Foreign Direct Investment Flows to India*
FDI inflows to India remained sluggish, when global
FDI flows to emerging market economies (EMEs) had
recovered in 2010-11, despite sound domestic economic
performance ahead of global recovery. The paper gathers
evidence through a panel exercise that actual FDI to India
during the year 2010-11 fell short of its potential level
(reflecting underlying macroeconomic parameters) partly
on account of amplification of policy uncertainty as
measured through Kauffmann’s Index.
FDI inflows to India witnessed significant
moderation in 2010-11 while other EMEs in Asia and
Latin America received large inflows. This had raised
concerns in the wake of widening current account
deficit in India beyond the perceived sustainable level
of 3.0 per cent of GDP during April-December 2010.
This also assumes significance as FDI is generally
known to be the most stable component of capital flows
needed to finance the current account deficit. Moreover,
it adds to investible resources, provides access to
advanced technologies, assists in gaining production
know-how and promotes exports.
A perusal of India’s FDI policy vis-à-vis other major
EMEs reveals that though India’s approach towards
foreign investment has been relatively conservative to
begin with, it progressively started catching up with
the more liberalised policy stance of other EMEs from
the early 1990s onwards, inter alia, in terms of wider
access to different sectors of the economy, ease of
starting business, repatriation of dividend and profits
and relaxations regarding norms for owning equity.
This progressive liberalisation, coupled with
considerable improvement in terms of macroeconomic
fundamentals, reflected in growing size of FDI flows to
the country that increased nearly 5 fold during first
decade of the present millennium.
Though the liberal policy stance and strong
economic fundamentals appear to have driven the steep
rise in FDI flows in India over past one decade and
sustained their momentum even during the period of
global economic crisis (2008-09 and 2009-10), the
subsequent moderation in investment flows despite
faster recovery from the crisis period appears somewhat
inexplicable. Survey of empirical literature and analysis
presented in the paper seems to suggest that these
divergent trends in FDI flows could be the result of
certain institutional factors that dampened the
investors’ sentiments despite continued strength of
economic fundamentals. Findings of the panel exercise,
examining FDI trends in 10 select EMEs over the last
7 year period, suggest that apart from macro
fundamentals, institutional factors such as time taken
to meet various procedural requirements make
significant impact on FDI inflows.
This paper has been organised as follows: Section
1 presents trends in global investment flows with
particular focus on EMEs and India. Section 2 traces
the evolution of India’s FDI policy framework, followed
by cross-country experience reflecting on India’s FDI
policy vis-à-vis that of select EMEs. Section 3 deals with
plausible explanations of relative slowdown in FDI
flows to India in 2010-11 and arrives at an econometric
evidence using panel estimation. The last section
presents the conclusions.
Section 1: Trends in FDI inflows
Widening growth differential across economies
and gradual opening up of capital accounts in the
emerging world resulted in a steep rise in cross border
investment flows during the past two decades. This
section briefly presents the recent trends in global
capital flows particularly to emerging economies
including India.
1.1 Global Trends in FDI inflows
During the period subsequent to dotcom burst,
there has been an unprecedented rise in the cross-border
flows and this exuberance was sustained until
the occurrence of global financial crisis in the year
2008-09. Between 2003 and 2007, global FDI flows grew
nearly four -fold and flows to EMEs during this period,
grew by about three-fold. After reaching a peak of US$
2.1 trillion in 2007, global FDI flows witnessed
significant moderation over the next two years to touch
US$ 1.1 trillion in 2009, following the global financial
crisis. On the other hand, FDI flows to developing
countries increased from US$ 565 billion in 2007 to
US$ 630 billion in 2008 before moderating to US$ 478
billion in 2009.
The decline in global FDI during 2009 was mainly
attributed to subdued cross border merger and
acquisition (M&A) activities and weaker return
prospects for foreign affiliates, which adversely
impacted equity investments as well as reinvested
earnings. According to UNCTAD, decline in M&A
activities occurred as the turmoil in stock markets
obscured the price signals upon which M&As rely. There
was a decline in the number of green field investment
cases as well, particularly those related to business and
financial services.
From an institutional perspective, FDI by private
equity funds declined as their fund raising dropped on
the back of investors’ risk aversion and the collapse of
the leveraged buyout market in tune with the
deterioration in credit market conditions. On the other
hand, FDI from sovereign wealth funds (SWFs) rose by
15 per cent in 2009. This was apparently due to the
revised investment strategy of SWFs - who have been
moving away from banking and financial sector towards
primary and manufacturing sector, which are less
vulnerable to financial market developments as well as
focusing more on Asia.
As the world economic recovery continued to be
uncertain and fragile, global FDI flows remained
stagnant at US$ 1.1 trillion in 2010. According to
UNCTAD’s Global Investment Trends Monitor (released
on January 17, 2011), although global FDI flows at
aggregate level remained stagnant, they showed an
uneven pattern across regions – while it contracted
further in advanced economies by about 7 per cent, FDI
flows recovered by almost 10 per cent in case of
developing economies as a group driven by strong
rebound in FDI flows in many countries of Latin
America and Asia. Rebound in FDI flows to developing
countries has been on the back of improved corporate
profitability and some improvement in M&A activities
with improved valuations of assets in the stock markets
and increased financial capability of potential buyers.
Improved macroeconomic conditions, particularly
in the emerging economies, which boosted corporate
profits coupled with better stock market valuations and
rising business confidence augured well for global FDI
prospects. According to UNCTAD, these favourable
developments may help translate MNC’s record level
of cash holdings (estimated to be in the range of US$
4-5 trillion among developed countries’ firms alone)
into new investments during 2011. The share of
developing countries, which now constitutes over 50
per cent in total FDI inflows, may increase further on
the back of strong growth prospects. However, currency
volatility, sovereign debt problems and potential
protectionist policies may pose some risks to this
positive outlook. Nonetheless, according to the Institute
of International Finance (January 2011), net FDI flows
to EMEs was projected to increase by over 11 per cent
in 2011. FDI flows into select countries are given in
Table 1.
Table 1: Countries with Higher Estimated Level of FDI Inflows than India in 2010 |
|
Amount (US$ billion) |
Variation (Per cent) |
2007 |
2008 |
2009 |
2010 (Estimates) |
2008 |
2009 |
2010 (Estimates) |
World |
2100.0 |
1770.9 |
1114.2 |
1122.0 |
-15.7 |
-37.1 |
0.7 |
Developed Economies |
1444.1 |
1018.3 |
565.9 |
526.6 |
-29.5 |
-44.4 |
-6.9 |
United States |
266.0 |
324.6 |
129.9 |
186.1 |
22.0 |
-60.0 |
43.3 |
France |
96.2 |
62.3 |
59.6 |
57.4 |
-35.2 |
-4.3 |
-3.7 |
Belgium |
118.4 |
110.0 |
33.8 |
50.5 |
-7.1 |
-69.3 |
49.4 |
United Kingdom |
186.4 |
91.5 |
45.7 |
46.2 |
-50.9 |
-50.1 |
1.1 |
Germany |
76.5 |
24.4 |
35.6 |
34.4 |
-68.1 |
45.9 |
-3.4 |
Developing Economies |
564.9 |
630.0 |
478.3 |
524.8 |
11.5 |
-24.1 |
9.7 |
China |
83.5 |
108.3 |
95.0 |
101.0 |
29.7 |
-12.3 |
6.3 |
Hong Kong |
54.3 |
59.6 |
48.4 |
62.6 |
9.8 |
-18.8 |
29.3 |
Russian |
55.1 |
75.5 |
38.7 |
39.7 |
37.0 |
-48.7 |
2.6 |
Federation |
|
|
|
|
|
|
|
Singapore |
35.8 |
10.9 |
16.8 |
37.4 |
-69.6 |
54.1 |
122.6 |
Saudi Arabia |
22.8 |
38.2 |
35.5 |
- |
67.5 |
-7.1 |
- |
Brazil |
34.6 |
45.1 |
25.9 |
30.2 |
30.3 |
-42.6 |
16.6 |
India |
25.0 |
40.4 |
34.6 |
23.7 |
61.6 |
-14.4 |
-31.5 |
Source: World Investment Report, 2010 and Global Investment Trends Monitor, UNCTAD. |
Section 1.2: Trends in FDI inflows to India
With the tripling of the FDI flows to EMEs during
the pre-crisis period of the 2000s, India also received
large FDI inflows in line with its robust domestic
economic performance. The attractiveness of India as
a preferred investment destination could be ascertained
from the large increase in FDI inflows to India, which
rose from around US$ 6 billion in 2001-02 to almost
US$ 38 billion in 2008-09. The significant increase in
FDI inflows to India reflected the impact of liberalisation
of the economy since the early 1990s as well as gradual
opening up of the capital account. As part of the capital
account liberalisation, FDI was gradually allowed in
almost all sectors, except a few on grounds of strategic
importance, subject to compliance of sector specific
rules and regulations. The large and stable FDI flows
also increasingly financed the current account deficit
over the period. During the recent global crisis, when
there was a significant deceleration in global FDI flows
during 2009-10, the decline in FDI flows to India was
relatively moderate reflecting robust equity flows on
the back of strong rebound in domestic growth ahead
of global recovery and steady reinvested earnings (with
a share of almost 25 per cent) reflecting better
profitability of foreign companies in India. However,
when there had been some recovery in global FDI flows,
especially driven by flows to Asian EMEs, during 2010-
11, gross FDI equity inflows to India witnessed
significant moderation. Gross equity FDI flows to India
moderated to US$ 20.3 billion during 2010-11 from US$
27.1 billion in the preceding year.
