M SC. BUSINESS ECONOMICS

LONDON METROPOLITAN BUSINESS SCHOOL

FINAL DISSERTATION ON

ROLE OF FOREIGN DIRECT INVESTMENT ON ECONOMIC GROWTH:

A CASE STUDY WITH SPECIAL REFERENCE TO CHINA AND INDIA

SUMITTED BY

JOSE PHILIPOSE VARGHESE

(09046537)

MAY 2011

This project is submitted in part fulfilment of the requirement for the completion of M.Sc Business Economics at the London Metropolitan University. The work is the sole

responsibility of the candidate.

SUPERVISOR

NISHAAL GOOROOCHURN

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ACKNOWLEDGEMENT

It is a great opportunity to do a dissertation on the topic “The role of Foreign Direct Investment on economic growth: a case study with special reference to India and China.” The undertaking of the same had enlightened my knowledge on the relationship of FDI and economic growth. It also provides enough knowledge on the pros and cons that an FDI undertaking brings to the host country.

My heartfelt thanks to the God almighty for all the help bestowed, without which this project would not have been successful.

I express my sincere gratitude to Mr. Nishaal Gooroochurn, Faculty Guide, London

Metropolitan University for his valuable guidance for the successful completion of this study

I wish to express my deep gratitude to my parents and friends who helped me and supported

me to complete this project.

Finally I would like to thank all those who helped me directly and indirectly for successful

completion of the project.

JOSE.P.V

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TABLE OF CONTENTS PAGE

Chapter 1

1. Introduction………………………………………………………..…….9

1.2 Motivation and purpose of the study…………………………………...10

1.3 Objectives……………………………………………………….……...10

1.4 Brief outline of the study……………………………………………….11

Chapter 2

2.1 Review of Literature……………………………………………...........13

2.2 Definition of FDI………………………………………………………17

2.3 General theories and concepts of FDI…………………………………18

2.3.1 Ownership Specific Advantage……………………………………...19

2.3.2 Location Specific Advantage………………………………………..19

2.3.3 Internalisation Specific Advantage………………………………….20

2.4 Types of FDI…………………………………………………………..20

2.4.1 Horizontal Foreign direct investment……………………………….20

2.4.2 Vertical FDI…………………………………………………………21

2.4.3 Greenfield Investment……………………………………………….22

2.4.4 Mergers and Acquisition…………………………………………….22

2.5 Determinants of FDI…………………………………………………...23

2.5.1 Economic factors…………………………………………………….23

2.5.2 Government policies…………………………………………………24

2.5.3 Strategy of MNE’s…………………………………………………...26

2.6 Impact of FDI in host country development…………………………...29

2.6.1 Impacts of FDI……………………………………………………….30

CHAPTER 3

3.1 FDI inflow in CHINA………………………………………………….35

3.1.1 The impact of FDI in Chinese economy……………………………...36

3.2 FDI inflow in India……………………………………………………..37

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CHAPTER 4

4 Methodology and Data collection …………………………………….42

4.1 Graphical analysis…………………………………………………...42

4.2 Regression analysis………………………………………………….44

CHAPTER 5

5.1 Findings and Conclusion…………………………………………….50

APPENDIX……………………………………………………………………...52

REFERENCE…………………………………………………………………...54

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LIST OF TABLES PAGE

Table: 2.1.1. The table below shows some relevant studies done on FDI and Economic growth………………15

Table: 2.5.1. The table below shows the major determinants of FDI and selected relevant studies done on it …27

Table : 4.2.1.1. Regression model summary for CHINA…………………………………………………………………......52

Table : 4.2.1.2. Regression Coefficient estimation table for CHINA…………………………………………………………52

Table : 4.2.2.1 Regression model summary for INDIA……………………………………………………………………….53

Table : 4.2.2.2 Regression coefficient summary for INDIA………………………………………………………………….53

LIST OF FIGURES

Figure: 4.1.1 FDI and GDP growth rate in CHINA…………………………………………………………………………..42

Figure: 4.1.2 FDI and GDP growth rate in INDIA…………………………………………………………………………...43

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ABBREVIATIONS

FDI – Foreign Direct Investment

GDP – Gross Domestic Product

LPG – Liberalization, Privatization and Globalization

MNC’s – Multinational Corporations

OECD – Organisation for Economic C0-operation and Development

UNCTAD- United Nations Conference on Trade and Development

OSA – Ownership Specific Advantage

LSA – Location Specific Advantage

ISA – Internalisation Specific Advantage

TNC’s – Transnational Corporations

MNE’s – Multinational Enterprises

SPSS – Statistical package for social sciences

FERA – Foreign Exchange Regulation ACT

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ABSTRACT

The purpose of the study is to empirically determine the impact of FDI on economic growth

of INDIA and CHINA. Both being the greatest and the rapid growing economy, had

witnessed a huge inflow of capital in several forms during the past few decades. Why such an

inflow and what had inculcated the investors to adopt such a project in these countries? This

paper, hence pinpoints in brief, the reason for such a massive undertaking by the

multinationals. The thesis undertaken also investigates the significant role of FDI among the

other determinants of economic growth in these countries. For the purpose data’s for the last

39 years are taken into consideration. Methodology used consists of graphical representation

and regression analysis. Graphical analysis is used to show the relationship between FDI and

economic growth in INDIA and China. From the graph it is clear that there is a positive

relationship between FDI and GDP in China and they move in the same direction, while it is

opposite in the case of India. To prove this a linear regression method is used with the help of

SPSS. The results so obtained suggest that FDI has a positive impact on China and a less, but

a positive impact on India’s economic growth.

