Relationship between FDI and GDP

By Ruchika Damani Roll Number: 222 Economic Honors 2ND Year St. Xaviers College, Kolkata

INDEX
S.NO
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CONTENT Introduction Benefits of FDI Problems with FDI Literature Survey Relationship between FDI and Economic Growth FDI in India Sectoral Flows of FDI into India The FDI Boom in India References

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2. 3. 4. 5. 6. 7. 8. 9.

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Introduction
The relationship between Foreign Direct Investment (FDI) and Gross Domestic Product (GDP) has motivated a voluminous empirical literature focusing on both industrial and developing countries. Neoclassical models of growth as well as endogenous growth models provide the basis for most of the empirical work on the FDI-growth relationship. Foreign direct investment, in its classic definition, is defined as a company from one country making a physical investment into building a factory in another country. The direct investment in buildings, machinery and equipment is in contrast with making a portfolio investment, which is considered an indirect investment. In recent years, given rapid growth and change in global investment patterns, the definition has been broadened to include the acquisition of a lasting management interest in a company or enterprise outside the investing firms home country. As such, it may take many forms, such as a direct acquisition of a foreign firm, construction of a facility, or investment in a joint venture or strategic alliance with a local firm with attendant input of technology, licensing of intellectual property, in the past decade, FDI has come to play a major role in the internationalization of business. Agents choose economies having high potential to grow. Thus, developing countries having are always preferred for FDI. The gross domestic product (GDP) is one the primary indicators used to gauge the health of a country's economy. It represents the total value of all goods and
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services produced over a specific time period. The volume of goods and services produced is proportional to the amount of investment that sector and hence a relation between FDI and GDP emerges. It is argued that FDI can bring technological diffusion to the sectors in India through knowledge spillover and can enhance a faster rate of growth of output via increased labor productivity. As per economic priori, the output of the firm is positive determinants of FDI the higher the output, the higher the FDI inflows because maximizing the output is one of the objectives of firms. Expansion of the economy via FDI flows is considered as a good indicator of economic growth as it increases job opportunities thereby creating employment.

Benefits of FDI
Capital formation is an important determinant of economic growth. While domestic investments add to the Capital Stock of an economy, FDI plays a complementary role in overall capital formation by filling the gap between domestic savings and investment. FDI has played an important role in the process of globalization during the past two decades. The rapid expansion of FDI by Multinational Enterprises since the mid-eighties may be attributed to significant changes in technologies, liberalization of trade and investment regimes and deregulation and privatization of markets in many countries including developing countries like India. Fresh investments, as well as Mergers & Acquisitions (M&A) play an important role in the cross country movement of FDI. While the quantity of FDI is important, equally important is the quality of FDI. The major factors that provide growth impetus to the host country include the extent of localization of the output of foreign firms plant, its export orientation, the vintage of technology used, the R&D best suited for the host economy, employment generation, inclusion of the poor and rural population in the resulting benefits. FDI permits the direct transfer of technologies. FDI plays an important role in the transmission of Capital and technology across home and host countries.
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 It assists in the promotion of the competition within the local input market of a country. The countries that get FDI from another country can also develop the human resources by getting their employees receive training on the operations of a particular business. Helps in the creation of new jobs in a particular country. As a result of receiving FDI from other countries, it has been possible for the recipient countries to keep their interest rates at lower levels. FDI can help Indian companies penetrate foreign markets and increase the exports. Boosts manufacturing sector. FDI encourages the transfer of management skills, intellectual property and technology.

Problems with FDI

While FDI is expected to create positive outcomes, it may also generate negative effects on the host country. The costs to the host economy can arise from the market power of large firms and their associated ability to generate very high profits or by domestic political interference by MNCs. FDI in manufacturing sector is generally believed to have a positive and significant effect on a countrys economic growth. However based on Empirical analysis of data from cross country FDI flows, Alfaro (2003) points out that the impact of FDI on growth is ambiguous. Though it is expected that growth tends to benefit the poor, this has not happened in many countries. There is no clear picture whether growth reduces poverty (World Bank, 2000). FDI may entail high travel and communication expenses. There is a chance that a company may lose out on its ownership to an overseas company. Government has less control over the functioning of the company that is functioning as wholly owned subsidiary of an overseas company. Foreign-owned projects are capital intensive and labor-efficient.