From a sectoral perspective, FDI in India mainly
flowed into services sector (with an average share of
41 per cent in the past five years) followed by
manufacturing (around 23 per cent) and mainly routed
through Mauritius (with an average share of 43 per cent
in the past five years) followed by Singapore (around
11 per cent). However, the share of services declined
over the years from almost 57 per cent in 2006-07 to
about 30 per cent in 2010-11, while the shares of
manufacturing, and ‘others’ largely comprising
‘electricity and other power generation’ increased over
the same period (Table 2). Sectoral information on the
recent trends in FDI flows to India show that the
moderation in gross equity FDI flows during 2010-11
has been mainly driven by sectors such as ‘construction,
real estate and mining’ and services such as ‘business
and financial services’. Manufacturing, which has been
the largest recipient of FDI in India, has also witnessed
some moderation (Table 2).
Section 2: FDI Policy Framework
Policy regime is one of the key factors driving
investment flows to a country. Apart from underlying
macro fundamentals, ability of a nation to attract
foreign investment essentially depends upon its policy
regime - whether it promotes or restrains the foreign
investment flows. This section undertakes a review of
India’s FDI policy framework and makes a comparison
of India’s policy vis-à-vis that of select EMEs.
2.1 FDI Policy Framework in India
There has been a sea change in India’s approach
to foreign investment from the early 1990s when it
began structural economic reforms encompassing
almost all the sectors of the economy.
Pre-Liberalisation Period
Historically, India had followed an extremely
cautious and selective approach while formulating FDI
policy in view of the dominance of ‘import-substitution
strategy’ of industrialisation. With the objective of
becoming ‘self reliant’, there was a dual nature of policy
intention – FDI through foreign collaboration was
welcomed in the areas of high technology and high
priorities to build national capability and discouraged
in low technology areas to protect and nurture domestic
industries. The regulatory framework was consolidated
through the enactment of Foreign Exchange Regulation
Act (FERA), 1973 wherein foreign equity holding in a
joint venture was allowed only up to 40 per cent.
Subsequently, various exemptions were extended to
foreign companies engaged in export oriented
businesses and high technology and high priority areas
including allowing equity holdings of over 40 per cent.
Moreover, drawing from successes of other country
experiences in Asia, Government not only established
special economic zones (SEZs) but also designed liberal
policy and provided incentives for promoting FDI in
these zones with a view to promote exports. As India
continued to be highly protective, these measures did
not add substantially to export competitiveness.
Recognising these limitations, partial liberalisation in
the trade and investment policy was introduced in the
1980s with the objective of enhancing export
competitiveness, modernisation and marketing of
exports through Trans-national Corporations (TNCs).
The announcements of Industrial Policy (1980 and
1982) and Technology Policy (1983) provided for a liberal
attitude towards foreign investments in terms of
changes in policy directions. The policy was characterised
by de-licensing of some of the industrial rules and
promotion of Indian manufacturing exports as well as
emphasising on modernisation of industries through
liberalised imports of capital goods and technology.
This was supported by trade liberalisation measures in
the form of tariff reduction and shifting of large number
of items from import licensing to open general licensing
(OGL).
Table 2: Equity FDI Inflows to India |
(Per cent) |
Sectors |
2006-07 |
2007-08 |
2008-09 |
2009-10 |
2010-11 |
Sectoral shares (Per cent) |
Manufactures |
17.6 |
19.2 |
21.0 |
22.9 |
32.1 |
Services |
56.9 |
41.2 |
45.1 |
32.8 |
30.1 |
Construction, Real estate and mining |
15.5 |
22.4 |
18.6 |
26.6 |
17.6 |
Others |
9.9 |
17.2 |
15.2 |
17.7 |
20.1 |
Total |
100.0 |
100.0 |
100.0 |
100.0 |
100.0 |
Equity Inflows (US$ billion) |
Manufactures |
1.6 |
3.7 |
4.8 |
5.1 |
4.8 |
Services |
5.3 |
8.0 |
10.2 |
7.4 |
4.5 |
Construction, Real estate and mining |
1.4 |
4.3 |
4.2 |
6.0 |
2.6 |
Others |
0.9 |
3.3 |
3.4 |
4.0 |
3.0 |
Total Equity FDI |
9.3 |
19.4 |
22.7 |
22.5 |
14.9 |
Post-Liberalisation Period
A major shift occurred when India embarked upon
economic liberalisation and reforms program in 1991
aiming to raise its growth potential and integrating with
the world economy. Industrial policy reforms gradually
removed restrictions on investment projects and
business expansion on the one hand and allowed
increased access to foreign technology and funding on
the other. A series of measures that were directed
towards liberalizing foreign investment included: (i)
introduction of dual route of approval of FDI – RBI’s
automatic route and Government’s approval (SIA/FIPB)
route, (ii) automatic permission for technology
agreements in high priority industries and removal of
restriction of FDI in low technology areas as well as
liberalisation of technology imports, (iii) permission to
Non-resident Indians (NRIs) and Overseas Corporate
Bodies (OCBs) to invest up to 100 per cent in high
priorities sectors, (iv) hike in the foreign equity
participation limits to 51 per cent for existing
companies and liberalisation of the use of foreign
‘brands name’ and (v) signing the convention of
multilateral investment guarantee agency (MIGA) for
protection of foreign investments. These efforts were
boosted by the enactment of Foreign Exchange
Management Act (FEMA), 1999 [that replaced the
Foreign Exchange Regulation Act (FERA), 1973] which
was less stringent. This along with the sequential
financial sector reforms paved way for greater capital
account liberalisation in India.
Investment proposals falling under the automatic
route and matters related to FEMA are dealt with by
RBI, while the Government handles investment
through approval route and issues that relate to FDI
policy per se through its three institutions, viz., the
Foreign Investment Promotion Board (FIPB), the
secretariat for industrial assistance (SIA) and the
Foreign Investment Implementation Authority (FIIA).
