operations require significant commitment in capital, especially if they are undertaken in capital intensive sectors where production is characterized by extensive economies of scale, as the case is for most FDI. If there is abundant capital in the home country, that may become one of the primary reasons for going in for foreign investment by large firms. Such firms would have adequate financial means and they would also be able to access the capital markets much more efficiently than small capital starved firms. The opportunity cost of capital for such firms also comes down due to relatively low interest rate which occurs as a result of capital abundance. These firms are willing to take up the risks and uncertainties associated with foreign investments because the returns on such investments also being high (Krykilis, 2003). Therefore, it is expected that if the interest rate of the home country is low, then 6

7 there would be high propensity for FDI inflows and vice versa (Clegg, 1987; Prugel, 1981; Lall, 1980; Grubaugh, 1987). 4. Technology: This factor is widely recognized as one factor that does have a sure and great impact on FDI, infact the FDI sometimes may be the cause for increasing technological progress as it also gets influenced by the level of technological progress of the economy. Every firm across different countries has its own ability to organize and produce technological inputs. This depends on several parameters like the legal systems and patent processes, the availability of technological inputs and the requisite skills to handle it, the market structure, the policy of the government related to education and the incentives that these policies offer to encourage education, scientific research, etc., (Krykilis, 2003). The ability of firms to generate technological inputs of a country is approximated by the number of patents issued. Thus higher the patents issued higher would be the outward FDI propensity of the country. Researchers across the globe have proved theoretically as well as empirically that technological capability is positively related with FDI (Lall, 1980; Prugel, 1981; Grubaugh, 1987; Clegg, 1987; Cantwell, 1981; Cantwell, 1987; Pearce, 1989; Kogut and Chang, 1991; Dunning, 1993, Krykilis, 2003). 5. Human Capital: Some researchers proved that the skill intensive sectors are more prone to attract the foreign direct investment than the rest (Juhl, 1979; Lall, 1980; Prugel, 1981; Clegg, 1987). The availability of the human resources is one factor that plays an important role in determining the FDI; however the sheer number does not affect the inflow as the quality of the human resource does. The size of labour force may be instrumental in determining the price of the factor, as low labour cost may increase the cost competitiveness of the firm. But in a skill intensive industry, the quality of the labour force determined by the number of people who are educated and the number of science and technology professionals that exist matters. The human capital supply varies depends largely on the education systems and also the government policies. The number of students both male and female who are taking up higher level of education is taken as a variable to measure this factor, as the data of R&D professionals in the Indian economy is not available for continuous years for the period of study. Many researchers showed that the higher the number of graduates, the higher would be the expected skill content in the employment. Thus, there is a positive relation that is suggested between human capital and FDI (Krykilis, 2003). 6. The Openness of the Economy: The FDI activities of the firms are constrained when there is protectionist policy followed; therefore these activities are encouraged when the country embarks on the path of liberalization. The reasons for this change are many. The capital controls are relaxed which makes the flow of capital and funds for investment between countries easier and faster (Scaperlanda and Mauer, 1973; Scaperlanda and Balough, 1983; Scaperlanda, 1992). The management skills of marketing products internationally, innovations, technology advancements and knowledge of external operations become unrestricted in an economy that is export oriented. The firms of an open economy may choose retaliation against the competition that FDI has brought in by different modes and may also involve themselves in the home markets of the import producing countries. (Krykilis, 2003). The exports plus imports level of a country is taken as a variable to represent this degree of economies openness. 7. Dummy Variable: Dummy variable is taken for measuring the impact of liberalization process started in 1991 in the Indian economy. It takes the value 0 for the years between 1980 and 1991 and the value 1 for the years between 1991 and

