Relationship Between FDI and GDP

7/30/2019 Relationship Between FDI and GDP

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Relationshipbetween

FDI and GDP

ByRuchika Damani

Roll Number: 222

Economic Honors2ND Year

St. Xaviers College, Kolkata


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INDEX

S.NO CONTENT PAGE

NO

1. Introduction 3-4

2. Benefits of FDI 5-6

3. Problems with FDI 7

4. Literature Survey 8-12

5. Relationship between FDI and Economic

Growth 13-17

6. FDI in India 18-19

7. Sectoral Flows of FDI into India 20-22

8. The FDI Boom in India 23-24

9. References 25


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IntroductionThe relationship between Foreign Direct Investment(FDI) and Gross Domestic Product (GDP) hasmotivated a voluminous empirical literature focusingon both industrial and developing countries.Neoclassical models of growth as well as endogenousgrowth models provide the basis for most of theempirical work on the FDI-growth relationship.Foreign direct investment, in its classic definition, isdefined as a company from one country making a

physical investment into building a factory in anothercountry. The direct investment in buildings,machinery and equipment is in contrast with making aportfolio investment, which is considered an indirectinvestment. In recent years, given rapid growth andchange in global investment patterns, the definitionhas been broadened to include the acquisition of alasting management interest in a company or

enterprise outside the investing firms home country.As such, it may take many forms, such as a directacquisition of a foreign firm, construction of a facility,or investment in a joint venture or strategic alliancewith 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 theinternationalization of business. Agents choose

economies having high potential to grow. Thus,developing countries having are always preferred forFDI.

The gross domestic product (GDP) is one the primaryindicators used to gauge the health of a country'seconomy. It represents the total value of all goods and


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services produced over a specific time period. Thevolume of goods and services produced is proportionalto the amount of investment that sector and hence arelation between FDI and GDP emerges.

It is argued that FDI can bring technological diffusionto the sectors in India through knowledge spillover andcan enhance a faster rate of growth of output viaincreased 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 objectivesof firms. Expansion of the economy via FDI flows isconsidered as a good indicator of economic growth asit increases job opportunities thereby creatingemployment.


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Benefits of FDICapital formation is an important determinant ofeconomic growth. While domestic investments add tothe Capital Stock of an economy, FDI plays acomplementary role in overall capital formation byfilling the gap between domestic savings andinvestment.

FDI has played an important role in the process ofglobalization during the past two decades. The rapid

expansion of FDI by Multinational Enterprises sincethe mid-eighties may be attributed to significantchanges in technologies, liberalization of trade andinvestment regimes and deregulation and privatizationof markets in many countries including developingcountries like India. Fresh investments, as well asMergers & Acquisitions (M&A) play an important rolein the cross country movement of FDI.

While the quantity of FDI is important, equallyimportant is the quality of FDI. The major factors thatprovide growth impetus to the host country includethe extent of localization of the output of foreign firms

plant, its export orientation, the vintage of technologyused, 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 ofCapital and technology across home and hostcountries.


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It assists in the promotion of the competitionwithin the local input market of a country.

The countries that get FDI from another countrycan also develop the human resources by gettingtheir employees receive training on the operationsof a particular business.

Helps in the creation of new jobs in a particularcountry. As a result of receiving FDI from othercountries, it has been possible for the recipientcountries to keep their interest rates at lowerlevels.

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.


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Problems with FDI

While FDI is expected to create positive outcomes, itmay also generate negative effects on the host country.The costs to the host economy can arise from themarket power of large firms and their associatedability to generate very high profits or by domesticpolitical interference by MNCs.

FDI in manufacturing sector is generally believed tohave a positive and significant effect on a countryseconomic growth. However based on Empiricalanalysis of data from cross country FDI flows, Alfaro(2003) points out that the impact of FDI on growth isambiguous.

Though it is expected that growth tends to benefit thepoor, this has not happened in many countries. Thereis no clear picture whether growth reduces poverty(World Bank, 2000).

FDI may entail high travel and communicationexpenses.

There is a chance that a company may lose out onits ownership to an overseas company.

Government has less control over the functioningof the company that is functioning as whollyowned subsidiary of an overseas company.

Foreign-owned projects are capital intensive andlabor-efficient.