FDI under the automatic route does not require
any prior approval either by the Government or the
Reserve Bank. The investors are only required to notify
the concerned regional office of the RBI within 30 days
of receipt of inward remittances and file the required
documents with that office within 30 days of issuance
of shares to foreign investors. Under the approval route,
the proposals are considered in a time-bound and
transparent manner by the FIPB. Approvals of composite
proposals involving foreign investment/ foreign
technical collaboration are also granted on the
recommendations of the FIPB. Current FDI policy in
terms of sector specific limits has been summarised in
Table 3 below:
Table 3: Sector Specific Limits of Foreign Investment in India |
Sector |
FDI Cap/
Equity |
Entry
Route |
Other
Conditions |
A. Agriculture |
|
|
|
1. Floriculture, Horticulture, Development and production of Seeds, Animal Husbandry, Pisciculture, Aquaculture, Cultivation of vegetables & mushrooms and services related to agro and allied sectors. |
100% |
Automatic |
|
2. Tea sector, including plantation |
100% |
FIPB |
|
(FDI is not allowed in any other agricultural sector /activity) |
B. Industry |
|
|
|
1. Mining covering exploration and mining of diamonds & precious stones; gold, silver and minerals. |
100% |
Automatic |
|
2. Coal and lignite mining for captive consumption by power projects, and iron & steel, cement production. |
100% |
Automatic |
|
3. Mining and mineral separation of titanium bearing minerals |
100% |
FIPB |
|
C. Manufacturing |
|
|
|
1. Alcohol- Distillation & Brewing |
100% |
Automatic |
|
2. Coffee & Rubber processing & Warehousing. |
100% |
Automatic |
|
3. Defence production |
26% |
FIPB |
|
4. Hazardous chemicals and isocyanates |
100% |
Automatic |
|
5. Industrial explosives -Manufacture |
100% |
Automatic |
|
6. Drugs and Pharmaceuticals |
100% |
Automatic |
|
7. Power including generation (except Atomic energy); transmission, distribution and power trading. |
100% |
Automatic |
|
(FDI is not permitted for generation, transmission & distribution of electricity produced in atomic power plant/atomic energy since private investment in this activity is prohibited and reserved for public sector.) |
D. Services |
|
|
|
1. Civil aviation |
|
|
|
a. Greenfield projects |
100% |
Automatic |
|
b. Existing projects |
100% |
FIPB beyond 74% |
|
2. Asset Reconstruction companies |
49% |
FIPB |
|
3. Banking |
|
|
|
a. Private sector |
74%
(FDI+FII). FII not to exceed 49% |
Automatic |
|
b. Public sector |
20% |
|
|
Table 3: Sector Specific Limits of Foreign Investment in India (Concld.) |
4. NBFCs: Merchant Banking underwriting, portfolio management services, investment
advisory services, financial consultancy, stock broking, asset management, venture
capital, custodian , factoring, leasing and finance, housing finance, forex broking, etc. |
100% |
Automatic |
Subject to
minimum
capitalisation norms |
5. Broadcasting |
|
|
|
a. FM Radio |
20% |
FIPB |
|
b. Cable network; |
49% (FDI+FII) |
FIPB |
|
c. Direct to home; |
100% |
FIPB |
|
d. Setting up Hardware facilities such as up-linking, HUB. |
49% |
FIPB |
|
e. Up-linking a news and current affairs TV Channel |
26% |
FIPB |
|
6. Commodity Exchanges |
49% (FDI+FII)
(FDI 26 % FII 23%) |
FIPB |
|
7. Insurance |
26% |
Automatic |
Clearance
from IRDA |
8. Petroleum and natural gas : |
|
|
|
a. Refining |
49% (PSUs).100%
(Pvt. Companies) |
FIPB (for PSUs).Automatic (Pvt.) |
|
9. Print Media |
|
|
|
a. Publishing of newspaper and periodicals dealing with news and current affairs |
26% |
FIPB |
Subject to
guidelines by Ministry of Information &
broadcasting |
b. Publishing of scientific magazines/speciality journals/periodicals |
100% |
FIPB |
10. Telecommunications |
|
|
|
a. Basic and cellular, unified access services, national/international long-distance, V-SAT, public mobile radio trunked services (PMRTS), global mobile personal communication services (GMPCS) and others. |
74% (including FDI, FII, NRI, FCCBs, ADRs/GDRs, convertible preference shares,etc. |
Automatic up to 49% and FIPB beyond 49%. |
|
Sectors where FDI is Banned |
1. Retail Trading (except single brand product retailing);
2. Atomic Energy;
3. Lottery Business including Government / private lottery, online lotteries etc;
4. Gambling and Betting including casinos etc.;
5. Business of chit fund;
6. Nidhi Company;
7. Trading in Transferable Development Rights (TDRs);
8. Activities/sector not opened to private sector investment;
9. Agriculture (excluding Floriculture, Horticulture, Development of seeds, Animal Husbandry, Pisciculture and cultivation of vegetables,
mushrooms etc. under controlled conditions and services related to agro and allied sectors) and Plantations (Other than Tea Plantations);
10. Real estate business, or construction of farm houses; Manufacturing of Cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco or of
tobacco substitutes. |
2.2 FDI Policy: The International Experience
Foreign direct investment is treated as an
important mechanism for channelizing transfer of
capital and technology and thus perceived to be a potent
factor in promoting economic growth in the host
countries. Moreover, multinational corporations
consider FDI as an important means to reorganise their
production activities across borders in accordance with
their corporate strategies and the competitive advantage
of host countries. These considerations have been the
key motivating elements in the evolution and attitude
of EMEs towards investment flows from abroad in the
past few decades particularly since the eighties. This
section reviews the FDI policies of select countries to
gather some perspective as to ‘where does India stand’
at the current juncture to draw policy imperatives for
FDI policy in India.
China
-
Encouragement to FDI has been an integral part of
the China’s economic reform process. It has
gradually opened up its economy for foreign
businesses and has attracted large amount of direct
foreign investment.
-
Government policies were characterised by setting
new regulations to permit joint ventures using
foreign capital and setting up SEZs and Open Cities.
The concept of SEZs was extended to fourteen more
coastal cities in 1984. Favorable regulations and
provisions were used to encourage FDI inflow,
especially export-oriented joint ventures and joint
ventures using advanced technologies in 1986.
-
Foreign joint ventures were provided with
preferential tax treatment, the freedom to import
inputs such as materials and equipment, the right
to retain and swap foreign exchange with each
other, and simpler licensing procedures in 1986.
Additional tax benefits were offered to exportoriented
joint ventures and those employing
advanced technology.
-
Priority was given to FDI in the agriculture, energy,
transportation, telecommunications, basic raw
materials, and high-technology industries, and FDI
projects which could take advantage of the rich
natural resources and relatively low labour costs in
the central and northwest regions.
-
China’s policies towards FDI have experienced
roughly three stages: gradual and limited opening,
active promoting through preferential treatment,
and promoting FDI in accordance with domestic
industrial objectives. These changes in policy
priorities inevitably affected the pattern of FDI
inflows in China.
Chile
-
In Chile, policy framework for foreign investment,
embodied in the constitution and in the Foreign
Investment Statute, is quite stable and transparent
and has been the most important factor in
facilitating foreign direct investment. Under this
framework, an investor signs a legal contract with
the state for the implementation of an individual
project and in return receives a number of specific
guarantees and rights.
-
Foreign investors in Chile can own up to 100 per
cent of a Chilean based company, and there is no
time limit on property rights. They also have access
to all productive activities and sectors of the
economy, except for a few restrictions in areas that
include coastal trade, air transport and the mass
media.
-
Chile attracted investment in mining, services,
electricity, gas and water industries and
manufacturing.
-
Investors are guaranteed the right to repatriate
capital one year after its entry and to remit profits
at any time.
-
Although Chile’s constitution is based on the
principle of non-discrimination, some tax
advantages are extended to foreign investors such
as invariability of income tax regime, invariability
of indirect taxes, and special policy regime for large
projects.
Malaysia
-
The Malaysian FDI regime is tightly regulated in
that all foreign manufacturing activity must be
licensed regardless of the nature of their business.
-
Until 1998, foreign equity share limits were made
conditional on performance and conditions set
forth by the industrial policy of the time.
-
In the past, the size of foreign equity share allowed
for investment in the manufacturing sector hinged
on the share of the products exported in order to
support the country’s export-oriented industrial
policy.
-
FDI projects that export at least 80 per cent of
production or production involving advanced
technology are promoted by the state and no equity
conditions are imposed. Following the crisis in
1997-98, the restriction was abolished as the
country was in need of FDI.
Korea
-
The Korean government maintained distinctive
foreign investment policies giving preference to
loans over direct investment to supplement its low
level of domestic savings during the early stage of
industrialisation. Korea’s heavy reliance on foreign
borrowing to finance its investment requirements
is in sharp contrast to other countries.
-
The Korean Government had emphasised the need
to enhance absorptive capacity as well as the
indigenisation of foreign technology through
reverse engineering at the outset of industrialisation
while restricting both FDI and foreign licensing.
This facilitated Korean firms to assimilate imported
technology, which eventually led to emergence of
global brands like Samsung, Hyundai, and LG.
-
The Korean government pursued liberalised FDI
policy regime in the aftermath of the Asian financial
crisis in 1997-98 to fulfil the conditionality of the
International Monetary Fund (IMF) in exchange for
standby credit.
-
Several new institutions came into being in Korea
immediately after the crisis. Invest Korea is Korea’s
national investment promotion agency mandated
to offer one-stop service as a means of attracting
foreign direct investment, while the Office of the
Investment Ombudsman was established to
provide investment after-care services to foreign invested
companies in Korea. These are affiliated
to the Korea Trade Investment Promotion Agency.
-
Korea enacted a new foreign investment promotion
act in 1998 to provide foreign investors incentives
which include tax exemptions and reductions,
financial support for employment and training,
cash grants for R&D projects, and exemptions or
reductions of leasing costs for land for factory and
business operations for a specified period.
-
One of the central reasons for the delays in the
construction process in Korea is said to be the
lengthy environmental and cultural due diligence
on proposed industrial park sites (OECD, 2008).
Thailand
-
Thailand followed a traditional import-substitution
strategy, imposing tariffs on imports, particularly
on finished products in the 1960s. The role of state
enterprises was greatly reduced from the 1950s and
investment in infrastructure was raised. Attention
was given to nurturing the institutional system
necessary for industrial development. Major policy
shift towards export promotion took place by early
1970s due to balance of payments problems since
most of components, raw materials, and machinery
to support the production process, had to be
imported.
-
On the FDI front, in 1977 a new Investment
Promotion Law was passed which provided the
Board of Investment (BOI) with more power to
provide incentives to priority areas and remove
obstacles faced by private investors (Table 4). After
the East Asian financial crisis, the Thai government
has taken a very favourable approach towards FDI
with a number of initiatives to develop the
industrial base and exports and progressive
liberalisation of laws and regulations constraining
foreign ownership in specified economic activities.