8 Data Analysis and Results: FDI is seen to increase as a percentage of the Gross Domestic Product of most of the economies indicating the movement towards more openness in the world economy. On the whole, FDI forms around 22 percent of the GDP of all the Economies of the world. As shown in Table I, The developed countries are seen to be moving closely with the World average. Whereas, the developing economies are seen to be improving very fast and keeping the share steady in the recent years. United Kingdom among the developed economies and Hong Kong, China in the developing economies are the top destinations of FDI, as seen in the Table, the economy of Hong Kong overwhelmingly attracting Foreign Investments followed by Singapore and Vietnam in East Asia. India is slowly picking up the speed as far as FDI is concerned. It started with a meager 0.33 percent and is presently at around 6 percent. Amongst the developing economies all the continents are faring equally as far as this parameter is concerned. Foreign capital is treated as a resource gap-filling factor in the context of capital scarcity in developing countries. In developing countries, FDI is now the principal source of foreign capital. There are good reasons to believe that FDI is preferred to other types of flows. One of the most preferred arguments for FDI is that it brings in a complete package of capital, technology and market access. It may also result in the manufacturing sectors earning a potential competitive advantage (Edward, 1992). In those manufacturing sectors which enjoy comparative advantage, the inflow of FDI would give rise to economies of scale and higher productivity and create linkage effects (Edward, 1992) with FDI, profitability and outward remittance of profits and dividends move in close tandem with the performance of the economy and the balance of payments (Siow, 1993). Coming to the scenario in Asia, few economies in this region are attracting heavy inflows and others remain a low player. As can be seen in the Table II, Asia contributes around one-fifth of the world s FDI. South, East and South-East Asia contributing almost four-fifth of the total inflows destined in this region. However, there is a huge skewness in favor of some economies in East Asia, with China dominating the scene among all the economies. The internal policy framework and the conducive environment for the foreign investors have been very fruitful over the period for China. South Asia is among a deprived region in entire Asia, with India contributing only around 3 percent to the regions inflow in the year Singapore and Thailand are among other economies in this region that attract a large inflow of Direct Investments. Take in Table I 8

9 Table I Inward FDI Stock as a Percentage of Gross Domestic Product, by Host Region and Economy, Region/economy World Developed economies Europe United Kingdom North America United States Other developed countries Developing economies Africa Latin America and the

10 Caribbean Asia and Oceania Asia West Asia East Asia China Hong Kong, China Korea, Democratic People's Republic of Korea, Republic of South Asia India Pakistan Sri Lanka South-East Asia Indonesia Malaysia

11 Philippines Singapore Thailand Viet Nam South-East Europe and the Commonwealth of Independent States (CIS) Source: World Investment Report 2006 Take in Table II Table II Inward FDI Flows, by Host Region and Economy, (in US $ Million) Asia % of World

12 West Asia % of Asia South, East and Southeast Asia % of Asia East Asia % of Asia China % of Asia Hong Kong, China Korea, Republic of Taiwan Province of China South Asia % of Asia

13 Bangladesh India % of Asia Pakistan Sri Lanka South-East Asia % of Asia Indonesia Malaysia Philippines Singapore % of Asia Thailand Source: World Investment Report 2006 (percentages estimated) 13

14 Since the data used is time series and for over two and half decades, it was checked for its stationarity and there was no stationarity observed. The descriptive statistics of the data set is given in Table III, as it can be observed that in India the Inflows of foreign direct investment in all years have been much higher than the outflows, this aspect owes itself to the liberalization policies which were put in place quite late in the economy only after 1991 when they were initiated. The process of integrating the domestic economy with the global economy though has advanced over a period; it still remains partial in many cases. Take in Table III Table III Descriptive Statistics Mean Std. Deviation FDI In FDI Out GDP ER I P T O

15 Correlations between variables is estimated and shown in the Table IV, the correlation coefficients are estimated using the Karl Pearson s method. As can be observed that GDP shows a high level of correlation with most of the variables whereas, the Exchange rate shows almost a negative and weak relationship with most of the variables in the model as is the case of Interest rates and technological development. Human capital development and openness of the economy is closely and positively related which is a good sign of economic progress. Take in Table IV Table IV Correlations FDII FDIO GDP REER INT PATENTS EDN XM D FDII Y ER I T HC O D The regression results are shown in Table V, here the FDI inflows are taken as dependent variable and other variables as independent. It can be observed that the constant in the model is significant. It can be seen that all variables except the exchange rate, interest rate and technological factor is seen to have values as expected in the model. However, this factor also shows no significance in the model. Though the overall 15

16 goodness of fit is very high and the Durbin-Watson statistics does not show any signs of autocorrelation among the data variables, surprisingly the exchange rate is not related to the inflows of FDI in the Indian scenario possibly because it was controlled for a major part of years in the period of study. The process of liberalization also shows a positive and significant impact on the FDI flows, as seen by the results of dummy variable, which should be a factor that the policy makers should note and go ahead with further fastening of the pace of relaxations of norms for FDI inflows in the economy. Thus, it can be said that that Indian FDI inflows are mainly dependent on the levels of openness and sectors of available for inflows rather than major macro economic considerations such as exchange rates and technological aspects. The domestic cost structures and the availability of human capital in abundance and openness in the economy seems to be a very significant factor to impact the FDI inflows as can be seen in the model. Take in Table V Table V OLS estimates of all variables in the model Variables FDI In t-statistics Y ER I T HC O D Constant R F statistic DW