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Literature Survey

A large number of empirical studies on the role of FDIin host countries suggest that FDI is an importantsource of capital, complements domestic privateinvestment, is usually associated with new jobopportunities and enhancement of technology transfer,and boosts overall economic growth in host countries.

De Mello (1999) attempted to find support for an FDI-led growth hypothesis when time series analysis andpanel data estimation for a sample of 32 OECD andnon- OECD countries covering the period 1970-1990were made. He estimates the impact of FDI on capitalaccumulation and output growth in the recipienteconomy.Nair-Reichert and Weinhold (2001) applied randomestimation to examine the relationship between FDIand 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 andeconomic growth ,by analyzing a time-series data overthe period 1969-2000 for three developing countries,namely Chile, Malaysia and Thailand, all of themmajor recipients of FDI with a different history of

macroeconomic episodes, policy regimes and growthpatterns. Their findings clearly suggest that it is FDIthat causes GDP in case of Malaysia and Thailand,while there is a strong evidence of the vice- versa forChile. This can be attributed to the reason that FDIdoesnt boost growth immediately; it delivers positive


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effects in the subsequent year after FDI increases. Thissuggests a significant link between FDI and GDPgrowth, one that develops over time becauseinvestment spending increases the nations productive

capacity. However one cannot deny the dependence ofFDI on GDP as GDP acts as an indicator of theeconomys well being and stability. It provides

confidence to investors for the success of theirventures in the host country. Moreover it has beenfound that the trade liberalization policy of the IndianGovernment had some positive short run impact onFDI flows.

A recent study by Kasibhatla and Sawhney (1996) inthe United States supports a unidirectional causalityfrom GDP to FDI and not the reverse. This may be dueto the fact that, for a developed country, FDI followsGDP, as GDP is an indicator of the market size.

Ericsson and Irandoust (2001) examined the causal

effects between FDI growth and output growth for thefour OECD countries applying a multi-countryframework to data from Denmark, Finland, Norwayand Sweden. The authors failed to detect any causalrelationship between FDI and output growth forDenmark and Finland. They suggested that thespecific dynamics and nature of FDI entering thesecountries could be responsible for these no-causality

results.Liu et al (2002) tested the existence of a long-runrelationship among economic growth, foreign directinvestment and trade in China. Using a co-integrationframework 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 relationshipamong FDI, growth, and exports.Chakraborty and Basu (2002) utilize the technique ofco-integration modeling to examine the link between

FDI and economic growth in India. The results suggestthat GDP in India is not caused by FDI and thecausality run more from GDP to FDI. Wang (2002)explores the kinds of FDI inflow most likely contributesignificantly to economic growth. Using data from 12Asian economies over the period of 1987-1997, shefound that only FDI in the manufacturing sector has asignificant and positive impact on economic growth

and attributes this positive contribution to FDIsspillover effects.Hsiao and Shen (2003) find a feedback associationbetween FDI and GDP in their time series analysis ofthe data from China. Using data on 80 countries forthe period 197195, Choe (2003) detects two-waycausation between FDI and growth, but the effects aremore apparent from growth to FDI.

Chowdhury and Mavrotas (2005) examined the causalrelationship between FDI and economic growth forthree developing countries, namely Chile, Malaysiaand Thailand. They found that it is GDP that causesFDI in the case of Chile and not vice versa, while forboth Malaysia and Thailand, there is a strong evidenceof a bi-directional causality between the two variables.

Duasa (2007), examined the causality between FDIand output growth in Malaysia, the study found nostrong evidence of causal relationship between FDIand economic growth. This indicates that, in the caseof Malaysia FDI does not cause economic growth, vice


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versa, but FDI does contribute to stability of growth asgrowth contributes to stability of FDI.As far as the growth trend of FDI is concerned, therecan 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 growingconfidence of the investors. However, lower growth rateis noticed during the period 1998-2000 and this canbe attributed primarily to the falling share of majorinvestor countries. Now, we further see a dip in FDIinflow in 2002-03 as a consequence of the drop inindustrial growth and GDP growth in 2002-03. The

FDI inflow is significantly related with the economiccondition of a country. If economic condition of acountry is healthy then FDI inflow will be more andwith the downturn inflow will decreasing Thisdownward trend reversed by year-end, showing thatthe investors regained confidence in India's strongereconomic growth and FDI inflows stimulated thereonwards.