-
The Alien Business Law, which was enacted in 1972
and restricted majority foreign ownership in certain
activities, was amended in 1999. The new law
relaxed limits on foreign participation in several
professions such as law, accounting, advertising
and most types of construction, which have been
moved from a completely prohibited list to the less
restrictive list of businesses.
To sum up, the spectacular performance of China
in attracting large amount of FDI could be attributed to
its proactive FDI policy comprising setting up of SEZs
particularly exports catering to the international
market, focus on infrastructure and comparative
advantage owing to the low labour costs. A comparison
of the FDI policies pursued by select emerging
economies, set out above, suggests that policies
although broadly common in terms of objective,
regulatory framework and focus on technological
upgradation and export promotion, the use of incentive
structure and restrictions on certain sectors, has varied
across countries. While China and Korea extend explicit
tax incentives to foreign investors, other countries
focus on stability and transparency of tax laws.
Similarly, while all the countries promote investment
in manufacturing and services sector, China stands out
with its relaxation for agriculture sector as well. It is,
however, apparent that though policies across countries
vary in specifics, there is a common element of
incentivisation of foreign investment (Table 4).
Table 4: FDI Policy and Institutional Framework in Select Countries |
|
Year of
Liberali sation |
Objective |
Incentives |
Priority Sectors |
Unique
features |
China |
1979 |
Transformation of
traditional agriculture,
promotion of
industrialization,
infrastructure and
export promotion. |
Foreign joint ventures were provided with
preferential tax treatment. Additional tax benefits to
export-oriented joint ventures and those employing
advanced technology. Privileged access was provided
to supplies of water, electricity and transportation
(paying the same price as state-owned enterprises)
and to interest-free RMB loans. |
Agriculture, energy,
transportation,
telecommunications, basic
raw materials, and high-
technology industries. |
Setting up
of Special Economic
Zones |
Chile |
1974 |
Technology transfer,
export promotion
and greater domestic
competition. |
Invariability of tax regime intended to provide a stable
tax horizon. |
All productive
activities and sectors of the
economy,
except for a few restrictions
in areas that include
coastal trade, air transport
and the mass media. |
Does not use
tax incentives
to attract
foreign
investment. |
Korea |
1998 |
Promotion of
absorptive capacity and
indigenisation of foreign
technology through
reverse engineering
at the outset of
industrialisation while
restricting both FDI and
foreign licensing. |
Businesses located in Foreign Investment Zone enjoy
full exemption of corporate income tax for five years
from the year in which the initial profit is made and
50 percent reduction for the subsequent two years.
High-tech foreign investments in the Free Economic
Zones are eligible for the full exemption three years
and 50 percent for the following two years. Cash
grants to high-tech green field investment and R&D
investment subject to the government approval. |
Manufacturing and services |
Loan-based
borrowing to
an FDI-based
development
strategy till late
1990s. |
Malaysia |
1980s |
Export promotion |
No specific tax incentives. |
Manufacturing and
services. |
Malaysian
Industrial
Development
Authority was
recognised to
be one of the
effective agencies in the
Asian region |
Thailand |
1977 |
Technology transfer and
export promotion |
No specific tax incentives. The Thai Board of
Investment has carried out activities under the three
broad categories to promote FDI.
1. Image building to demonstrate how the host
country is an appropriate location for FDI.
2. Investment generation by targeting investors
through various activities.
3. Servicing investors |
Manufacturing and services |
– |
2.3 Cross-Country Comparison of FDI
Policies – Where does India stand?
A true comparison of the policies could be
attempted if the varied policies across countries could
be reduced to a common comparable index or a
measure. Therefore, with a view to examine and
analyse ‘where does India stand’ vis-a-vis other
countries at the current juncture in terms of FDI policy
framework, the present section draws largely from the
results of a survey of 87 economies undertaken by the
World Bank in 2009 and published in its latest
publication titled ‘Investing Across Borders’.
The survey has considered four indicators, viz.,
‘Investing across Borders’, ‘Starting a Foreign Business’,
‘Accessing Industrial Land’, and ‘Arbitrating Commercial
Disputes’ to provide assessment about FDI climate in
a particular country. Investing across Borders indicator
measures the degree to which domestic laws allow
foreign companies to establish or acquire local firms.
Starting foreign business indicator record the time,
procedures, and regulations involved in establishing a
local subsidiary of a foreign company. Accessing
industrial land indicator evaluates legal options for
foreign companies seeking to lease or buy land in a host
economy, the availability of information about land
plots, and the steps involved in leasing land. Arbitrating
commercial disputes indicator assesses the strength of
legal frameworks for alternative dispute resolution,
rules for arbitration, and the extent to which the
judiciary supports and facilitates arbitration. India’s
relative position in terms of these four parameters visà-
vis major 15 emerging economies, which compete
with India in attracting foreign investment, is set out
in Tables 5A and 5B.
Following key observations could be made from this
comparison:
Table 5A: Investing Across Borders – Sector wise Caps – 2009 |
Country |
Mining,
oil
and
gas |
Agricul
-
ture and forestry |
Light manu-
facturing |
Telecomm
-unications |
Electr-
icity |
Banking |
Insurance |
Transpor-
tation |
Media |
Construction,
tourism and
retail |
Health care
and waste
manag-
ement |
Argentina |
100 |
100 |
100 |
100 |
100 |
100 |
100 |
79.6 |
30 |
100 |
100 |
Brazil |
100 |
100 |
100 |
100 |
100 |
100 |
100 |
68 |
30 |
100 |
50 |
Chile |
100 |
100 |
100 |
100 |
100 |
100 |
100 |
100 |
100 |
100 |
100 |
China |
75 |
100 |
75 |
49 |
85.4 |
62.5 |
50 |
49 |
0 |
83.3 |
85 |
India |
100 |
50* |
81.5 |
74 |
100 |
87* |
26 |
59.6 |
63* |
83.7* |
100 |
Indonesia |
97.5 |
72 |
68.8 |
57 |
95 |
99 |
80 |
49 |
5 |
85 |
82.5 |
Korea Rep. |
100 |
100 |
100 |
49 |
85.4 |
100 |
100 |
79.6 |
39.5 |
100 |
100 |
Malaysia |
70 |
85 |
100 |
39.5 |
30 |
49 |
49 |
100 |
65 |
90 |
65 |
Mexico |
50 |
49 |
100 |
74.5 |
0 |
100 |
49 |
54.4 |
24.5 |
100 |
100 |
Philippines |
40 |
40 |
75 |
40 |
65.7 |
60 |
100 |
40 |
0 |
100 |
100 |
Russian Federation |
100 |
100 |
100 |
100 |
100 |
100 |
49 |
79.6 |
75 |
100 |
100 |
South Africa |
74 |
100 |
100 |
70 |
100 |
100 |
100 |
100 |
60 |
100 |
100 |
Thailand |
49 |
49 |
87.3 |
49 |
49 |
49 |
49 |
49 |
27.5 |
66 |
49 |
*: See para on limitations of the data.
Source: Investing Across Borders, World Bank, 2010. |
Table 5B: Investing Across Borders – Key Indicators 2009 |
Country
ECONOMY |
Starting a Foreign Business |
Accessing Industrial Land |
Arbitrating Commercial Disputes |
Time
(days) |
Proced-
ures
(num-
ber) |
Ease of
establish-ment
index
(0 = min,
100 = max) |
Strength of
lease rights
index
(0 = min,
100 = max) |
Strength
of
owne-
rship
rights
index
(0 = min,
100 = max) |
Access to
land
inform-
ation
index
(0 = min,
100 = max) |
Availa-
bility
of land inform-
ation
index
(0 = min,
100 = max) |
Time
to
lease
private
land
(days) |
Time
to
lease
public
land
(days) |
Strength
of
laws
index
(0 = min,
100 = max) |
Ease of
process
index
(0 = min,
100 = max) |
Extent of
judicial
assis-
tance
index
(0 = min,
100 = max) |
|
|
|
|
|
|
|
|
|
|
|
|
Argentina |
50 |
18 |
65 |
79.3 |
100 |
44.4 |
85 |
48 |
112 |
63.5 |
72.2 |
55.1 |
Brazil |
166 |
17 |
62.5 |
85.7 |
100 |
33.3 |
75 |
66 |
180 |
84.9 |
45.7 |
57.2 |
Chile |
29 |
11 |
63.2 |
85.7 |
100 |
33.3 |
80 |
23 |
93 |
94.9 |
62.8 |
74.8 |
China |
99 |
18 |
63.7 |
96.4 |
n/a |
50 |
52.5 |
59 |
129 |
94.9 |
76.1 |
60.2 |
India |
46 |
16 |
76.3 |
92.9 |
87.5 |
15.8 |
85 |
90 |
295 |
88.5 |
67.6 |
53.4 |
Indonesia |
86 |
12 |
52.6 |
78.6 |
n/a |
21.4 |
85 |
35 |
81 |
95.4 |
81.8 |
41.3 |
Korea Rep. |
17 |
11 |
71.1 |
85.7 |
100 |
68.4 |
70 |
10 |
53 |
94.9 |
81.9 |
70.2 |
Malaysia |
14 |
11 |
60.5 |
78.5 |
87.5 |
23.1 |
85 |
96 |
355 |
94.9 |
81.8 |
66.7 |
Mexico |
31 |
11 |
65.8 |
81.3 |
100 |
33.3 |
90 |
83 |
151 |
79.1 |
84.7 |
52.7 |
Philippines |
80 |
17 |
57.9 |
68.8 |
n/a |
23.5 |
87.5 |
16 |
n/a |
95.4 |
87 |
33.7 |
Russian Federation |
31 |
10 |
68.4 |
85.7 |
100 |
44.4 |
90 |
62 |
231 |
71.6 |
76.1 |
76.6 |
South Africa |
65 |
8 |
78.9 |
84.5 |
100 |
47.4 |
85 |
42 |
304 |
82.4 |
79 |
94.5 |
Thailand |
34 |
9 |
60.5 |
80.7 |
62.5 |
27.8 |
70 |
30 |
128 |
84.9 |
81.8 |
40.8 |
Source: Investing Across Borders, World Bank, 2010. |
-
A comparative analysis among the select countries
reveals that countries such as Argentina, Brazil,
Chile and the Russian Federation have sectoral caps
higher than those of India implying that their FDI
policy is more liberal.