Dissertation word count: 12902

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CHAPTER 1

INTRODUCTION

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1. INTRODUCTION

The recent studies conducted on FDI shows that the relevance of FDI inflows for the

economic growth is very important and the policy makers adopted more liberalized approach

to gain the benefit out of it. It is argued that FDI inflow has got so many effects on a growing

economy. The role of FDI in creating employment, transferring technology, creating spillover

effects and other activities that can act as a fuel for economic growth is quite worth noticing.

Studies done by Alfero (2003), Blomstrom et.al (1994) and Borenstein (1998) suggests that a

country inorder to attract FDI inflows should possess some relevant factors like better labour

market, balance of payment, technology and infrastructure, stable policies etc. These factors

act as a determinant to the flow of FDI in the host country. The thesis explicitly covers the

theory relating to the importance of FDI, the factors determining its growth and FDI impact

on host country development.

The country of concern in the thesis is India and China. China opened its economy during

1979 by adopting open door policy. The growth since then was so remarkable and

astonishing. The relationship between FDI inflow and GDP growth was so uniform and

upward after 1980 indicating the major role of FDI inflows on GDP growth rate of China.

Many researchers argued that this inflow of FDI was mainly due to the liberalized approach

made by the Chinese economy. The recent economic reforms that it had made, indulged

several multinational giants to invest in the host country. The introduction of open door

policy and China’s WTO entry are such reforms that can be highlighted while discussing

about FDI. The paper thus examines the role of FDI, which it had played during this

significant time period in CHINA for this massive growth.

India’s economic growth after the introduction of the famous ‘LPG’ (Liberalisation,

Privatisation and Globalisation) concept was remarkable. The paper therefore explores the

irregular start up of FDI in INDIA and also evaluates the development that it had brought

about in the economy.

Thesis does not provide a comparative analysis, but it shows the relevant role of FDI on

economic growth in both the countries. The role of other determinants with regard to FDI is

also discussed and analysed briefly. The data’s from the periods 1970 to 2009 is taken for the

analysis to check the rate of FDI inflows. For the purpose regression analysis is employed to

calculate the relevance of FDI in China and India. The analysis showed a positive effect on

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China and a less positive effect on India, thus indicating that FDI has a major role in China’s

growth and a minor role on India’s growth rate.

1.2. MOTIVATION AND PURPOSE OF THE STUDY

Indian and Chinese economies were partially closed and were under the control of stringent

rules and regulations during 1970’s and 80’s. The growth that had happened in these

geographical areas was astonishing during 1990’s. There are several factors that had

contributed for such an economic outburst. The role of FDI as such a factor is significant.

Many researchers say that it is due to the various economic strategies of each country for e.g.,

‘open door policy’ of China and opening of Indian economy by introducing the

‘Liberalization, privatisation and globalization’ or the ‘LPG’ concept that attracted such a

huge investment, which was actually true. Even during the recession time both the economy

had performed well and even attracted more investment and capital. The level of inflow in

both the countries was astonishing and varying, which is quiet exciting to study.

The main frame of the study is to analyse the economic strategies of each countries and to

find the factors which are lacking on the part of the straggler. The purpose of the study is to

create a model of both the countries and to analyse the pros and cons that exist in both

economies and to find ways to overcome the problem of laggards through an effective

empirical analysis. The study also intends to reveal a path for the less developed and other

developing economy’s, which might emerge in the next few decades.

There are only few research works that are from the Indian point of view. This study is also

aimed to fill those gaps.

1.3. OBJECTIVES

1. To evaluate the contribution of FDI in economic growth (in INDIA and CHINA)

2. To find the nature of contribution made by these investment.

3. To evaluate the rate of inflow of these investment in INDIA and CHINA

4. To study the significance of FDI with other economic growth indicators.

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1.4. BRIEF OUTLINE OF THE STUDY

The paper is divided into four chapters. The first part covers the introduction, motivation and

purpose of the study. The second chapter covers the review of literature and the theoretical

aspects of FDI – including its definitions, types, determinants and impacts of FDI. The third

chapter covers the FDI trends and related strategies adopted in China and India to attract FDI

inflows. The fourth chapter deals with the methodology and empirical analysis of the study of

concern. It includes graphical representation and regression analysis to find the inflow of FDI

and also to discover the relationship between both FDI and GDP in China and India. After

doing the graphical analysis, a regression equation is formulated. The equation consists of

some variables that exert direct impact on GDP growth. The main purpose of the equation is

to find the contribution of FDI, the primary variable of concern and also to analyse the impact

of other variables on GDP growth rate in India and China. The last chapter covers the

findings and conclusion.

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CAHAPTER 2

REVIEW OF LITERATURE

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2.1. REVIEW OF LITERATURE

Caves (1996), suggests that the underlying principle to attract heavy foreign investment starts

from the belief that FDI brings numerous positive effects. This include employee training,

productivity gains, technology transfer, improved managerial skills, improved international

production networks, introduction of innovative ideas to the host countries, employment

opportunities etc. Ndikumana and Verick (2008), Andreas (2006) and Lumbila (2005),

suggests that FDI has significant positive effect on economic growth. Romer (1993), argues

there exist a wide “Idea Gaps” between poor and rich countries. He views that foreign

investment can facilitate technological transfer and business know- how to less-developed or

poorer countries and, as a consequence, FDI might boost host countries firms productivity

and hence increases economic growth. A relative study done by Blomstrom (1986) concludes

that Mexican sectors with a high degree of foreign investment show high productivity

growth. FDI is also characterized by immense positive spillovers. As per the study of Lipsey

and Sjoholm (2005), FDI has positive spillover effects.

