IMPACT OF TRADE OPENNESS ON FOREIGN

DIRECT INVESTMENT IN INDIA

Presented by:

Group B03

Indu Segu (2019087)

Jaimin Brahmbhatt (2019088)

Jonathan Fernandes (2019089)

Krishna Singh (2019090)

Kunal Pramanik (2019091)

Introduction
The topic of this study is “Impact of trade openness on FDI in India”. Impact of trade openness on
FDI is and has been debatable. In the study we aim to examine the relationship between FDI and
trade openness over a period of 2002-2016 (15 years). This period can be called and era of strong
liberalization, it started from 1991 when the Indian economy was opened to world trade. We
examine not only the relationship between the two variables but also the impact of leading
macroeconomic variables on FDI. Here, for this study FDI is a dependent variable and others are to
be considered as independent variable. We have run Regression analysis using these variables and
multiple regression analysis by adding an independent variable in terms of financial development.
The analysis shows positive relation with good significance and growth in favourable direction in era
of strong liberalization. Let’s start by understanding key terms.

Trade openness

Trade openness is a measure of economic policies that either restrict or invite trade between
countries.

For example, if a country sets a policy of high trade tariffs, thus restricting the desirability of
international trade, this restrictive policy will inhibit other countries from sending exports and
accepting imports from that country. According to dominating economic theory, this restrictiveness,
this lack of trade openness, will have an economic effect of slowing economic development/growth.
Conversely, according to economic theory, trade openness will have an economic effect of
increasing economic development and growth.

FDI

A foreign direct investment (FDI) is an investment made by a firm or individual in one country into
business interests located in another country. Generally, FDI takes place when an investor
establishes foreign business operations or acquires foreign business assets in a foreign company.
However, FDIs are distinguished from portfolio investments in which an investor merely
purchases equities of foreign-based companies.

Recession

A recession is a macroeconomic term that refers to a significant decline in general economic activity
in a designated region. It is typically recognized after two consecutive quarters of economic decline,
as reflected by GDP in conjunction with monthly indicators like employment. Recessions are officially
declared in the U.S. by a committee of experts at the National Bureau of Economic Research (NBER),
who determines the peak and subsequent trough of the business cycle which demonstrates the
recession.

Problem Statement
Here we are trying investigate the relationship between FDI and trade openness and also to what
significance.
Objective
Our objective is to determine if a change in trade openness of the economy leads to a significant
change in FDI inflows in the economy.

Literature review

The impact of trade openness on FDI is controversial. Nations endeavour to attract more FDI
for a number of reasons relating to beliefs that FDI has a variety of positive e ffects such as
technology transfer, employee training, backward and forward linkages, labour mobility,
increased productivity, technical assistance and provision of access of local firms to
international markets. Many empirical studies advocate the arguments that FDI has a positive
impact on trade openness in recipient countries. In their study, Lane and Melesi-Ferretti (2001)
got the result that in growing countries, openness has a positive impact. Liargovas and Skandalis
tested 36 growing countries’ relationship between FDIs and openness between the years 1990-2008
using panel regression analysis and founded a positive and important relationship between
openness and the FDIs coming to the country. Hence, the transfer and adoption of relevant
technologies enhances productivity and helps countries to create labour-intensive
activities. The transfer of advanced technologies increases the demand of productive labour
and supports countries by enhancing labour generation activities besides training managers
and workers to increase their productivity in order to get long run benefits from their
services. This would gene rate new jobs which might be seen as a short-run impact. It is
suggested that an increase in the demand plays a pivotal role in trade and the country’s
policy to support innovation, education and provision of infrastructural facilities.

It seems a paired effect in terms of FDI trade showing a robust relationship between FDI and
trade. Past experience provides an ample explanation that FDI promotes exports and helps local
firms to get access to global markets as well as operate efficiently by adopting new technologies
and try to be competitive, which highlights the value of economic freedom to attract FDI. Apergis
(2008) and confirms that the cause and effect mechanism for exports. The major determinants of
foreign direct investment are trade openness, market size, labour force growth and infrastructure
growth. FDI also relies upon the rate of return that an investor receives from the host country.

Ashgar (2016) examined the relationship between FDI inflows and trade openness in South -
Asian economies. He examined the relationship of seven countries for the 1998 -2010 period
based on panel data using random effects estimation. Trade openness was measured by
three indicators, in terms of (Abdel Mahmoud Ibrahim Tahmad, n.d.) (Selahattin GÜRİŞ)
imports, exports and a joint combination of both factors. His results suggested that there is a
significant relationship between trade openness and foreign direct investment inflows. Trade
openness has a positive and significant impact on FDI inflows in South-Asian countries.
Methodology
The project has been conducted on the data set collected for the year 2002 to 2016. The data for
2017 and 2018 will be calculated using the regression equation which will be obtained after the
regression analysis has been performed.