-
The sectoral caps are lower in China than in India
in most of the sectors barring agriculture and
forestry and insurance. A noteworthy aspect is that
China permits 100 per cent FDI in agriculture while
completely prohibits FDI in media. In India, on the
other hand, foreign ownership is allowed up to 100
per cent in sectors like ‘mining, oil and gas’,
electricity and ‘healthcare and waste management’.
-
India positioned well vis-a-vis comparable
counterparts in the select countries in terms of the
indicator ‘starting a foreign business’. In 2009,
starting a foreign business took around 46 days
with 16 procedures in India as compared with 99
days with 18 procedures in China and 166 days
with 17 procedures in Brazil (Table 5 B).
-
In terms of another key indicator, viz., ‘accessing
industrial land’ India’s position is mixed. While the
ranking in terms of indices based on lease rights
and ownership rights is quite high, the time to lease
private and public land is one of the highest among
select countries at 90 days and 295 days, respectively.
In China, it takes 59 days to lease private land and
129 days to lease public land. This also has
important bearing on the investment decisions by
foreign companies.
-
In terms of the indicator ‘arbitrating commercial
disputes’ India is on par with Brazil and the Russian
Federation. Although, the strength of laws index is
fairly good, the extent of judicial assistance index
is moderate.
Thus, a review of FDI policies in India and across
major EMEs suggests that though India’s policy stance
in terms of access to different sectors of the economy,
repatriation of dividend and norms for owning equity
are comparable to that of other EMEs, policy in terms
of qualitative parameters such as ‘time to lease private
land’, ‘access to land information’ and ‘Extent of
Judicial assistance’ are relatively more conservative.
Since time taken to set up a project adds to the cost and
affect competitiveness, an otherwise fairly liberal policy
regime may turn out to be less competitive or
economically unviable owing to procedural delays.
Thus, latter may affect the cross border flow of
investible funds. But an assessment of precise impact
of these qualitative parameters on the flow of FDI is an
empirical question. The following section makes an
attempt to quantify the impact of various factors that
govern the flow of FDI in India.
Section 3: FDI flows to India in recent
period – Distinct slowdown despite strong
fundamentals – Plausible Explanations
As stated above, global FDI flows moderated
significantly since the eruption of global financial crisis
in 2008, albeit with an uneven pattern across regions
and countries. Though initially developing countries
showed some resilience, crisis eventually spread
through the trade, financial and confidence channels
and FDI flows declined in both the advanced and
developing economies during 2009. Subsequently,
while FDI flows to advanced countries continued to
decline, FDI flows to many of the Latin American and
Asian countries witnessed strong rebound during 2010
on the back of improved corporate profitability and
some improvement in M&A activities.
FDI flows to India also moderated during 2009 but
unlike trends in other EMEs, flows continued to be
sluggish during 2010 despite strong domestic growth
ahead of global recovery. This raised concerns for policy
makers in India against the backdrop of expansion in
the current account deficit.
An analysis of trends in FDI flows during 2010
reveal that among the EMEs, countries such as
Indonesia, Thailand, Brazil, Argentina, Chile and
Mexico registered increases in the range of 14-171 per
cent during 2010 over 2009 (Table 6). In contrast, FDI
inflows to India declined by 32 per cent, year-on-year,
during 2010. This moderation in FDI inflows warrants
a deeper examination of the causal factors from a crosscountry
perspective.
An analysis of key macroeconomic indicators in the
select EMEs reveals that India’s macroeconomic
performance compares with other EMEs which received
higher FDI inflows during 2010 (Charts 1 & 2).
For instance, the GDP growth of India improved
during 2010 as was the case with the select EMEs. The
current account balance as percent of GDP deteriorated
across the select EMEs, except Argentina. However,
inflation in India was generally higher (remaining at
double digits for a long period) than other select EMEs
(except Argentina).
Thus, without any significant deterioration in
Indian macroeconomic performance compared to the
select EMEs during 2010, the moderation in FDI inflows
to India points towards the probable role of institutional
factors that might have discouraged FDI inflows.
Table 6: FDI Inflows in Select EMEs |
(US$ billion) |
|
Argentina |
Brazil |
Chile |
India |
Indonesia |
Mexico |
South Africa |
Thailand |
2007 |
6.5 |
34.6 |
12.5 |
25.5 |
6.9 |
29.1 |
5.7 |
11.3 |
2008 |
9.7 |
45.1 |
15.2 |
43.4 |
9.3 |
24.9 |
9.6 |
8.5 |
(50.2) |
(30.3) |
(21.1) |
(70.3) |
(34.5) |
-(14.3) |
(68.1) |
-(24.7) |
2009 |
4.0 |
25.9 |
12.7 |
35.6 |
4.9 |
14.5 |
5.4 |
5.0 |
-(92.0) |
-(14.3) |
-(39.9) |
-(49.4) |
-(85.9) |
-(200.8) |
-(92.1) |
-(120.2) |
Q1-10 |
1.9 |
5.5 |
5.5 |
6.1 |
2.9 |
4.8 |
0.4 |
1.5 |
Q2-10 |
0.0 |
6.6 |
2.5 |
6.0 |
3.3 |
7.6 |
0.4 |
2.0 |
Q3-10 |
1.9 |
10.5 |
5.3 |
6.7 |
3.4 |
2.4 |
0.1 |
1.5 |
Q4-10 |
0.9 |
25.9 |
1.9 |
5.3 |
3.7 |
2.8 |
- |
0.7 |
2010 |
4.7 |
48.5 |
15.2 |
24.1 |
13.3 |
17.6 |
0.9 |
5.7 |
(17.5) |
(87.3) |
(19.7) |
-(32.3) |
(171.4) |
(21.4) |
-(80.4) |
(14.0) |
Note: Figures in brackets relate to percentage variation over the corresponding period of the previous year.
Source:IMF, BOP Statistics. |
3.1 FDI slowdown – Explanations Offered
In the recent past, various economists,
policymakers, academicians and corporate researchers
suggested that India’s regulatory policies in terms of
procedural delays, complex rules and regulations
related to land acquisition, legal requirements and
environmental obligations might have played a role in
holding the investors back from investing into India.
The uncertainty created by the actions taken by policy
makers might have led to unfriendly business
environment in India. In this context, some of the
statements and observations made in various reports
are detailed below:
Infrastructure projects in India carry significant
risks associated with meeting government regulation,
environment norms and legal requirements; inadequate
user charges; and execution and construction risks
(CRISIL Report, January 2011).
Procedural delays are bothering nearly all of the
respondents with almost 93 percent of the respondents
indicating this issue to be ‘quite to very serious’. The
time consuming systems and procedures to be complied
with, the bureaucratic layers to be dealt with and the
multiple bodies from which clearances are to be
obtained- all add up substantially to the transaction
cost involved and take up a lot of management time
thus making it an issue of serious concern for the
investors (FDI Survey by FICCI, December 2010).
Identification of ‘environment clearances, land
acquisition and rehabilitation’ as the key issues that
delayed large investment projects in the steel industry
(Kotak Institutional Equities Research, October, 2010).
The Posco project (still in the pipeline) involves
wider issues: Rs. 52,000 crore in foreign direct
investments that will be seen as a test case for India’s
ability to accommodate big-ticket capital from abroad.