Some economists found that FDI exerts varying effects. For instance the study conducted by

Theodore, Edward and Magnus (2005) suggests that FDI can have varying effects – that is

both positive and negative effect. Some economists were of the opinion that it has got more

positive effect, but FDI inflow depends on several factors in the host countries. Alfero

(2003) admits that FDI inflow to certain sectors induces economic growth – according to him

the economy achieves more growth when, FDI inflows to the manufacturing sector is high

when compared to that of primary sector. Many factors in the host countries such as labour

market, capital market, technology, balance of payment etc also are adversely affected

through FDI inflow which in turn acts as a fuel for economic growth, Lall (2002). Another

study done by Blomstrom et.al (1994) states that, those countries that have a certain level of

income can take up new technologies and enjoy its benefits through FDI. However some

research works had proved the importance of human capital in attracting the FDI. The studies

conducted had revealed that an educated workforce or human capital can only understand the

importance of innovation and technology diffusion and thus supports the inflow of FDI to

their economy. Borenstein (1998), in his study found out the relative importance of FDI and

human capital in economic growth. He also suggests that an economy may need a minimum

stock of human capital to understand the positive effects of FDI. For instance, another study

done by Borenztein, De-Gregorio and Lee (1998), states that FDI has a positive effect in the

host country when the economy has a highly educated workforce who welcomes FDI

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spillover effects. Carkovic and Levine (2002), also argues about the importance of educated

workforce in attracting FDI and hence increasing growth.

The significant role of FDI, in bringing foreign technology towards the host country is

indispensable. Borenstein et.al (1998) postulates that, FDI plays a vital role when it comes to

technological transfer, which in turn might contribute to larger economic growth than

domestic investment. Findlay (1978) in his studies sees that the rate of technical progress in

the host country can be increased by the inflow of FDI through a “contagron” effect. In a

debate regarding to the importance of FDI, De Gregorio (2003) contributes that FDI brings in

knowledge expertise and technologies that are not available in the host country; thereby

increasing productivity growth through out the economy. In his study on Latin American

economy, he found out that FDI is thrice more efficient than domestic investment, when it

comes to economic growth. A similar study conducted by De Mello (1997) suggests that

there is a positive correlation and it boosts investment levels, thereby creating a space for

economic growth.

Explanations regarding FDI and its relative importance on long- term and short-term

economic growth is quite importance at this juncture. Neo-classical economists postulate that

FDI persuades economic growth by increasing the amount of capital per person. However,

this may not influence long- run growth due to diminishing returns to capital. Sauchez-Robles

and Bengos (2003) emphasizes that, even though the correlation between FDI and economic

growth is positive, a host country in order to benefit from long term FDI inflows must require

economic stability minimum human capital and liberalized markets. The other interesting

study done by Bende- Nabende et.al (2002) found that long term impact of FDI on

productivity is more positive for less economically advanced countries and negative for

economically advanced countries. Rome (1986) and Lucas (1988) claims that FDI also

influences long- run variables such as Human capital and Research and development.

FDI when analysed in short- term aspect, it is more beneficial than long-term (Andeolu B

Ajamoaler, 2007). Durham (2004) contributes that FDI effects are more conditional on the

“absorbtive” capability of host countries. Obwana (2001) quotes in his study relating to the

determinants of FDI and growth on Uganda, that parameters like political stability, macro

economic and policy consistency are so important in attracting FDI inflows. To add to this,

the study done by Bhasin et al. 1994, Love and Lage- Hidalgo, 2000 and Lipsey 2000) is

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more important, they found that determinates like factor prices, market size of the host

country and balance of payments are significant in attracting FDI inflows.

In the case of India and China the economic growth which they achieved is largely due to the

post liberalization periods of each country. The factors like political stability, policy

consistency and other factors like better labour force etc also had played a vital role in

attracting such a huge inflow, hence making them the most desirable place for investment. A

study done by Pradeep Agarwal (2000) on five South Asian countries relating to foreign

direct investment, argues that the role of FDI on GDP growth rate was negative during Pre-

1980’s and slightly positive during 1980’s and strongly positive during 1990’s. He found out

that this high inflow of FDI is largely due to a strong market oriented policies and open

international trade strategies of these countries. According to a study done by Zhang (2006)

on FDI and economic growth in China, states that FDI promotes economic and this positive

growth is achieved overtime. Xiaobuo Dang (2008) asserts that FDI has got significant role in

increasing economic growth and determinants like infrastructure and political environment

plays a crucial role in exerting a pull on FDI inflows.

Table: 2.1.1. The table below shows some relevant studies done on FDI and Economic growth

AUTHOR YEAR OF STUDY METHODOLOGY

USED

FINDINGS

Agarwal.P 2000 Time series cross sectional analysis of panel data from five South Asian countries

Prior 1980’s period- FDI inflow on GDP growth rate was negative. Early 1980’s- mildly positive. Early 1990’s- positive.

Andreas. J 2005 Panel data analysis FDI enhances economic growth in developing economies when compared to that of the developed economies.

Alfaro.et.al 2004 Panel data cross country regression

FDI has got a significant role in economic growth. He also pinpoints the importance of local financial market in achieving this economic growth through.

Balasubramanyam 1997 Panel data cross country regression

FDI promotes growth and is more efficient in export

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promoting regimes rather than import substituting ones.

Sauchez-Robles and Bengos

2002 Panel data analysis FDI has got positive correlation with economic growth in the host country.

Borensztein et.al 1998 Panel data cross country regression. Instrumental variable regression.

He argued about the sufficient absorptive capability of the host country and found out that FDI contributes to economic growth. He argues that sufficient human capital is necessary in the host country to achieve this growth.

Carkovic and Levine 2002 Generalized method of moment’s panel estimator.

