Locational Determinants of Foreign Direct Investment in India: a Time Series Analysis

Foreign direct investment (FDI) is probably one of the most significant factors leading to the globalization of the international economy. FDI inflows to the developing countries increased remarkably in the 1990s and now accounts for about 40 per cent of global FDI. Similar trends have also been observed in India. Foreign direct investment in India has expanded rapidly following the liberalization program initiated in the early 1990s. The immediate challenge before the Congress Government constituted in 1991 was to overcome the severe economic crises and direct the economy towards a sustained growth. Accelerating economic growth through liberalization and globalization necessitated not only dismantling the stringent rules and regulations but also inviting foreign capital and technology. It also meant restructuring its trade regime to prepare the economy for greater integration with the global economy. Gradually the interaction and interdependence of economic and foreign policies intensified during the first half of 1990s. It situates the process of economic liberalization in the wider context of foreign policy to explore the interaction between economics and politics in India during the period of 1990-1995. The major policy shift from the IS strategy towards a more outward oriented economy led by export development has attracted the interest of foreign investors in India. Figure 1 shows this trend in the level of annual inflows of both actual FDI for the period 1997-2004

Figure: 1 Actual FDI (Net) 1997-2004Source: Economic survey 2004-2005,( http:/indiabudget.nic.in)

Aggregate FDI inflows into India were somewhat lower during 2003-04 as compared to that during 2002-03. The reduction is attributable to a small decline (US$379 million) in fresh equity capital inflows in 2003-04. Reinvested earnings during 2003-04 at US$1.8 billion were more or less the same as in 2002-03. FDI flows into India, on BOP basis, after rising sharply from 1999-2000, have been showing a decline since 2001-02. FDI (net) undertaken by Indian enterprises overseas, was also lower at US$1.3 billion during 2003-04, compared to US$1.8 billion in 2002-03.India seems a quite attractive location to many foreign multinational enterprises (MNEs) due to favorable factors such as high economic growth, fast growing population, English speaking people, lower cost for workers etcEarlier there have been relatively few empirical studies which have examined location decisions of MNEs choosing India as an investment location. Previous studies have relied more on collection of primary data using managerial perceptions for measuring the explanatory factors. The rapid growth of FDI and its increasing importance, it is critical for both the public and private sectors to have as complete an understanding of the macroeconomic determinants of this phenomenon as possible. Building on the prior literature the focus of this paper is on the location-related determinants of FDI. This is undertaken by means of a time series analysis of major locational factors impacting upon the level of FDI inflows for the period of 1997-2004.

Locational determinants of foreign direct investment

A firm becomes multinational mainly for three reasons. They are Ownership advantages, Location-specific advantages and Internalization. In this study, we focus on the location-specific advantages of the host country as determinants of FDI in order to account for the geographical distribution of FDI inflows across transition economies. Large market size, proximity to home market, low-cost labor and favorable tax treatment in the host country are all considered as location advantages. At the same time, we also address to transition specific issues such as changes in macroeconomic and institutional environments.Location-specific advantages are further classified by three types of motives of FDI. First, market-seeking investment is undertaken to sustain existing markets or to exploit new markets. For example, due to tariffs and other forms of barriers, the firm has to relocate production to the host country where it had previously served by exporting.Second, when firms invest abroad to acquire resources not available in the home country, the investment is called resource- or asset-seeking. Resources may be natural resources, raw materials, or low-cost inputs such as labor. Third, the investment is rationalized or efficiency-seeking when the firm can gain from the common governance of geographically dispersed activities in the presence of economies of scale and scope.This study mainly focusing on the host country based factors. The host country factors or elements can be grouped in two categories, First group comprises of natural resources, most kinds of labour, and proximity to markets. Second group comprise of a range of environmental variables that act as a function of political, economic, legal, and infra-structural factors of a host country.

The model and the variables

Though the literature on the subject has suggested several possible explanatory variables, it is not possible to include all of them. The main criteria for reducing the number of variables are as follows:

(i) Relation and importance of the variable for India,(ii) Availability of data;(iii) Degrees of freedom; (iv) The economic model is specified as:(v) FDI = f (MS, OE/FT, I, DMA, EE, IE) ------------ (1)

Where FDI = Foreign direct Investment,MS = Size of domestic market,OE/FT = openness of the economy to foreign trade,I = Infrastructure of the host country,DMA = Domestic market Attractiveness,EE = External economic stability,IE = Internal economic stability.

The economic theory suggests that a positive relationship between FDI and size of domestic market, openness of the economy to foreign trade, and infrastructure of the country. While a negative relationship between FDI and External economic stability, internal economic stability. The larger the market size, the more demand for the products or services to be provided by the FDI.Figure:2

Figure 2 shows that the FDI inward and outward values for the year 2004 to 2006, and figure 3 shows the comparative statement of FDI inwards and outwards of India and China for the year 1990 to 2000. This information made the clear picture of the importance of the locational determinants for attracting foreign direct investments towards the host country. As is evident from these figures India has only very recently emerged as a destination for FDI since the pre-reform years were marked with a sharp antipathy toward foreign capital unless under certain conditions. Reliable data on actual FDI inflows into different sectors is not available. On the basis of “approvals” data it appears that much of the FDI is directed towards infrastructure and energy sectors. More approvals were made in the nonmanufacturing sector as compared to the manufacturing sector. Metallurgy, power and fuel sectors recorded the most growth with falls in transport, industrial machinery and food processing.