The mining project by Vedanta in the same state
(Orissa) has already been stalled on environment
grounds (The Telegraph newspaper statement, October
19, 2010).
When hard choices need to be made about large
projects that are considered central to economic growth
but are detrimental to the environment. Let us all
accept the reality that there is undoubtedly a trade-off
between growth and environment (EPW, October 16,
2010).
Apart from hundreds of industry projects, he
(environment Minister) has held up construction of a
second airport in the commercial hub of Mumbai and
dozens of road and dam projects await clearance (China
Daily, November 6, 2010).
To ascertain these assertions which seek to imply
that probably relatively more restrictive policy
environment in India vis-à-vis other countries might
have caused sluggishness in FDI flows, following
section undertakes an econometric exercise using data
of select EMEs.
3.2 Reasons for FDI slowdown – An Econometric Evidence
The review of theoretical and select empirical
literature reveals that FDI flows are driven by both pull
and push factors. While pull factors that reflect the
macroeconomic parameters could be influenced by the
policies followed by the host country, push factors
essentially represent global economic situation and
remain beyond the control of economies receiving these
flows (Box I).
Data and Methodology
The paper attempts a panel exercise for the select
major emerging market economies to ascertain
determinants of FDI flows. The data set comprises
observations for the period from 2003-04 to 2009-10
for 10 major emerging economies, viz., Argentina, Brazil,
Chile, India, Malaysia, Mexico, Philippines, Russia,
South Africa and Thailand. To ensure the comparability
entire dataset has been sourced from the Global
Development Finance, published by the World Bank.
FDI flows have been measured as FDI inflows to GDP
ratio which has been regressed over a range of
explanatory variables. Drawing from the literature
review presented above, some of the variables that have
been chosen and could be significant in determining
the FDI flows comprise: market size, openness, currency
valuation, growth prospects, macroeconomic
sustainability, regulatory regime and proportion of
global FDI received by emerging economies.
Market size: Larger market size is expected to
attract more FDI as it provides greater potential for
demand and lower production costs through scale
economies. Market size has been proxied by GDP in
purchasing power parity (PPP) terms.
Openness: Impact of openness or liberalised trade
is somewhat ambiguous and depends on relative
strength of two effects. First, economy with trade
barriers is expected to attract more horizontal FDI so that production sites could be built within the national
boundaries of those restricted economies. Second,
increasing openness attracts vertical FDI flows in search
of cheap intermediate and capital goods (Resmini,
2000). Also, openness in trade is correlated with
economic liberalisation policy of an economy that may
sound favorable to investors. Openness has been
proxied by sum of current receipts and payments to
GDP ratio.
Box I
Foreign Investment Flows – Theoretical Underpinnings
The research on this subject has so far been largely
devoted to factors determining the FDI and policy
formulations in response to those factors. Until 1960s,
FDI was modelled as a part of neoclassical capital theory
and the basic motive behind the movement of this
capital into a host country was search for higher rate
of returns. Over the period, with growing realisation
the motives for capital movement have been far more
diverse than mere search for higher returns, there has
been a plethora of theoretical and empirical research
directed towards identifying factors determining
different types of capital flows. It was the insight of
Hymer (1960) who by differentiating direct investment
from portfolio investment created basis for studies on
factors determining the FDI flows. Hymer highlighted
certain facts and evidences2 on the basis of which he
concluded that the nature of the direct and portfolio
investment differs and therefore same theories cannot
be applied to both types of investment. The key
feature that Hymer identified for motivation of FDI
was the level of control which a firm of home country
gets through direct investment in host country. He
also stressed upon market imperfections such as the
ownership of knowledge not known to rivals, existence
of differentiated products giving profit advantage to a
firm investing abroad, problems related to licensing the
product, etc., for supporting FDI decisions. However,
the literature argues that his theory over-emphasised
the role of structural market failure and ignored the
transaction cost side of market failure (Dunning 1981,
Rugman, 1980). Moreover, his theory did not explain
the locational and dynamic aspect of FDI.
Later, Caves (1971) expanded upon Hymer’s theory of
direct investment and embedded it in the industrial
organisation literature. By differentiating horizontal
and vertical FDI, he identified factors such as possession
of superior knowledge or information, motives to
avoid uncertainty in a market characterized by a few
suppliers and objective of creating entry barriers, etc.,
as being responsible for rising FDI flows. With the
rising presence of multinational enterprises in the
global economy, the view on FDI was expanded with
the internationalisation theories of FDI that stressed
on transaction costs. The internationalisation theory
of FDI identified accumulation and internalisation of
knowledge as the motivation for FDI, which bypasses
intermediate product markets in knowledge.
The theorists such as Horst (1972), who stressed upon
locational determinants of FDI, identified prevalence of
natural resources as an important factor for FDI inflow.
Wheeler and Mody (1992) identified ergodic and nonergodic
systems that determine the location of FDI.
The ergodic system focussed on classical variables such
as geographical features, labor costs, transport costs
and market size as factors determining the FDI flows.
Various empirical studies still rely on these variables
to determine potential for FDI flows. The non-ergodic system focussed on externalities that emerge from
investment in firms experiencing agglomeration
economies, in other words, indicating the clustering
effects of FDI.
The research work of Dunning (1977, 1981) provided
a comprehensive analysis of FDI based on ownership,
location and the internationalisation (OLI) paradigm.
His eclectic theory of FDI highlighted various benefits
emerging from FDI: the ownership-specific advantages
which comprise access to spare capacity, economies of
joint supply, greater access to markets and knowledge,
diversification of risk, technology and trademarks,
firm size; the location-specific advantages consisting
of distribution of inputs and markets, costs of labor,
materials and transport costs, government intervention
and policies, commercial and legal infrastructure, etc.;
internalisation-specific advantages covering reduction
in search, negotiation and monitoring costs, tariff
avoidance, etc. The critics of eclectic theory of FDI have
regarded it as a taxomony rather than a theory of FDI as it
covered a range of theories and employs a large number
of variables. It has also been criticised for reformulation
over time to incorporate new ideas and to reflect
contemporary trends in FDI. The prior version of his
theory ignored the role of strategy in determining the
FDI flows. The role of strategic motivations, which was
first analysed by Knickerbocker (1973), were extended
by Acocella (1991). As per these strategic theories, the
reasons behind strategic alliances included economies
of scale, the reduction of risk and access to knowledge
and expertise. The strategic alliances highlight the
motivation for mergers and acquisitions taking place in
the current era of M&A boom.
All these theories mainly explain the supply side of FDI
that creates a push to FDI for flowing out of the home
economy. Broadly, these factors and motives comprise
profit expansion through knowledge advantage, lower
cost advantage, greater market access, gains from scale
economies, strategic motives such as acquiring input
supplies or creating worldwide near to monopoly
powers, locational advantages, reduction in risk and
agglomeration gains.
A vast literature on demand side factors that pull FDI
into a host economy is also available. The studies such
as World Bank (1995), Blomstrom and Kokko (2001),
highlight gains from FDI in the form of competition
and efficiency effects, spillover effects, effects of
backward and forward linkages, technological effects,
accumulation of knowledge capital, stable flow of funds
with no debt-servicing obligation attached, greater
external market discipline on macroeconomic policy,
broadening and deepening of national capital markets,
etc. for the host country. These theoretical studies have
given a lot of space for empirical research on factors
determining the inflow and outflow of FDI and the
role played by policy initiatives undertaken on the part
of host countries to attract FDI. The country specific
studies have analysed the role of regulatory regime of
the host country in attracting FDI. These studies have
focussed on timing, activities of supervisory authorities
and content of external and internal regulatory
measures.
A lot of literature highlighting the role played by policy
environment discusses the issues of creating investor
friendly environment for FDI. As per Oxelheim (1993),
in attracting inward investment during the period of
transition from a national market to an integrated
part of the global market, governments can influence
the relative cost of capital by using an adequate mix
of interventions. Policymakers may affect the corporate
decision about where to locate a production facility
by managing a set of international relative prices:
exchange rates, relative inflation and interest rates.
In general, they can create investment incentives
or business opportunities by creating deviations
from the international purchasing power parity and
the international Fisher effect. Additional business
incentives controlled by policymakers are relative
taxes and relative political risk. This study has argued
that appropriate policies appear to be a necessary
precondition for attracting FDI.
The United Nations Centre for Transnational
Corporation has provided seven policy instruments
used to attract FDI: ownership policies, tax and subsidy
measures, policies concerning convertibility of foreign
exchange and remittance of earnings, price control
measures, performance requirements, sector-specific
limitations and incentives and miscellaneous entry
and procedural rules that are assumed to impose a
considerable cost on a potential FDI. A World Bank
report on indicators of FDI regulation (2010) has found
that restrictive and obsolete laws and regulations
impede FDI, red tape and poor implementation of
laws creates further barriers to FDI, good regulations
and efficient processes matter for FDI and effective
institutions help in fostering FDI. Thus, the report
highlights the importance of regulatory framework.