FDI exerts a positive impact on growth, that is independent of other growth determinants (educated workforce, infrastructure, markets and liberalized policies)

Nair-Reichert and Weinhold

2001 Panel data analysis. mixed, fixed and random co-efficient approach

They found out that there exists heterogeneity across developing economies regarding the impact of FDI and other variables on economic growth.

Obwona 2001 Two stage least square estimation method

Foreign investment has got major role in enhancing economic development in Uganda.

Ram and Zhang 2002 Panel data cross country regression

FDI gas got positive effect on the host country’s economic growth.

S.Adewumi 2006 Graphical analysis,

regression and granger

causality

FDI has got positive

impact on GDP growth

rate in Africa.

Xiaohong Ma 2009 Regression analysis FDI has significant role

in Economic growth in

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China

Source: Created by the author.

2.2. DEFINITION OF FDI

A clear cut definition of FDI is very difficult (Haluk sezer (Piggot and Cook, 2006).

Definitions of FDI were formulated depending on its international characteristics and MNC’s

activities in host countries and some authors even contrast it with portfolio investment. The

definition thus evolved and recognized, often has two common elements such as,

involvement of two countries – which quite often described as the multinational FDI

character, and the other elements which is basically related to the issue of ownership and

management – which makes it entirely different from portfolio investment. FDI is therefore

considered as the ownership and management of production activities abroad, whereas

foreign portfolio investment is the transfer of financial capital, loan or equity from one

country to another.

FDI stand aside due to its complexity, because it involves transfer of managerial and

organisational ability and technical know-how. The definition of FDI is not isolated. The FDI

being a part of MNC’s activities, a single and isolated definition is not possible. Therefore the

definition of MNC’s is some what similar to that of MNC’s (Haluk sezer (Piggot and Cook,

2006).

Despite of its difficulty many definitions have evolved. According to the IMF balance of

payment manual defines FDI “as an investment that is made to acquire a lasting interest in an

enterprise operating in an economy other than that of the investor, the investor’s purpose

being to have an effective voice in the management of the enterprise” Imada Moosa (2002).

Haluk sezer (Piggot and Cook, 2006) defines FDI “as the acquisition, establishment or

increase in production facilities by a firm in a foreign country. This definition thus cover all

three elements of FDI such as mergers and acquisitions, ‘greenfield investment’ and

reinvestment.

Robert E. Lipsey (1999) defined, FDI ‘as the investment that involves some degree of control

of the acquired or created firm which is in any other country apart from investors country’ (S.

Adewumi, 2006)

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OECD has provided an extensive definition of FDI (“OECD Benchmark Definition of

Foreign Direct Investment, 2008, 4th edition)

“Foreign Direct Investment occurs when a business located in one country (the direct

investors) invests in a business located in another country (the direct investment enterprise)

with the objective of creating a strategic and a lasting relationship. Within an effective policy

framework FDI can assist host countries in developing local businesses, promoting trade and

contributing to technology transfer. Similarly, it can provide greater market access to

businesses in home countries. Governments, businesses and other stakeholders need reliable

FDI statistics to inform and support their decisions for investments worldwide.”

By keeping in mind all the above said definitions, we can define FDI as the investment made

by a firm (MNC’s) in another country to utilize the resources available in that country so as

to expand internationally and to gain long-term profits.

2.3. GENERAL THEORIES AND CONCEPTS OF FDI

A specific and a neat theory for FDI is difficult, because of the complexity it has. Economist

had even struggled to give an exact definition for FDI. The theories thus formed are

considered as the theories of MNC’s and therefore it is inseparable from the firm’s theory.

Another difficulty involved is its multidimensional aspects, it involves capital theory,

international finance theory, firm’s theory, distribution theory, trade theory and also it covers

some aspects of politics and sociology. Due to these characteristics it is impossible to

recognize a single neat theory of FDI (Haluk sezer (Piggot and Cook, 2006))

The rising importance of FDI in this global scenario over the last few decades, made the

economists and the researchers to identify and generate some important explanations for FDI.

These explanations thus generated, is considered as the conclusion of several findings.

Because of the existence of substantial overlap in these explanations, we can group them into

three genuine categories, traditional, modern and radical theories.

For the purpose of the case study, it is however important to go through the types of FDI and

the factors that determine the flow of such FDI’s in the host country.

To understand these general theories of FDI mentioned above, it is useful to discuss the OLI

paradigm by Dunning (1977, 1981). MNC’s while taking up foreign investment projects will

go through some advantages that the host country possess. Dunning explained these

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advantage variables as; Ownership advantage (O), Locational advantage (L) and

Internalization specific advantage. ‘L’- type advantage is the external factor of the firm, while

‘O’- type and ‘I’- type advantage are internal aspects of the firm. Of these advantages, ‘L’-

type is considered as the most relevant one for FDI flows from developed to developing

economies in common and mainly to transition countries. (Marco.Neuhaus, 2006).

2.3.1. Ownership Specific Advantage or OSA (H.Sezer (Piggot and Cook, 2006), M.Neuhaus,

2006)

Ownership specific advantages are the knowledge based and firm specific assets that the firm

possess, but which are not available to its competitors. These advantages constitute cost

benefits and lead to market power. They mainly arise due to imperfections that exist in factor

and commodity markets. Imperfections in factor market include management expertise,

patents, trade secrets, difference in the accessibility to capital market, trade marks and brands,

while in the commodity markets appear in the form of promotional skills, collusion and

product differentiation. Imperfect market situation arise due to several factors such as;

economies of scale and government policies regarding interest rates, taxes etc. these

imperfections in the market gives rise to several OSA’s which can be categorized as follows:

Monetary and financial advantage – these include access to capital market to get

cheaper capital.

Industrial organization – advantages arising from Research and development and

Economies of scale in an oligopolistic market.