Regression analysis
Regression analysis has been run on the data set on trade openness and FDI to set up the regression
model (after taking the natural logarithm)

Let the regression equation be given by:

Y= α + βX

Where α= the y-intercept and β=slope

For running the regression, the dependent variable Y= FDI and the independent variable X=Trade
openness.

After running the regression analysis in MS Excel below is the overall summary snapshot.

Where,

α= 15.32290914

β= 3.26144355619897

Hence the regression equation is given by: Y= 15.32290914 + 3.26144355619897X

Hence it can be inferred that with 1% change of the Trade Openness the FDI will change by 3.26%

Using the above equation, the value of the FDI is calculated that gives us the predicted value of FDI
and then the difference of the observed value and predicted value is taken to get the residuals or
the error terms.

Residuals= Observed value – Predicted Value

The below table provides the snapshot of the residuals for the given set of data.
A scatter plot of the observed and the predicted value of the regression has been captured in the
below snapshot.

Trade openess(ln) Line Fit Plot

25
24.5
24
FDI (ln)

23.5
23 FDI (ln)
22.5 Predicted FDI (ln)
22
21.5
0 0.5 1 1.5 2 2.5 3
Trade openess(ln)

Analysis of the regression result

Statistics Value Significance

R square 0.701307144647302 R square measures the strength of the regression. It can
be seen that the two variables are strongly correlated
with a strength of 70.13%
Multiple R 0.83744083053509 The value of multiple R signifies that the trade openness
and FDI are positively correlated. The same can be also
inferred from the above scatter plot.
Trend Forecasting

Trade openness in 2016 = 2.5347363

FDI in 2016= 24.51782362

1) Assuming that in 2017, Trade openness increases by 12%

Trade openness in 2017 = 2.838904656
FDI = 3.261443556(2.838904656) + 15.32290914
= 24.58183644
Taking antilog,
FDI = 47397553010
Therefore, FDI in 2017 is forecasted to 47397553010

We can conclude that 4.483923812 increase in Trade openness would result in 2938981464 increase
in FDI
2) Assuming that in 2018, Trade openness increases by 12%
Trade openness in 2018 = 3.179573215
FDI = 3.261443556(3.179573215) + 15.32290914
= 25.69290771
Taking antilog,
FDI = 143975316700
Therefore, FDI in 2018 is forecasted to 143975316700

We can conclude that 6.939464798 increase in Trade openness would result in 96577763690
increase in FDI
3) Assuming that in 2019, Trade openness increases by 12%
Trade openness in 2019 = 3.561122001
FDI = 3.261443556(3.561122001) + 15.32290914
= 26.93730754
Taking antilog,
FDI = 499716882500
Therefore, FDI in 2018 is forecasted to 499716882500

We can conclude that 11.16617948 unit increase in Trade openness would result in 3.55742E+11
unit increase in FDI.
Hypothesis Testing

Null Hypothesis (H0: B=0):

There is no significant relation between trade openness and FDI.

Alternate Hypothesis (H0: B≠0)

There is a significant relation between trade openness and FDI.

A T-test will be performed to check if the null hypothesis can be rejected or not using the below
decision-making rules.

Decision making

We will reject the null hypothesis if the value tcal > ttab at n-k degrees of freedom, else we accept the
null hypothesis.

Where n= No of observations

k= no of estimated parameters in the regression.

Therefore, the degree of freedom is 13.

tcal= 5.52475966791634 (from the regression)

ttab=2.1604 at 13 degree of freedom at 5% level of significance.

Since tcal > ttab at 13 degree of freedom and at 5% level of significance. Hence, we can reject the null
hypothesis.

Conclusion: There is significant relationship between trade openness and FDI.

Impact of trade openness and financial development on FDI inflow (Multiple
Regression Analysis)
As per the above analysis it has been seen that trade openness and FDI are significantly related. Now
to check if there has been any impact of financial developmet and trade openness together on the
FDI inflow to India, a multiple regression is performed on the data set.

To make the calculation easier the natural logarithm of the financial development is taken and
regression is run on MS Excel where,

X1= Trade openness (Independent Variable)

X2=Financial Development (Independent Variable)

Y= FDI (Dependent variable)

Let the regression equation be given by:

Y= α + β1X1 + β2X2

Where,

α= the y-intercept

β1=coefficient for trade openness.

Β2=coefficient for financial development

After running the multiple regression analysis below is the snapshot of the same.