Macroeconomic stability - Lower inflation rate and
stable exchange rate are expected to attract greater FDI
by mitigating uncertainty risk. It has been proxied by
inflation and exchange rate volatility.
Exchange rate valuation - Froot and Stein (1991)
have evidently found that a weaker host country
currency tends to increase inward FDI as depreciation
makes host country assets less expensive relative to assets in the home country which may act as an
attraction for vertical FDI. On the other hand, a stronger
real exchange rate might be expected to strengthen the
incentive of foreign companies to produce domestically
thereby attract more horizontal FDI. However, the
second hypothesis does not appear to have attracted
much support in the empirical literature (Walsh and
Yu, 2010). It has been measured by value of US dollar
in terms of respective domestic currencies.
Clustering effects: A larger stock of FDI is regarded
as a signal of a benign business climate for foreign
investors and thus may attract more FDI. Moreover, by
clustering with other firms, new investors benefit from
positive spillovers from existing investors in the host
country. The studies of Wheeler and Mody (1992),
Barrel and Pain (1999) and Campos and Kinoshida
(2003) have found empirical evidence of agglomeration
effects. It has been proxied by the stock of FDI.
Institutions and Governance - Institutional and
Governance quality has been identified as a likely
determinant of FDI, particularly for less developed
countries, for a variety of reasons. First, good
governance is associated with higher economic growth,
which should attract more FDI inflows. Second, poor
institutions that enable corruption tend to add to
investment costs and reduce profits. Third, the high
sunk cost of FDI makes investors highly sensitive to
uncertainty, including the political uncertainty that
arises from poor institutions (Walsh and Yu, 2010).
Institutional framework and governance has been
captured by ‘Government Effectiveness’ Index
(Kaufmann Index)3. It captures perceptions of the
quality of public services, the quality of the civil service
and the degree of its independence from political
pressures, the quality of policy formulation and
implementation, and the credibility of the government’s
commitment to such policies. Score is assigned on the
scale of -2.5 to 2.5. Higher score means Government
procedures are more efficient.
Macro Economic Sustainability could be a key
factor in attracting foreign investment. If government
finances and external sector are considered sustainable,
foreign investor feel assured of the safety of its
investments. Sustainability has been captured through
two variables. Fiscal sustainability has been captured
by GFD to GDP ratio and external sector sustainability
has been captured by net IIP to GDP ratio.
Apart from these pull factors, push factors such
as global economic environment and policy stance of
the developed world may be critical factors in
determining the FDI flows. For instance, higher global
liquidity would cause larger flow of resources to EMEs
searching for higher returns. It could be proxied by the
FDI to EMEs.
Limitations of the data
Inferences drawn in the study should however be
seen in the light of following data limitations:
-
The study is based on the macro level data and
may not capture strictly the firm specific
characteristics in the determination of FDI.
-
Dataset for each variable have been sourced from
a single source to ensure comparability. Since
international agencies may make suitable
adjustments for the sake of comparability, data
for an individual country may marginally vary
from the country’s own datasets.
-
The sectoral caps for India, as provided by the
World Bank in its survey ‘Investing across Borders’,
in respect of agriculture, banking, media,
‘construction, tourism and single brand retail’ are
apparently at variance with extant guidelines. This
is because the average caps were reported for the
respective sectors in its publication and the same
have been reproduced in the study.
Fixed effect model4 of the following form was
estimated for a group of emerging economies, where
fy(i, t) is the FDI to GDP ratio of an individual economy
i in the year t, and x (i, t) is the vector of explanatory
variables.
where the a(i)s are individual specific constants,
and the d(i)s are group specific dummy variables which
equal 1 only when j = i.
Panel has been estimated for the period 2000-01
to 2010-11 for 10 countries5.
Results
The estimated equation6 is shown below, with
t-statistics shown in parentheses:
where
fy – foreign direct investment to GDP ratio;
Openness – current flows to GDP ratio; Gdiff – growth
differential amongst the sample countries; dwages –
change in labour cost; FDIEMERG = size of FDI to
emerging economies; IIPY – Net International
Investment Position; Govt. Effect – Index of Government
Effectiveness (Kaufmann Index).
In line with a priori expectations, all the pull
factors viz., openness, growth differential, net
international investment position and Kaufmann Index
of Government Effectiveness were found to be
positively related. Labour cost, as expected, had inverse
relationship with FDI inflows. All the variables were
statistically significant. Similarly, the push factor
captured through size of FDI flowing into emerging
economies was also found to be positively related and
impact has been statistically significant.
GDP in PPP terms capturing size of the market was
also examined. Although it was statistically insignificant
(not reported), its sign was in line with a priori
expectations, i.e., bigger the market size larger the FDI
flows. Similarly, the sign for exchange rate although
correct as per a priori expectation, was statistically
insignificant and has not been reported.
The results show that ten percentage points rise
in openness, growth differential and IIP cause 0.3, 0.8
and .2 percentage point rise in FDI to GDP ratio,
respectively. Similarly, every US$ 10 billion rise in the
size of global FDI to emerging economies causes 0.09
percentage point rise in FDI/GDP ratio. On the other
hand, every US$ 10 rise in the wage rate is likely to
reduce the FDI ratio by .04 percentage points.
The Index denoting ‘Government Effectiveness
(Gov. Effect) as expected has inverse relationship with
FDI flows implying that policy certainty could be a major
determinant of FDI inflows. As per our results, if Gov
Effect Index rises by one point on the scale of -2.5 to
2.5, FDI to GDP ratio rises by 4 percentage points.
Thus, the panel results show that higher the
degree of openness, expected growth of the economy,
net international assets and size of FDI flows to EMEs,
larger the size of FDI that flows to the country. Similarly,
higher the certainty of implementation of efficient and
quality policies, higher would be the flow of FDI. On
the other hand, higher labour cost is likely to discourage
the flow of FDI to the country.
What caused dip in FDI flows to India during 2010-11?
Our empirical exercise portrays a range of factors
that significantly impact the size of FDI flows. With a
view to segregate the impact of non-economic factors
including government policy, a contra factual scenario
is generated for the year 2010-11 by updating values
for all the explanatory variables except for the
Kaufmann Index. Estimated potential and actual FDI
levels are presented in the Chart 3 and contra factual
scenario that assumes no deterioration in government
effectiveness index has been presented in Chart 3a.
|
|
It could be observed from Chart 3 that actual FDI
to India closely tracked the potential FDI path. The
potential FDI level is the estimated level that should
occur given the trends in underlying fundamentals. In
the year 2010-11, the actual FDI flows at 1.5 per cent
of GDP are marginally lower than the estimated level
of 1.8 per cent of GDP. Chart 3a, presents a contrafactual
scenario where potential level of FDI flows for
the year 2010-11 is worked out by updating values of
all the variables except ‘Govt. Effect’. The latter is
retained at preceding year’s level. In could be observed
that in case of contra-factual scenario, in the year 2010-
11, gap between potential and actual level of FDI
increased by more than 25 per cent. Since, the contra
factual estimated for 2010-11 updated value of all other
variables except Govt. Effect, the larger gap between
potential and the actual in the year could be attributed
to index of Government Effectiveness7.
In other words, contra factual estimate of FDI for
the year 2010-11 incorporates impact of all the
economic variables, viz., growth differential, openness,
net IIP, labour cost and size of ‘FDI to all emerging
economies’ whereas it keeps qualitative variable ‘Govt.
Effect’ unaltered. Keeping ‘Govt. Effect’ unaltered
means that had there been no amplification in policy
uncertainty over the preceding year’s level, FDI inflows
to India would have been more than 35 per cent higher
than that was actually received.
Thus, empirical results corroborate our assertion made
in the analytics presented above that the qualitative
factors play an important role in attracting FDI flows,
and slowdown in FDI flows in the absence of any
deterioration in the macro economic variables could
probably be on account of such qualitative factors.
Section 4: Conclusions
An analysis of the recent trends in FDI flows at
the global level as well as across regions/countries
suggests that India has generally attracted higher FDI
flows in line with its robust domestic economic
performance and gradual liberalisation of the FDI policy
as part of the cautious capital account liberalisation
process. Even during the recent global crisis, FDI
inflows to India did not show as much moderation as
was the case at the global level as well as in other EMEs.
However, when the global FDI flows to EMEs recovered
during 2010-11, FDI flows to India remained sluggish
despite relatively better domestic economic performance
ahead of global recovery. This has raised questions
especially in the backdrop of the widening of the
current account deficit beyond the sustainable level of
about 3 per cent.
In order to analyse the factors behind such moderation,
an empirical exercise was undertaken which did suggest
the role of institutional factors (Government’s to
implement quality policy regime) in causing the
slowdown in FDI inflows to India despite robustness
of macroeconomic variables.