Technical advantage – advantages in holding patent rights, management expertise etc.

Access to raw materials.

2.3.2. Location Specific Advantage or (LSA) (Haluk sezer (Piggot and Cook, 2006))

These are those advantages that the company possess, when it locates it production facilities

or activities in a particular geographical region. Such advantages can be categorized as

follows:

Imperfections in foreign labour market - MNC’s shift their product activities to areas,

were they can get cheap work force.

Access to minerals and raw materials in host regions.

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Trade barriers – these induces MNC’s to start or set up production or business in

certain areas. For example, Japanese companies interest in Europe to avoid Common

External Tariff.

Government economic policies – government may in turn change economic policies

to attract FDI flows. The case study undertaken proves the same fact that the

liberalized policies of China and India have opened the economy and as a

consequence it increased FDI inflows.

2.3.3. Internalisation Specific Advantage or ISA

It refers to the capability of the firms to utilize the ownership advantage internally rather than

through markets (Nagesh Kumar, (Dunning and Narula,1996). It happens when the

imperfection in the foreign markets make market solutions too costly (Haluk sezer (Piggot and

Cook, 2006))

The benefits of internalisation can be classified as follows:

Vertical integration advantage such as price discrimination and transfer pricing

Relevance of intermediate products for research activities.

Benefits of training due to internalisation of human skills.

These above said OLI paradigm acts as a base for general theories of FDI. Now lets discuss

about the major types of FDI and important factors that determines the FDI inflows.

2.4. TYPES OF FDI

Researchers, based on the business activities of MNC’s had formulated several types of

FDI’s. They are horizontal foreign direct investment, vertical foreign direct investment,

Greenfield investment, mergers and acquisitions and benefit seeking FDI’s.

2.4.1. Horizontal Foreign Direct Investments (J. Paul, 2008)

It refers to MNC’s regional (host country) diversification of established domestic products or

services. Horizontal FDI occurs when MNC’s goes to host countries to produce their existing

products at their home country. Japanese MNC’s for example adopt the same kind of

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investments with the belief to avoid risks by sharing their resources, knowledge and

experiences.

Horizontal FDI takes place when:

A firm achieve monopolistic characteristics in a spotted region.

A firm competes in an infant industry

Economies of scale supply numerous competitive advantages.

A firm has enough human resources and capital to look after the diversified

organization.

A firm has the advantage of management expertise when compared to that of their

competitors.

2.4.2. Vertical Foreign Direct Investment (J. Paul, 2008)

Vertical foreign direct investment refers to investments made by a company in a particular

industry abroad. In this the company will be responsible for the control of entire activities

starting from raw materials to finished goods and distribution.

Vertical FDI can be again divided into two such as, Forward vertical FDIK and Backward

vertical FDI.

Forward vertical FDI

It is a sort of promotional activity made by the MNC’s, in which it distributes home made

goods or products abroad or it refers to the production of Final goods in the host using the

intermediate goods from the home country.

Forward Vertical Integration takes place when:

The present distributors are unreliable.

Limited availability of quality distributors

The firm has both human resource and capital needed to run the new distribution

business.

The present distributors have high profit margins.

There is an advantage of high stable production.

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Backward FDI

It occurs when MNC’s choose a particular region or foreign economy to produce

intermediary materials, which can be used as inputs for its production in the home country.

Backward vertical FDI takes place when:

The present suppliers are unreliable

The number of competitors is large and suppliers are relatively less.

A firm competes in an infant industry or growing industry.

The firm has sufficient human resources and capital to run the new supplying

business.

The firm needs a stable production situation – which is more important.

2.4.3. Greenfield Investment

It refers to firm’s investment in new facilities abroad or widening up of existing facilities

(www.slideshare.net). It can also be defined as the starting up of a completely new operation

in foreign country. This sort of investment is considered as the host nations primary target of

promotional efforts, because it generates job opportunities, new production units and

technology transfer. It also has got the advantage of integrating host country with the global

market (www.slideshare.net)

2.4.4. Mergers and Acquisition (Banerjee, Nair, Agarwal, 2009)

Mergers and Acquisition is considered as the primary source of FDI. In an Acquisition

strategy, a firm joins with another established firm working in the host country to overcome

the barriers of trade and business and makes the acquired firm a subsidiary business. For

example Tata motors India acquired Jaguar a company in Britain, by doing so Tata had the

advantage of supplying its home product abroad and also got the advantage of technological

know-how from Jaguar for its home products.

Apart from Greenfield investment, Merger and Acquisition generates cash flow within a short

span of period, because by definition a firm does not have to start from base process by

engaging in Merger and Acquisition. Another advantage of Mergers and Acquisition with

that of Greenfield Investment is that it gets instant access to host country firm’s resources.

FDI can again be classified into three based on the motivational factors and benefits of

investing firm’s. They are as follows:

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Resource Seeking FDI – in this the MNC’s eye’s on the resources available in the host

countries (which some times that are not available in the home country) such as cheap labour,

raw materials etc.

Market Seeking FDI – these are investments that are intended to penetrate a new market.

Efficiency seeking FDI – this strategy is adopted by the firms with an intension to increase

their efficiency by utilizing the gains of economies of scale and scope. This is considered as

the third step by the firms, after resource seeking and market seeking FDI. This strategy is

adopted by the firm’s to gain more profits and can be mostly seen among the developing

economies. For example; investments among EU nations. (www.slideshare.net)

2.5. DETERMINANTS OF FDI (Sanjay Lall, 1997)

The determinants of FDI can be broadly divided into three set of factors, such as economic,

government policies and MNC’s strategies.