Literature Survey
A large number of empirical studies on the role of FDI in host countries suggest that FDI is an important source of capital, complements domestic private investment, is usually associated with new job opportunities and enhancement of technology transfer, and boosts overall economic growth in host countries. De Mello (1999) attempted to find support for an FDIled growth hypothesis when time series analysis and panel data estimation for a sample of 32 OECD and non- OECD countries covering the period 1970-1990 were made. He estimates the impact of FDI on capital accumulation and output growth in the recipient economy. Nair-Reichert and Weinhold (2001) applied random estimation to examine the relationship between FDI and growth in developing countries and find that there is a causal link between FDI and growth. Abdur Chowdhury & George Mavrotas(in 2003) examined the causal relationship between FDI and economic growth ,by analyzing a time-series data over the period 1969-2000 for three developing countries, namely Chile, Malaysia and Thailand, all of them major recipients of FDI with a different history of macroeconomic episodes, policy regimes and growth patterns. Their findings clearly suggest that it is FDI that causes GDP in case of Malaysia and Thailand, while there is a strong evidence of the vice- versa for Chile. This can be attributed to the reason that FDI doesnt boost growth immediately; it delivers positive
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effects in the subsequent year after FDI increases. This suggests a significant link between FDI and GDP growth, one that develops over time because investment spending increases the nations productive capacity. However one cannot deny the dependence of FDI on GDP as GDP acts as an indicator of the economys well being and stability. It provides confidence to investors for the success of their ventures in the host country. Moreover it has been found that the trade liberalization policy of the Indian Government had some positive short run impact on FDI flows. A recent study by Kasibhatla and Sawhney (1996) in the United States supports a unidirectional causality from GDP to FDI and not the reverse. This may be due to the fact that, for a developed country, FDI follows GDP, as GDP is an indicator of the market size. Ericsson and Irandoust (2001) examined the causal effects between FDI growth and output growth for the four OECD countries applying a multi-country framework to data from Denmark, Finland, Norway and Sweden. The authors failed to detect any causal relationship between FDI and output growth for Denmark and Finland. They suggested that the specific dynamics and nature of FDI entering these countries could be responsible for these no-causality results. Liu et al (2002) tested the existence of a long-run relationship among economic growth, foreign direct investment and trade in China. Using a co-integration framework with quarterly data for exports, imports, FDI and growth from 1981 to 1997, the research found
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the existence of a bi-directional causal relationship among FDI, growth, and exports. Chakraborty and Basu (2002) utilize the technique of co-integration modeling to examine the link between FDI and economic growth in India. The results suggest that GDP in India is not caused by FDI and the causality run more from GDP to FDI. Wang (2002) explores the kinds of FDI inflow most likely contribute significantly to economic growth. Using data from 12 Asian economies over the period of 1987-1997, she found that only FDI in the manufacturing sector has a significant and positive impact on economic growth and attributes this positive contribution to FDIs spillover effects. Hsiao and Shen (2003) find a feedback association between FDI and GDP in their time series analysis of the data from China. Using data on 80 countries for the period 197195, Choe (2003) detects two-way causation between FDI and growth, but the effects are more apparent from growth to FDI. Chowdhury and Mavrotas (2005) examined the causal relationship between FDI and economic growth for three developing countries, namely Chile, Malaysia and Thailand. They found that it is GDP that causes FDI in the case of Chile and not vice versa, while for both Malaysia and Thailand, there is a strong evidence of a bi-directional causality between the two variables. Duasa (2007), examined the causality between FDI and output growth in Malaysia, the study found no strong evidence of causal relationship between FDI and economic growth. This indicates that, in the case of Malaysia FDI does not cause economic growth, vice