A panel exercise for 10 major EMEs showed that
FDI is significantly influenced by openness, growth
prospects, macroeconomic sustainability (International
Investment Position), labour cost and government’s
effectiveness.
A comparison of actual FDI flows to India vis-à-vis
the potential level worked out on the basis of underlying
macroeconomic fundamentals showed that actual FDI
which has generally tracked the potential level till 2009-
10, fell short of its potential by about 25 per cent during
2010-11. Further, counter factual scenario attempted
to segregate economic and non-economic factors
seemed to suggest that this large divergence between
actual and potential during 2010-11 was partly on
account of rise in policy uncertainty .
Apart from the role of institutional factors, as
compared to other EMEs, there are also certain sectors
including agriculture where FDI is not allowed, while
the sectoral caps in some sectors such as insurance and
media are relatively low compared to the global
patterns. In this context, it may be noted that the caps
and restrictions are based on domestic considerations
and there is no uniform standards that fits all countries.
However, as the economy integrates further with the
global economy and domestic economic and political
conditions permit, there may be a need to relook at the
sectoral caps (especially in insurance) and restrictions
on FDI flows (especially in multi-brand retail). Further,
given the international experience, it is argued that FDI
in retail would help in reaping the benefits of organised
supply chains and reduction in wastage in terms of
better prices to both farmers and consumers. The main
apprehensions in India, however, are that FDI in retail
would expose the domestic retailers – especially the
small family managed outlets - to unfair competition
and thereby eventually leading to large-scale exit of
domestic retailers and hence significant job losses. A
balanced and objective view needs to be taken in this
regard. Another important sector is the generation,
transmission and distribution of electricity produced
in atomic power, where FDI is not permitted at present,
may merit a revisit. In this context, it may be noted
that electricity distribution services is a preferred sector
for FDI. According to UNCTAD four out of top ten crossborder
deals during 2009 were in this segment, which
led to increase in FDI in this sector even in the face of
decline in overall FDI. Similarly, the demands for raising
the present FDI limits of 26 per cent in the insurance
sector may be reviewed taking into account the
changing demographic patterns as well as the role of
insurance companies in supplying the required long
term finance in the economy.
Against this backdrop, it is pertinent to highlight
the number of measures announced by the Government
of India on April 1, 2011 to further liberalise the FDI
policy to promote FDI inflows to India. These measures,
inter alia included (i) allowing issuance of equity shares
against non-cash transactions such as import of capital
goods under the approval route, (ii) removal of the
condition of prior approval in case of existing joint
ventures/technical collaborations in the ‘same field’,
(iii) providing the flexibility to companies to prescribe
a conversion formula subject to FEMA/SEBI guidelines
instead of specifying the price of convertible instruments
upfront, (iv) simplifying the procedures for classification
of companies into two categories – ‘companies owned
or controlled by foreign investors’ and ‘companies
owned and controlled by Indian residents’ and (v)
allowing FDI in the development and production of
seeds and planting material without the stipulation of
‘under controlled conditions’. These measures are
expected to boost India’s image as a preferred
investment destination and attract FDI inflows to India
in the near future.
References:
Acocella, N. Strategic Foreign Direct Investment in EC.,
Economic Notes, Vol.20, No.2, 1991.
Ahluwalia, M. S. (2011), “FDI in multi-brand retail is
good, benefits farmers”, The Times of India, http://timesofindia.indiatimes.com/business/india-business/FDI-in-multi-brand-retail-is-good-benefits-farmers-
Montek-/articleshow/7328844.cms#ixzz1EmeD95sm”.
Ahn, Choong Yong (2008), “New Directions of Korea’s
Foreign Direct Investment Policy in the Multi-Track FTA
Era: Inducement and Aftercare Services”, OECD Global
Forum for International Investment, March.
Ali Shaukat and Wei Guo (2005), ‘Determinants of FDI
in China’, Journal of Global Business and Technology,
Volume 1, Number 2, Fall.
Antràs, Pol, Mihir A. Desai and C. Fritz Foley (2007),
‘Multinational Firms, FDI Flows and Imperfect Capital
Markets’, NBER Working Paper No. 12855, January.
Blonigen,Bruce A. ( 2005), A Review of the Empirical
Literature on FDI and Determinants’ NBER Working
Paper No.11299, April.
Brimble, Peter (2002), The Foreign Direct Investment:
Performance and Attraction The Case of Thailand, 2002.
Workshop on Foreign Direct Investment: Opportunities
and Challenges for Cambodia, Laos and Vietnam in
Hanoi, August.
Caves, R. E. (1971), “International Corporations: The
industrial economics of foreign investment”. Economica.
Dunning, J. H. (1977), “Trade location of economic
activity and the multinational enterprise: A search for
and eclectic approach, in Ohlin, B.; Jasselborn, P.O.; and
Wikman, P.M. (eds.), The International Allocation of
Economic Activity, London: Macmillan.
------ (1981) “Explaining the international direct
investment position of countries,” Welwirtshaftiches
Archiv.
Eichengreen Barry and Hui Tong (2005), ‘Is China’s FDI
Coming at the Expense of Other Countries’? NBER
Working Paper No. 11335, May.
Fortanier, Fabienne (2001), Foreign Direct Investment
and Sustainable Development, OECD, November.
Fung, K.C., HitomiIizaka, Sarah Tong (2002), Foreign
Direct Investment in China: Policy, Trend and Impact,
IMF Working Paper No.74 .
Horst, T., (1972), The industrial comprosition of U.S.
exports and subsidiary sales to the Canadian market,
American Economic Review, 62.
Hymer, Stephen H. (1960), The International Operations
of National Firms: A Study of Direct Foreign Investment,
Ph.D. Thesis, Cambrige: MIT Press, published in 1976.
Jenkins, Carolyn and Lynne Thomas (2002), Foreign
Direct Investment in Southern Africa: Determinants,
Characteristics and Implications for Economic Growth
and Poverty Alleviation’, October.
Kearney A.T. (2010), “A. T. Kearney Global Management
Consultants : Expanding Opportunities for Global
Retailers, ‘The 2010 A.T. Kearney Global Retail
Development Index’.
Lipsey, Robert E. (2007), ‘Defining and Measuring the
Location of FDI Output’, NBER Working Paper No.
12996, March.
Long, Guoqiang (2005), ‘China’s Policies on FDI: Review
and Evaluation’ In Does Foreign Direct Investment
Promote Development?, eds ., Moran Theodore H,
Edward M. Graham and Magnus Blomström, Institute
of International Economics.
Magnus Blomstorm (2001), Foreign direct investment
and spillovers of technology, International Journal of
Technology Management.
Oxelheim, L. (1993), “Foreign Direct Investment and
the Liberalization of Capital Movements” in Oxelheim,
L. (ed), The Global Race for Foreign Direct Investment
– Prospectus for the Future, Berlin and New York:
Springer Verlag.
Piteli,Eleni E. N. (2010), Determinants of Foreign Direct
Investment in Developed Countries: A Comparison
between European and Non-European Countries,
Contributions to Political Economy Vol. 29, pp111–128.
Rajan,Ramkishen S., Sunil Rongala and Ramya Ghosh
(2008), ‘Attracting Foreign Direct Investment (FDI) to
India’, April.
Razin, Assaf and EfraimSadka (2007), ‘Productivity and
Taxes as Drivers of FDI’, NBER Working Paper No.
13094, May.
Razin, Assaf, Yona Rubinstein, EfraimSadka (2004),
Fixed Costs and FDI: The Conflicting Effects of
Productivity Shocks’, NBER Working Paper No. 10864,
October.
Rugman, A. M. (1980) “Internationalisation as a general
theory of foreign direct investment. A reappraisal of the
literature”, Weltwirstschafiliches Archiv.
Shah, Ajay and Ila Patnaik (2007), India’s Experience
with Capital Flows: The Elusive Quest for a Sustainable
Current Account Deficit, in Sebastian Edwards(Eds)‘Capital Controls and Capital Flows in Emerging
Economies: Policies, Practices and Consequences’,
University of Chicago Press.
Te Velde, Dirk Willem (2002), ‘Government Policies
Towards Inward Foreign Direct Investment in
Developing Countries: Implications for Human Capital Formation and Income Inequality’, OECD Development
Centre Working Paper No. 193, August.
Walsh, James P. and Jiangyan Yu (2010), Determinants
of Foreign Direct Investment: A Sectoral and Institutional
Approach, IMF Working Paper No.187
World Bank (2010), ‘Investing Across Borders - A Survey
of 87 Economies’.
Wheeler, D. and Mody, A., International Investment
Location Decisions: The Case of U.S. Firms, Journal of
International Economics, Vol. 33, No.1-2, Ausgust 1992.
World Bank (2010), ‘Doing Business’ Various Issues.
|