Y= α + β1X1 + β2X2

α= 16.7342142743338

β1= 3.24045923946456

β2= 1.56808014496096

Y= 16.7342142743338 + 3.24045923946456X1 + 1.56808014496096X2

From the above equation it can be inferred that with 1% increase in trade openness, the FDI inflow
will increase by 3.24% keeping the financial development constant. On the other way, a 1% increase
in financial development will increase FDI inflow by 1.57% keeping the trade openness constant.

Now using the above equation, the predicted value of Y is calculated and residual error terms are
calculated. Below is the snapshot of the same.

Hypothesis Testing

H0: β0 = β1 = 0 or There is no significant relation between FDI, trade openness and financial
development.

H1: one or more β’s ≠ 0 or There is a relation between FDI, trade openness and financial
development

df = n-k

= 15-3 = 12

For Trade openness variable:

tcalc = 5.35140586204542

ttab = 2.179

tcalc > ttab at 5% level of significance at 12 degrees of freedom, we reject null hypothesis H0

Implies there is significant relation between FDI and trade openness.

For financial development:

tcalc = 0.627138716159004

ttab = 2.179

tcalc < ttab at 5% level of significance at 12 degrees of freedom, we accept null hypothesis H0
Implies there is no significant relation between FDI and financial development.

Impact of Recession and Trade Openness on FDI (using dummy variable)

To study the impact of economic recession in the years 2008 and 2009, we have used dummy
variables where a year with recession is represented as 1 and year without a recession is
represented as 0.

The data is shown below:

The regression analysis is performed on above data and the below result is obtained

Multiple R = 0.850955 implies highly positive correlation between Trade openness, FDI and recession

Regression line equation for coefficient, t-stat, p-value is given as

Coefficients: α = 15.59361, β0 = 3.13636, β1 = 0.381049

FDI = 15.59361+ 3.13636 T + 0.381049 D

t-statistics: α = 10.0787, β0 = 5.195213, β1 = 0.996257

FDI = 10.0787+ 5.195213T + 0.996257 D

p-value: α = 0, β0 = 0.0002236, β1 = 0.33879

FDI = 0 + 0.0002236 + 0.33879 D

AdjR2 (Coefficient of determination): 0.678 (We can say change in FDI has 67.8% variant for the
change in trade openness and recession)

Testing the hypothesis

H0: β0 = β1 = 0 or There is no significant relation between FDI, trade openness and D

H1: one or more β’s ≠ 0 or There is a relation between FDI, trade openness and D

df = n-k

= 15-3 = 12

For Trade openness variable:

tcalc = 5.195213

ttab = 2.179

tcalc > ttab at 5% level of significance, we reject null hypothesis H0

Implies there is significant relation between FDI and trade openness

For Dummy variable:

tcalc = 0.996257

ttab = 2.179

tcalc < ttab at 5% level of significance, we accept null hypothesis H0

Implies there is no significant relation between FDI and Dummy (Recession)

Summary
Based on our analysis we conclude that for the given FDI and Trade openness data of past
15 years, there is a significant relationship between them in

 Simple regression analysis

 Multiple regression analysis
 Seasonal variation using dummy variable

Level of significance 5%

The null hypothesis is valid when we consider the relationship between FDI and recession,
hence the FDI is not significantly affected by recession under given consideration.

Null hypothesis (H0): No relationship between trade openness and FDI

Alternative hypothesis (H1): There is relationship between trade openness and FDI
Null hypothesis (H0): No relationship between trade openness, financial development and FDI
Alternative hypothesis (H1) (for multiple regression): There is relationship between trade openness, financial
development and FDI
Null hypothesis (H0): There is no relationship between trade openness, recession and FDI
Alternative hypothesis (H1) (for Dummy): There is relationship between trade openness, recession and FDI
t –cal (trade
Equation Df R2 openness) t - tabular Hypothesis

Simple regression
F=α + β*T 13 0.710786 5.1952 2.179 Reject H0
Multiple
regression F=α + β1*T + β2*T 12 0.662583898 5.3514 2.179 Reject H0

Dummy Variable
F=α + β1*T + β2*T 12 0.724125 0.9962 2.179 Accept H0
References
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-http://www.usc.es/economet/journals1/aeid/aeid1524.pdf

https://www.researchgate.net/publication/330376635_The_impact_of_trade_openness_on_foreign
_direct_investment_in_Sudan_by_sector_in_the_1990-2017_period_An_empirical_analysis

- https://www.investopedia.com/terms/r/recession.asp

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- https://eds.a.ebscohost.com/eds/pdfviewer/pdfviewer?vid=3&sid=8d87e9fe-be6e-44ee-9570-
2e8da132712c%40sessionmgr4007

- https://www.youtube.com/watch?v=PhL1rZp66AA

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2e8da132712c%40sessionmgr4007