2.5.1 Economic Factors

Market size – globalization and trade liberalization had enhanced growth of world markets as

well as the domestic markets. Evidence from various studies indicates that the size of the

market plays a major role in attracting FDI flows. For instance the size of the domestic

markets in China and India acts as a catalyst to attract huge FDI in these geographical

regions. Similarly the growth of intra-regional trade and the prospective regional markets in

south East Asian fuelled the growth of investments in these regions. Factors like skilled

human capital, advance infrastructure, liberalized FDI policies and stable government

policies acts as a magnet in attracting FDI’s. This is more evident in the small states of

Singapore and Hong Kong, were the above said factors prevails, thereby indicating that small

economies can generate large amount of FDI.

The available resources in the host country are another factor that the MNC’s eye’s for

investment. The resources like petroleum and minerals are now the powerful determinants of

FDI in some regions. The location as a part resource also has got upper hand in promoting

FDI inflows. The fortunate regions that are closer to developed economy markets and the

potential growing regions also enhance the inflow of FDI.

23

Competitiveness and efficiency of the host country plays a significant role in drawing FDI. in

this changing scenario, the role of skilled labours, better management and financial skills are

very important. The MNE’s have proficiency to bring along with them the skilled labours, but

in practical it generates high costs for them. In order to avoid that, the MNC’s look for those

countries that can supply these sort of skilled employees.

Apart from skilled workforce, the factors like better suppliers and good infrastructure also

plays a vital role in directing the route for FDI inflows. Existence of a strong supplier’s base

enables the host countries to capture more spillover effects from TNC’s and this in turn also

lower the initial cost to the foreign entrepreneurs’ to set up facilities in that region. Taiwan

for example has this advantage and it is able to attract more technological and high value-

added FDI’s.

Like strong supplier base, infrastructure also has its own role in drawing more FDI’s. China

for example has the capability to attract huge FDI because of their advanced infrastructure

facilities when compared to that of India.

A countries financial system also has got some relevance in this competing scenario for

capturing FDI. An efficient national financial system is actually of less importance to TNC’s,

but it is of great importance for the domestic firms. Though it will be less important for

MNC’s in host country, but it is vital to create a better image in global market. Companies do

often invest, in those place, were there is less risk and sound economy.

2.5.2 Government policies

Political stability is the most crucial factors that the investors look for. Political environment

characterized by minimum level of predictability and stability is necessary for the MNC’s to

set up facilities that can yield long term returns. Investors more often pay attention to the long

term economic situation, were they can earn huge profits in the future when compared to that

of short term policies like tax concessions.

An efficient policy framework is very important for an host country to signal the foreign

investors to invest, as a consequence it promote dynamic spillover effects, more employment

opportunity, technological transfer and diffusion of better managerial skills to the host

country. These contributions from FDI, therefore brings better economic growth.

Privatization and Macro economic policies

24

Privatization and FDI are considered as the two sides of the same coin. Evidence from Latin

America, Africa and some of the Asian countries shows that privatization regimes, are

successful in capturing investment flows to these areas. Privatization also had enhanced

MNE’s to diversify in those sectors (such as telecommunication and aviation) which they

never had significant role.

In many parts privatization is included in their policy agenda’s. Africa thus can be taken as an

example for the same. Studies show that privatization policies in the developing countries

during 1988-92 had stimulated about $49 billion in sales. During this period the privatization

had accounted for about 7% of the total FDI inflows. The privatization is therefore becoming

more relevant at this present scenario. Even the developing economy is concentrating on

privatizing the infrastructure in order to increase the related FDI inflows.

Like privatization another determinant of FDI is a well executed macro economic policies. A

relatively well managed economy, characterized by realistic interest and exchange rates, low

inflationary rates and well managed external debt, gives more confidence for the

entrepreneurs to invest in that country. Countries which lack such a stable macro economic

policies which are mentioned above suffers from recession and balance of payment problems,

this relatively diverge foreign investment.

Policies supporting private sector

Policies such as openness to market forces and the private sector and well implemented

accounting and legal framework encourages foreign investment. An environment which is

basically liberal in nature, transparent, stable and better suitable for private sector sends

positive impulse to MNE’s to invest. Totally, a policy that has a ‘business like’ attitude

enhances better investment scenarios in the host country.

Industrial and Trade Strategies

These strategies provide a basic guideline for manufacturing activity and also for allocation

of resources by local enterprises and MNC’s. The mostly accepted trade strategy is the

outward oriented one- this strategy provides MNC’s the best settings to work efficiently. In

the early days, the main drive for FDI inflows was made through the adoption of import

substitution, now it has opened the doors for export oriented regimes. Economies thus

adopted more liberalized trade policies to promote investments, because openness to the

25

export market is considered as the best way for better resource allocation and for developing

efficient capabilities and management practices.

The liberalized trade has got numerous advantages; they act as a magnet to attract the

attention of MNC’s for FDI. The role of regional trading blocs is also important in attracting

FDI’s. In the countries characterised by low domestic and fragmented markets and poor

infrastructure, regional integration can bring positive effects. Apart from trade liberalization

industrial policies also plays vital role in attracting FDI inflows. The major elements of

industrial policies are ownership requirements, technology support, entry, exit and growth

regimes, labour market policies etc. generally policies towards market oriented, non-

discriminatory and liberal policies generate more FDI inflows. Evidence from Japan and

India suggests the importance of liberal policies to import technology. Firms should be

allowed liberal policies to import new technology’s depending on their perception of market

forces along with a genuine support from the government in all aspects. Japan adopted

similar technology and was successful. India, followed a quite stringent and controlled

policies on technology imports, which resulted in lower FDI inflows. Recent studies gives the

conclusion that, liberal policies on technology coincided with liberal policies in general, can

attract better and more foreign direct investments.