Even though we do not incorporate the trends for theyears 2007-08 and 2008-09, it is worth mentioningthat in context of the recent global economic crisis,financial flows in form of FDI to the developing nationswas expected to slow down, but the initial inflow forthe year 2008-09 was surprisingly positive for India.

Though portfolio funds withdrew sharply during 2008-2009 FDI inflows remained satisfactory throughout the

year.

India after liberalization experienced a hike in foreigninward capital, conforming to the evidence for otherdeveloping countries. Due to the cyclical recession inthe US, Japan and various parts of Europe and the fall


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in US interest rates during 1989-92, there was a moveof world capital to the developing countries in searchof higher returns. Secondly, the role of internal or pullfactors such as credible economic reforms, superior

macroeconomic performance and domestic policiesattracted foreign investment and encouraged investorconfidence. As far as India is concerned, the relativelyhigh differential rate of return on Indian assets mighthave played a role in attracting foreign capital after theopening of financial markets. The timing of these flowshowever, suggests that internal or pull factors wereequally 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 inwardFDI position of a country is related to its EconomicDevelopment relative to the rest of the world. Itsuggests that the countries changes through fivedifferent stages of development. These stages are beingclassified according to the propensity of the countriesto the outward and/or inward investors (Dunning andNarula, 1994). This propensity, in turn, depends onthe extent and pattern of the ownership-specificadvantages of domestic firms, its location advantagesand the degree of utilization of the ownership-specificadvantages by the domestic and foreign firms in theinternationalization of markets.

The impact of FDI on growth rate of output wasconstrained by the existence of diminishing returns ofphysical capital.

Therefore FDI could only exert an effect on the level ofoutput per capita, but not on the growth rate. In otherwords, it was unable to alter the growth of output inthe long run. In the context of the new theory ofEconomic Growth, FDI is considered as an engine of

growth of mainstream economies. As noted by theWorld Bank (2002), several recent studies concludedthat FDI can promote the Economic Development ofthe Host Country by promoting productivity growthand export. However, the exact relationship betweenForeign Multinational Corporations and their host


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countries varies considerably between countries andamong industries. The characteristics of the HostCountry and the policy environment is importantdeterminants of net benefit of FDI.

The role of FDI in the growth process has been a topicof discussion in several countries. These discussionshave provided rich insights into the relationshipbetween FDI and Growth. Although several studies onFDI and Growth in Developing Economies exist,however, few studies on this subject have been doneon BRICS (Brazil, Russia, India, China and SouthAfrica) countries. Moreover, most of the studies

provide a descriptive discussion of FDI andEconomic Growth. The available studies haveemployed cross section regression methodologies butrecent time series studies do not support the FDI ledEconomic Growth hypotheses. A large body ofliterature explores the direct and indirect relationshipbetween Foreign Direct Investment (FDI) and Growth,with substantial number of evidences that highlight

the apparent relationship between Foreign DirectInvestment and Trade. Recent empirical evidences arerather mixed. Some found no causality between FDIand Economic Growth (Jung and Marshall, 1985)others found unidirectional relationship. Chow (1995)reported bidirectional relationship between FDI andEconomic Growth. The heterogeneity that observed inthe previous study results may be due to adoption of

different testing procedures, different lag structurespecifications and the different filtering techniquesused in the methodologies.Specifically, this study examines whether:i) Economic Growth of a country drives the FDI inflowii) 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 atwo-way causal link between FDI and Host Countrys

Economic Growth. Countries with fast EconomicGrowth generate more demand for FDI and offeropportunities for making profits. On the other hand,inward FDI flows may enhance growth throughpositive direct and indirect effects on variables thataffect growth. Thus, the study expects a bi-directionalcausality between FDI and Growth.