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versa, but FDI does contribute to stability of growth as growth contributes to stability of FDI. As far as the growth trend of FDI is concerned, there can be seen a marked increase in the magnitude of FDI inflows into the country in the post reform period, signaling the liberal policy regime and growing confidence of the investors. However, lower growth rate is noticed during the period 1998-2000 and this can be attributed primarily to the falling share of major investor countries. Now, we further see a dip in FDI inflow in 2002-03 as a consequence of the drop in industrial growth and GDP growth in 2002-03. The FDI inflow is significantly related with the economic condition of a country. If economic condition of a country is healthy then FDI inflow will be more and with the downturn inflow will decreasing This downward trend reversed by year-end, showing that the investors regained confidence in India's stronger economic growth and FDI inflows stimulated there onwards. Even though we do not incorporate the trends for the years 2007-08 and 2008-09, it is worth mentioning that in context of the recent global economic crisis, financial flows in form of FDI to the developing nations was expected to slow down, but the initial inflow for the year 2008-09 was surprisingly positive for India. Though portfolio funds withdrew sharply during 20082009 FDI inflows remained satisfactory throughout the year. India after liberalization experienced a hike in foreign inward capital, conforming to the evidence for other developing countries. Due to the cyclical recession in the US, Japan and various parts of Europe and the fall
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in US interest rates during 1989-92, there was a move of world capital to the developing countries in search of higher returns. Secondly, the role of internal or pull factors such as credible economic reforms, superior macroeconomic performance and domestic policies attracted foreign investment and encouraged investor confidence. As far as India is concerned, the relatively high differential rate of return on Indian assets might have played a role in attracting foreign capital after the opening of financial markets. The timing of these flows however, suggests that internal or pull factors were equally important.

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Relationship between FDI and Economic Growth

The notion of Investment led Economic Development has put forward the idea that the outward and inward FDI position of a country is related to its Economic Development relative to the rest of the world. It suggests that the countries changes through five different stages of development. These stages are being classified according to the propensity of the countries to the outward and/or inward investors (Dunning and Narula, 1994). This propensity, in turn, depends on the extent and pattern of the ownership-specific advantages of domestic firms, its location advantages and the degree of utilization of the ownership-specific advantages by the domestic and foreign firms in the internationalization of markets. The impact of FDI on growth rate of output was constrained by the existence of diminishing returns of physical capital. Therefore FDI could only exert an effect on the level of output per capita, but not on the growth rate. In other words, it was unable to alter the growth of output in the long run. In the context of the new theory of Economic Growth, FDI is considered as an engine of growth of mainstream economies. As noted by the World Bank (2002), several recent studies concluded that FDI can promote the Economic Development of the Host Country by promoting productivity growth and export. However, the exact relationship between Foreign Multinational Corporations and their host
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countries varies considerably between countries and among industries. The characteristics of the Host Country and the policy environment is important determinants of net benefit of FDI. The role of FDI in the growth process has been a topic of discussion in several countries. These discussions have provided rich insights into the relationship between FDI and Growth. Although several studies on FDI and Growth in Developing Economies exist, however, few studies on this subject have been done on BRICS (Brazil, Russia, India, China and South Africa) countries. Moreover, most of the studies provide a descriptive discussion of FDI and Economic Growth. The available studies have employed cross section regression methodologies but recent time series studies do not support the FDI led Economic Growth hypotheses. A large body of literature explores the direct and indirect relationship between Foreign Direct Investment (FDI) and Growth, with substantial number of evidences that highlight the apparent relationship between Foreign Direct Investment and Trade. Recent empirical evidences are rather mixed. Some found no causality between FDI and Economic Growth (Jung and Marshall, 1985) others found unidirectional relationship. Chow (1995) reported bidirectional relationship between FDI and Economic Growth. The heterogeneity that observed in the previous study results may be due to adoption of different testing procedures, different lag structure specifications and the different filtering techniques used in the methodologies. Specifically, this study examines whether: i) Economic Growth of a country drives the FDI inflow ii) FDI-leads the Economic Growth of a country
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iii) The two way causal link between them The most interesting economic scenario suggests a two-way causal link between FDI and Host Countrys Economic Growth. Countries with fast Economic Growth generate more demand for FDI and offer opportunities for making profits. On the other hand, inward FDI flows may enhance growth through positive direct and indirect effects on variables that affect growth. Thus, the study expects a bi-directional causality between FDI and Growth. Our primary objective is to determine whether increase in growth rates (measured by increase in GDP for the period under study) has in turn led to increased inflow of FDI. Traditional wisdom suggests that if the GDP for the economy is growing at a steady rate then foreign investors may perceive this a lucrative investment opportunity and hence there should be greater inflow of Foreign Direct Investment into the said country. To test whether the above holds true we regress FDI on the Gross Domestic product for the period under study. Therefore, we assume that FDI is the dependant variable and GDP is the independent variable and our objective is to determine whether increase in GDP leads to increased inflow of FDI. By regression of a variable y (say) on another variable x (say) we mean the dependence of y on x, on the average. In bi variate analysis, one of the major problems is the prediction of the value of the dependant variable when the value of the independent variable is known. The problem becomes simplified if we can express the dependant variable (say y) as a
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function of the independent variable (say x).This equation is known as the regression equation of y on x. In the simplest case we can write y = a + bx, so that a + bx0 is the predicted value of y0 when x = x0 We are interested in determining whether increase in GDP has led to increased inflow of FDI for India. That is, we are interested in testing the null hypothesis H0: b =0 against the alternative: H1: b 0 The relevant t-statistic has been found out to be -7.2811 which is greater than the predicted value of the t-statistic obtained from the Biometrica table (t / 2 = 2.11, /=5%). Moreover from the P-value approach we get that 1.28E-06 < .05. Therefore we reject the Null Hypothesis at 5% level of significance. The X variable is highly significant. The co-efficient of the X variable has been found out to be 0.000174 which is positive. Hence it implies that a unit increase in GDP leads to 0.000174 unit increase in FDI. It therefore appears from our analysis that increase in GDP has led to increased inflow of FDI in case of India for the period under study. The regression line of Y on X is given by the following scatter diagram. If we carry out the regression of FDI on GDP (lag of one year) even then the value of the t-statistic obtained is significant and we reject the null hypothesis. The Scatter Plot Showing The relation between FDI & GDP (lag of one Year) is shown below.
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However, if we reverse the causality that is we assume that Foreign Direct Investment is the independent variable and regress Gross Domestic Product on Foreign Direct Investment, we find that for India increase in GDP has led to increased inflow of Foreign Direct Investment. The result can be intuitively explained by the fact that increased inflow of FDI has led to the expansion of sectors which use foreign capital intensively, which has in turn led to increased production (as is reflected by a higher GDP).