Figure: 3

The services sector (including telecommunications) increased its share during 1992-94 but this growth slackened off due to shortfall in demand. Since several key subjects (such as education, health, roads (except national highways), electricity, property rights etc.) lie within the jurisdiction of individual states, the progress of administrative reforms at the level of state governments is an important determinant of state level economic performance in several years including State domestic product growth, investment, infrastructure and attractiveness as FDI destinations.In the past decade FDI approvals varied considerably over the geographical span of India. Four states namely Karnataka, Maharashtra, Tamilnadu and Gujarat accounted for over one-third of total FDI approvals. The shares of these individual states were, respectively, 7.6%, 13.7%, 6.7% and 5.3%. The shares of other major states were considerably lower: West Bengal (3.7%), Andhra Pradesh (4.2%), Madhya Pradesh (4.5%) and Orissa (3.8 %). The shares of Kerala, Haryana, Punjab and Rajasthan were comparatively smaller whereas the flow of FDI into populous states such as Bihar and Uttar Pradesh has been virtually negligible. The rate of approval increased considerably and that influenced on the FDI flows to India. The USA is the largest investor in India with investment of over Rs. 570 billion (as on 2002).It would be easier if we could see the sector wise comparison of FDI and the corresponding GDP values. Figure 4 shows the comparative information for the recent period. From that we could understand the sectoral real growth rates in GDP for the year 2000 to 2005. The lower contribution of industry to GDP growth relative to services in recent years is partly because of its lower share in GDP, and does not adequately capture the signs of industrial resurgence. First, growth of industrial sector, from a low of 2.7 per cent in 2001-02, revived to 7.1 per cent and 7.4 per cent in 2002-03 and 2003-04, respectively, and after accelerating to over 9.5 per cent in the next two years, touched 10.0 per cent in 2006-07. Second, growth of industry, as a proportion of the corresponding growth in services, which was 78.9 per cent on an average between 1991-92 and 1999-2000, improved to 88.7 per cent in the last seven years.

Figure: 4Sectoral real growth rates in GDP at factor cost(At 1999-2000 prices). Industrial growth would have been even higher, had it not been

for a relatively disappointing performance of the other two sub-sectors, namely, mining and quarrying; and electricity, gas and water supply. Industry has never consistently grown at over seven percent per year for more than three years in a row before 2004-05. Every year, manufacturing, according to the monthly Index of Industrial Production (IIP) available until December 2006, has been growing at double digit rates every month since March 2006. The information from the above table can be compared with the actual FDI inflows of India in the same time. Figure 5 gives the year wise comparison of the FDI values for the year 1991 to 2006. The advance estimates (AE) of gross domestic product (GDP) for 2006-07, released by the Central Statistical Organization (CSO) on February 7, 2007, places the growth of GDP at factor cost at constant (1999-2000) prices in the current year at 9.2 per cent. Growth in 2005-06, initially estimated by the CSO at the AE stage at 8.1 per cent in February 2006, was revised upwards to 8.4 per cent at the revised estimate stage in May 2006 and further to 9.0 per cent in the quick estimates released by the CSO on January 31, 2007

Conclusion

As far as the economic interpretation of the model is concerned, the size of the domestic market is positively related to foreign direct investment. The greater the market, the more customers and the more opportunities to invest. Since FDI is mostly in the form of physical investment, investors would prefer the markets with better infrastructure. The attractiveness of the host market also affects the FDI positively and significantly. In many ways India’s principal problem remains that of boosting its rate of saving and investment from the current about 23% of GDP to over 30% of GDP in order to make growth prospects take a quantum jump and become comparable with the high growth phases of the Chinese and East Asian economies. FDI becomes important in its own right if it makes contributions towards technology progress; productivity spillovers and consolidating niche export markets. This paper emphasizes the view that an enlightened FDI policy is to be seen as part of a general policy of enhancing investment in this economy under conditions of sustained production efficiency.

Reference:

1) Economic Liberalization and India's Foreign Policy/Chan-Wahn Kim. Delhi, Kalpaz 2) John H. Dunning’s “GLOBALIZATION INDUCED CHANGES AND THE ROLE OF FDI POLICIES”3) Website: http:/indiabudget.nic.in4) Government of India (2002) “Report of the Steering Committee on Foreign DirectInvestment” Planning Commission, August.5) Recent Trends in FDI Flows and Prospects for India - Raghbendra Jha6) www.unctad.org/wir or www.unctad.org/fdistatistic