17 The FDI outflow of the Indian economy has been largely restricted by policies almost till the turn of the millennium. The regression results of FDI outflows as a dependent variable can be seen in Table VI. As can be observed that none of the variables are significant except the human capital and most of the variables are showing reverse correlations as against the expected signs in the model. Thus, the model can be discarded as not relevant in Indian context as Indian liberalization of FDI outflows has still a long way to go. This need to be tested further when the liberalization process takes off in true sense and in a complete manner. Take in Table VI Table VI OLS estimates of all variables in the model Variables FDI Out t-statistics Y 3.73E ER I T HC 4.46E O 4.74E D Constant R F statistic DW

18 Conclusions: The exchange rate and economic growth seem to show least impact on the FDI inflows in Indian economy and human capital and openness of the economy plays a significant role as far as attracting inflows are concerned. These results are exactly opposite to the findings related to developed countries FDI determinants, where exchange rate and GDP play a more positive and important role (Krykilis, 2003). This shows that the liberalization process of the economy needs to be fastened and more and more sectors should be thrown open for inward flows. Similarly the model does not work for outward flows as in many cases the flow is restricted by policy. Thus, it can be said that human capital plays a significant role, which can be related to the abundance of human resources at a competitive cost. Finally, national endowment resulting in natural competitiveness does determine the FDI of Indian economy. References: 1. Aliber, R.Z. (1970), A theory of foreign direct investment, in Kindleberger, C.P. (Ed.), The International Corporation, MIT Press, Cambridge, MA. 2. Anna Soci., (2002), FDI: The Current State of Play, Paper presented at the EAEPE (European Association for Evolutionary Political Economy) Conference at Crete, University of Bologna. 3. Balasundram Maniam and Chatterjee Amitava, (1998), The Determinants of U.S. Foreign Direct Investment in India: Implications and Policy Issues, Managerial Finance, Vol. 24, No. 7, pp Bhalla V.K., (1994), Foreign Investment and New Economic Policy, Anmol Publications, Pvt. Ltd., New Delhi, P Cantwell, J. (1981), Technological Advantage as a Determinant of the International Economic Activity of Firms, Discussion Papers in International Investment and Business Studies, No. 105, University of Reading, Reading. 6. Cantwell, J. (1987), The reorganization of European industries after integration: selected evidence on the role of transnational enterprise activities, Journal of Common Market Studies, Vol. 36, pp Chen Edward K.Y., (1992), Changing pattern of financial flows in Asia-pacific Region and Policy Responses Asian Development Review, Vol.10, No Chenery, H.B., Robinson, S. and Syrquim, M. (1986), Industrialisation and Growth: Comparative Study, Oxford University Press, New York, NY. 9. Clegg, J. (1987), Multinational Enterprises and World Competition, Macmillan, London. 10. Dunning, J.H. (1993), Multinational Enterprises and the Global Economy, Addison-Wesley, Workingham. 11. Dunning, J.H. and R.Narula, (1994), The Investment Development Path Revisited: Some Emerging Issues, in Dunning J. and Narula, R., (eds.), Foreign Direct Investment and Governments: Catalysts for Economic Restructuring, Routledge, London. 18

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20 30. Prugel, T.A. (1981), The determinants of foreign direct investment: an analysis of US manufacturing industries, Managerial and Decision Economics, Vol. 2, pp Ranis Gustav, Schive Chi, (1985 ), Direct Foreign Investment in Taiwan s Development in Galenson Walter (ed) Foreign Trade and Investment, The University of Wisconsin Press, Madeson. 32. Reddaway W.B., (1968), Effects of U.K. Direct Investment Overseas, Cambridge University Press, Cambridge. 33. Roy J. Ruffin, (1979), Growth and Long-rune theory of International Capital Movements, American Economic Review, Vol. 69, No. 5, December, pp Scaperlanda, A. (1992), Direct investment controls and international equilibrium: the US experience, Eastern Economic Journal, Vol. 18, pp Scaperlanda, A. and Balough, R. (1983), Determinants of US direct investment in the EEC revisited, European Economic Review, Vol. 21, pp Scaperlanda, A. and Mauer, L.J. (1973), The impact of controls on US direct foreign investment in the EEC, Southern Economic Journal, Vol. 39, pp United Nations, (2005) World Investment Report, New York. 38. United Nations,( 1997), World Investment Report, New York. 39. Yue Chia Siow, (1993), Foreign Direct Investment in ASEAN Economies, Asian Development Review, Vol. 11, No. 1, P. 75 Further Readings: i) Buckley, P.J. and Casson, M. (1976), the Future of the Multinational Enterprise, Macmillan, London. ii) Buckley, P.J. and Casson, M. (1985), the Economic Theory of the Multinational Enterprise, Macmillan, London. iii) Caves, R.E. (1971), Industrial corporations: the industrial economics of foreign investment, Economica, Vol. 38, pp