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FDI in India
As the third-largest economy in the world in PPP terms, India is a preferred destination for foreign direct investments (FDI); India has strengths in information technology and other important areas such as auto components, apparels, chemicals, pharmaceuticals, and jeweler and so on. Although India has always held promise for global investors, but its rigid FDI policies was a significant hindrance in this context. However, as a result of a series of ambitious and positive economic reforms aimed at deregulating the economy and stimulating foreign investment, India has positioned (projected) itself as one of the front-runners in Asia Pacific Region. India has a large pool of skilled managerial and technical expertise. The size of the middle-class population at 300 million exceeds the population of both the US and the EU, and represents a powerful consumer market. India's recently liberalized FDI policy permits up to a 100% FDI stake in ventures. Industrial policy reforms have substantially reduced industrial licensing requirements, removed restrictions on expansion and facilitated easy access to foreign technology and FDI. The upward moving growth curve of the real-estate sector owes some credit to a booming economy and liberalized FDI regime. A number of changes were approved on the FDI policy to remove the cap in most of the sectors. Restrictions will be relaxed in sectors as diverse as civil aviation, construction development, industrial parks, commodity exchanges, petroleum and natural gas, credit-information services, mining

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and so on. But this still leaves an unfinished agenda of permitting greater foreign investment in politically sensitive areas like insurance and retailing. According to the government's Secretariat for Industrial Assistance, FDI inflows into India reached a record US$19.5bn in fiscal year 2006/07 (April-March). This was more than double the total of US$7.8bn in the previous fiscal year. Between April and September 2007, FDI inflows were US$8.2bn.

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Sectoral Flows Of FDI into India

Services Sector:The Services Sector Accounts for more than 505 of the Countrys GDP. It makes up more than 25% employment. Reasons for growth of services Sector:The introduction of the New Economic Policy In 1991 by Manmohan Singh led to a wide expansion of the Services Sector. Also Global presence of TNCs & Production processes were allowed. More over there was liberalization of many service sector activities (Telecom, Transport, Finance, etc.) FDI flows: The Services sector attracted $3.12 Billion FDI in the first seven months of 2009-10. 22% of FDI Inflows in April- October was enjoyed by the Services Sector. In 2008-09, The service industry attracted the maximum FDI worth $6.11 Billion. FDI Policies in Services Sector:100% FDI is permitted in many service sector industries. For e.g. Real Estate, Construction, Tourism, Films, IT & IT- enabled Services, Advertising, etc.
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It enabled the domestic companies to prepare for global competition. Current issues with FDI in Services Sector: Very Weak linkages of service sector with the Indian Economy (Only few cities) Requires highly skilled workers Employee welfare in times of crisis.