Our primary objective is to determine whether increasein growth rates (measured by increase in GDP for theperiod under study) has in turn led to increased inflowof FDI. Traditional wisdom suggests that if the GDP forthe economy is growing at a steady rate then foreigninvestors may perceive this a lucrative investmentopportunity and hence there should be greater inflowof Foreign Direct Investment into the said country. To

test whether the above holds true we regress FDI onthe Gross Domestic product for the period understudy. Therefore, we assume that FDI is the dependantvariable and GDP is the independent variable and ourobjective is to determine whether increase in GDPleads 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 theaverage. In bi variate analysis, one of the majorproblems is the prediction of the value of thedependant variable when the value of the independentvariable is known. The problem becomes simplified ifwe can express the dependant variable (say y) as a


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function of the independent variable (say x).Thisequation is known as the regression equation of y onx.In the simplest case we can write

y= a+ bx,so that a+ bx0is the predicted value ofy0when x= x0

We are interested in determining whether increase inGDP has led to increased inflow of FDI for India.

That is, we are interested in testing the null hypothesisH0: b=0

against the alternative:

H1: b 0

The relevant t-statistic has been found out to be-7.2811which is greater than the predicted value of thet-statistic obtained from the Biometrica table(t

/ 2 = 2.11, /=5%).

Moreover from the P-value approach we get that1.28E-06 < .05. Therefore we reject the Null Hypothesis

at 5% level of significance. The X variable is highlysignificant. The co-efficient of the X variable has beenfound out to be 0.000174 which is positive. Hence itimplies that a unit increase in GDP leads to 0.000174unit increase in FDI.It therefore appears from our analysis that increase inGDP has led to increased inflow of FDI in case of Indiafor 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 issignificant 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 assumethat Foreign Direct Investment is the independentvariable and regress Gross Domestic Product onForeign Direct Investment, we find that for Indiaincrease in GDP has led to increased inflow of ForeignDirect Investment. The result can be intuitively

explained by the fact that increased inflow of FDI hasled to the expansion of sectors which use foreigncapital intensively, which has in turn led to increasedproduction (as is reflected by a higher GDP).


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and so on. But this still leaves an unfinished agenda ofpermitting greater foreign investment in politicallysensitive areas like insurance and retailing. Accordingto the government's Secretariat for Industrial

Assistance, FDI inflows into India reached a recordUS$19.5bn in fiscal year 2006/07 (April-March). Thiswas more than double the total of US$7.8bn in theprevious fiscal year. Between April and September2007, FDI inflows were US$8.2bn.


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Sectoral Flows Of FDI into

IndiaServices Sector:-

The Services Sector Accounts for more than 505 of theCountrys GDP.It makes up more than 25% employment.

Reasons for growth of services Sector:-The introduction of the New Economic Policy In 1991by Manmohan Singh led to a wide expansion of theServices Sector. Also Global presence of TNCs &Production processes were allowed.More over there was liberalization of many servicesector 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 sectorindustries.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 forglobal competition.

Current issues with FDI in Services Sector:-

Very Weak linkages of service sector with theIndian Economy (Only few cities)

Requires highly skilled workers Employee welfare in times of crisis.

Retail:-

The retail sector is one of the fastest growing sectorswith huge potential for expansion because of thedemands 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 ofchoices and a more diversified basket.

The indirect benefits like better roads, onlinemarketing, expansion of telecom sector.


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It will also give a big push to other sectors likeagriculture, small and medium enterprises.

Drawbacks of FDI in Retail:-

Foreign players would displace the unorganizedretailers because of their superior financialstrengths.

The entry of large global retailers such as Wal-Mart would kill local shops and many jobs.

Induce unfair trade practices like predatorypricing, 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 IndianPopulation stays in towns and are engaged inagricultural practices.

Agriculture allows 100% inflow of FDI.There are no restrictions with respect to allowance ofFDI in The Agricultural Sector.


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* There has been a sharp rise in the number of FDIsapproved in 2004.

* During the first seven months of 2004, betweenJanuary and July, Rs. 5,220 crore worth of FDI wasapproved.

* Almost a third share of the investment in India is byNRI.

* According to the latest Reserve Bank of India figures,

outflows through various NRI deposits schemesamounted to $903 million since May 2004, as againstnet inflows of $1.2 billion in the corresponding periodlast year.


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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 toIndia, 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 DevelopmentIndian 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 April17, 2004.

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http://www.directessays.comhttp://www.docstoc.com

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Relationship Between FDI and GDP