2.5.3. Startegy of MNE’s

Strategies adopted by MNE’s often acts as a vital determinant of FDI’s in developing

countries. There are several factors that determine this sort of MNE’s strategies. The mostly

discussed among them are the host country risk factors and corporate level approaches to

various international operations.

Country Risks

While going for an investment project, the MNE’s analyse the host country environment. The

results of such analysis are very confidential and circulated on a limited basis. Factors like

macro management, labour market, stable policy and other political factors are considered as

a benchmark for studying the country risk, before committing for an investment project.

The table below shows the major determinants of FDI and selected relevant studies

done on it

26

Table: 2.5.1

Factors determining FDI inflows in

a host country

Selected relevant studies done on the determinants of FDI.

Economic Factors:

Market – size, growth perspect and

stability, entry and exit, distribution

and taste & preferences, urbanisation

etc.

Resources – location and natural

resources

Competitiveness – labour availability,

skills, infrastructure, supplier

availability, finance, technological

support etc.

Author Topic of study Findings

Cheng and kwan (2000) Determinants of location in China

Found out that major determinants of FDI are market size, better infrastructure and preferential policies.

Pistoresi (2000) Locationa specific and policy related determinants of FDI in Latin America and Asia

FDi inflows depends on political and economic factors

Traxler and Woitech (2000) Labour market regimes as a determinant of location

Entrepreneurs do not consider labour market as high priority factor for FDI

Policies of government:

Macro policies – access to forex, ease

of remittance and management of

crucial macro variables.

Private sector – permission of private

ownership, stable policies, better

financial market, easy entry and exit

etc.

Industry and Trade – regional

integration, trade strategies, liberalized

technology import policies etc.

FDI policies – transparent and stable

policies, ease of entry, better incentive,

ownership etc.

Sung and Lapan (2000) FDI and Exchange rate volatility

With enough exchange rate volatility, firms can earn more profit by opening numerous plants

Kosteletou and Liargovas (2000)

Relationship between FDI and real exchange rate

There is causality between real exchange rate to FDI in big countries. FDI depends on host country charectristics and inflows vary between member countries.

Clegg and Scott (1999) Link between FDI and European integration

FDI depends on host country characteristics and inflows vary between

27

member countries.

Schoeman et.al (2000) Impact of fiscal

policy on FDI in

South Africa

FDI inflows are

affected by tax

burden and

fiscsal policies

Strategies of MNC’s

Risks involved – country risk factors,

labour markets, stability of policy.

Location, sourcing and integration.

Lehmann (1999)

Ramcharran (1999)

Role of country

risk relationship

Economic and

political risks

decreases FDI

inflows

Cleeze (2000) Factors that

determine

location of

Japanese FDI in

UK

Wage

differences are

not important,

but production

growth is

important

List and Co (2000) Relationship

between location

and environment

regulations

Environmental

policies do have

impact on FDI

inflows.

Source: Imad A Moosa, (2002), page: 63, S.Lall, (1997), page: 18.

2.6. IMPACT OF FOREIGN DIRECT INVESTMENT IN HOST COUNTRY

DEVELOPMENT

28

Most of the economies in the world try to attract FDI with the hope that it will have a

significant positive effect on the economy. Based on this paradigm, many research works and

case studies have been done to explore the contribution of FDI on economic growth. Many

had come with a mixture of conclusion, stating that it has both positive and negative effect.

For instance the study conducted by Theodore, Edward and Magnus (2005) suggest that FDI

can have varying effects – that is both positive and negative effect. Some say economist were

of the opinion it has got more positive impact, but depends on several factors in the host

country such as sectors of the economy – the economy achieves more growth when FDI

inflows to the manufacturing sector is high when compared to that of primary sector Alfaro

(2003). Many factors in the host countries such as labour market, capital market, technology,

balance of payment etc also are adversely affected through FDI inflow which in turn acts as a

fuel for economic growth Lall (2002). The arguments relating to the causality of growth and

FDI inflow and vice versa are the focal point for several researchers. The study of

Chowdhary and Mavrotas (2003) indicates that when an economy experience high growth it

tends to attract more FDI inflows than the countries with weaker growth.

All the above mentioned assumptions and findings however brought into light some major

effects (both positive and negative) of Foreign Direct Investment. As we have seen earlier in

the literature studies, it is clear that Foreign Direct Investment is associated with activities

like transfer of technology, capital, managerial skills, promotional skills, organisational re-

engineering etc. this process in turn generates both costs and benefits for both (investing as

well as for host country) the countries which are involved. To measure these costs and

benefits is a difficult task, apart from this, the most widespread and common explanation for

FDI is that, it has a positive impact. This section covers most significant globally discussed

issues that are associated with FDI. These include FDI impact on capital market, labour

market, management techniques, balance of payments and technological change or

overhauling.

2.6.1. Impacts of Foreign Direct Investment

Technological Transfer (Haluk sezer (Piggot and Cook, 2006))

29

The recent exploration in the developing countries reveals that FDI is seen as a way to

encourage technological change. MNC’s while opting for a foreign investment, would more

likely to bring along with them their own technologies instead of depending on the local

facilities. There are two sided effects for technology when it follows FDI, such as direct –

when associated with technology spillovers. However both the aspects mentioned above is

considered as a positive contribution of FDI to economic growth.

Recent empirical analysis based on this context supports the following conclusions: (OECD,

2002)

Diffusion of technology in an FDI undertaking occurs through four channels such as vertical

and horizontal linkages, switching of skilled labour from MNC’s to local firms and also

through Research and Development. Empirical evidence shows that more positive impact is

seen in vertical linkages, especially in the backward linkages, because the local suppliers get

adequate training and technological assistance from MNC’s in order to raise the quality of

supplier products and services. MNE’s even assist them in the purchase of raw materials and

intermediary goods and also helps them to establish a most modern production facilities in

the host countries. This will ensure better business environment and economic growth.