Retail:The retail sector is one of the fastest growing sectors with huge potential for expansion because of the demands of a rising population in India. Reasons For Growth of FDI in Retail: Low Share of organized retailing. Increase in disposable income and customer aspiration. Increase in Expenditure On luxury Items. Benefits of FDI In Retail:Generates huge employment. Increased investment in technology. The huge tax revenue generated. The consumer gains from the wide variety of choices and a more diversified basket. The indirect benefits like better roads, online marketing, expansion of telecom sector.

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It will also give a big push to other sectors like agriculture, small and medium enterprises. Drawbacks of FDI in Retail: Foreign players would displace the unorganized retailers because of their superior financial strengths. The entry of large global retailers such as WalMart would kill local shops and many jobs. Induce unfair trade practices like predatory pricing, in the absence of proper regulatory guidelines. Increase in real estate prices and marginalize domestic entrepreneurs. Agriculture:Agriculture has been the mainstay of the Indian Economy Since Independence. Majority of the Indian Population stays in towns and are engaged in agricultural practices. Agriculture allows 100% inflow of FDI. There are no restrictions with respect to allowance of FDI in The Agricultural Sector.

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The FDI boom in India

* India is now the third most favored destination for Foreign Direct Investment (FDI), behind China and the USA, according to an AT Kearney survey that tracked investor confidence among global executives to decide their order of preferences. * India's share of global FDI flows rose from 1.8 per cent in 1996 to 2.2 percent in 1997. * FDI in India in 1997-98 was lower at U.S. $ 5,025 million compared to U.S. $ 6,008 million in 1996-97 because of a decline in portfolio investment. Although foreign direct investment (FDI) increased by 18.6 per cent from U.S. $ 2,696 million in 1996-97 to U.S. $ 3,197 million in 1997- 98 * International developments continue to capital flows into India in 1998-99 as well. attract

* Mauritius, as in the previous two years, was the dominant source of FDI inflows in 1997- 98. U.S.A. and S. Korea were, respectively, the second and third largest sources of FDI. * S. Korea increased its flow of investment in India from a meager U.S. $ 6.3 million in 1996-97 (0.2 per cent of total FDI) to U.S. $ 333.1 million in 1997-98 (10.4 per cent share).

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* There has been a sharp rise in the number of FDIs approved in 2004. * During the first seven months of 2004, between January and July, Rs. 5,220 crore worth of FDI was approved. * Almost a third share of the investment in India is by NRI. * According to the latest Reserve Bank of India figures, outflows through various NRI deposits schemes amounted to $903 million since May 2004, as against net inflows of $1.2 billion in the corresponding period last year.

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References
Ahluwalia Montek.S: Indias Economic Reforms an Appraisal Anderson Jonathan (November 2003): Capital Account Controls and Liberalization: Lessons for India and China, UBS Investment Research. Arumugam Sivakumar: Neo Classical Finance and the Full Convertible Rupee, Economic and Political Weekly November 18, 2006. Caves, Jones and Frankel: World Trade and Payments: An Introduction, Ninth Edition, Pearson Education, Inc. Economic Openness: Growth and Recovery in Asia, May 1999, From the Asian Development Outlook 1999. Economic Survey, Various Years, Government of India. Iyare Sunday O, Bhaumik Pradip K and Banik Arindam: Explaining FDI Inflows to India, China and the Caribbean An Extended Neighbourhood Approach, Economic and Political Weekly, July 24, 2004. Krugman and Obstfeld: International Economics Theory and Policy, Sixth Edition, Pearson Education, Inc. Kumar Nagesh: Liberalization, Foreign Direct Investment Flows and Development Indian Experience in the 1990s, Economic and Political Weekly , April 2, 2005. Mohan Rakesh: Capital Flows to India, BIS papers 44. Money Market: Need for restraints on Inflows, Economic and Political Weekly April 17, 2004. Rakshit Mihir: Oil Price Shock Some Analytical and Policy Perspectives, Economic and Political Weekly , October 15, 2005. Sikdar Soumyen: Foreign Capital Inflow into India: Determinants and Management, Asian Development Bank. Williamson John: Why Capital Account Convertibility in India is Premature, Economic and Political Weekly , May 13, 2006.

Websites:
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