Evidence relating to horizontal spillovers with regard to FDI is less. But some available

evidence suggests that horizontal spillovers are more effective when organizational functions

in totally different sectors.

Apart from the above two channels, labour migration and Research and Development also

plays a major role in technological transfer. Employees who are affiliated with a foreign

company acquire superior technological know-how and managerial skills. Bende Nabende

(2002) suggests in his study that there is a wide scope for the spread of technological know-

how, especially when the employees switch to domestic firm from an MNC. MNE’s therefore

avoid these spillovers by giving high ransoms to skilled staffs. The other method which they

commonly follow is the consideration of expatriate staffs in the host country instead of local

ones.

Impact on Human Capital and Labour Market (OECD, 2002, H.Sezer (Piggot and Cook,

2006))

30

Some are of the opinion that FDI has got a positive impact on the labour market and that of

the host country human capital is considered as one of the element in locational advantage,

while MNE’s looks for foreign investment in the host country. The developing country in

order to attain positive environment for FDI should give utmost importance to general

education and human capital. Minimum level of education is necessary for an host country to

maximise both FDI inflows and human capital spillovers from MNE’s. Another important

factor to be considered for FDI is the existence of a well maintained labour-market standard.

It is clear from the evidence that MNE’s mostly invest in those regions were the standard of

labour is similar to that of their home country. In other words, the environments were

employees has certain degree of security, freedom from discrimination and abuse etc act as a

pull factor for FDI inflows. However the role of MNE’s in giving adequate training and up

gradation activities with regard to human capital in host country is more significant than that

of the domestic enterprises.

Effects of FDI on labour market are another debateful matter. Some advocates that FDI have

a positive impact on employment in the developing economy. These positive effects can

again be direct and indirect in a sense like creating new jobs and new post along the value

chain respectively. Spillover effects during MNE’s activities in a host country generally

increases labour productivity, which inturn induces economic growth. Moreover it is clear

that MNE’s can influence the level of income distribution by demanding different types of

labour and offering higher remuneration for skilled workers. MNC’s when they engage in

international business requires more educated and skilled staffs to manage and to run their

business efficiently. Foreign firms do have the advantage of better Research and

Development facilities and latest technologies, so they look for skilled labours by paying

huge remuneration, hence compelling them to work for them. This activity of the MNC does

quite often create a gap between skilled and unskilled labours within a host country, thereby

creating a room for inequality.

Effects on Capital Market (H.Sezer (Piggot and Cook, 2006)

A significant characteristic of a developing country when compared to that of the developed

economy is the existence of weak capital formation. In order to boost capital into the

economy, eased restrictions on FDI inflows required. Policies regarding special incentives

and reduced tariff rates were executed to increase the FDI inflows in many of the developing

economies. MNC’s when compared to that of local firms do not suffer from credit constraint

31

and they bring along with the capital for setting up their business in a host country. This

capital in turn induces sustained economic growth.

It is worth explaining at this juncture the “crowding out” effect made by FDI. MNC’s when

they enter host country would prefer local financial market in order to finance their business

and therefore domestic firms has to compete with them to avail the existing capital. Because

of the advantage of business profitability and possession of huge assets than local firms,

financial institutions give loans or capital to MNC’s than to domestic firm on the ground of

safe return. This might gradually drives the domestic firms out of business and thereby giving

MNE’s the room to absorb the available capital. This situation is therefore referred to as

“crowding out” effect.

Impact on Balance of Payment (H.Sezer (Piggot and Cook, 2006)

The effects of FDI on host countries balance of payment is quite important to study at this

juncture. The inflow of FDI can bring three direct positive impacts on a host country balance

of payment. First, only foreign investment project in a host country by MNC is considered as

an additional unit of capital made to the national account and also it brings in foreign

exchange. Secondly, a host countries current account can be benefited by FDI replacing

imports. Thirdly, FDI undertakings are made by the MNC’s to the place were they can get

lowest possible cost of production. This in turn increases export oriented affiliation with the

host country which will benefit the developing country’s current account.

Apart from positive direct effects there are also indirect effects of FDI, especially the

spillover effects. The spillover effect, which originates from the MNC’s business process

encourage the developing host country, especially their local firms to export more. This

spillover effects also give the local or domestic firms to understand and to implement the

methods to be successful in foreign market, which is also an added advantage. MNC’s while

dealing business with other countries, generates enormous pressure to lower the trade

barriers. This reduced trade barriers benefits the domestic firms to do business between their

country and with other developing nations. The other indirect effects often take place in the

form of diffusion of skills. Employees who are acquired export knowledge and the contacts

from MNC’s, might decide to move to domestic firms. This in turn again benefits the local

firms through the diffusion of those export management techniques and contacts.

32

Effects of FDI on balance of payment has got two sided effects, apart from positive effects, it

can also bring negative effects to the host country such as adverse balance of payment effects.

As per Razmi (2005) the economic liberalization policies of less developed country’s to

improve FDI inflows, might bring adverse effect to the countries balance of payment. The

most important negative effect through FDI will be the trade deficits. The FDI tends to bring

more imports than the export to the host country and that situation even get worse when the

country is still running in such deficits , which in turn disturbs country’s balance of trade.

Studies had proven that there are three factors that contribute to trade deficits. They are as

follows:

1. MNC’s bring in large amount of machinery and equipment to the host country, were

it is scarce.

2. MNC’s who are in search of low cost of production and who are interested in moving

the facilities to those area bring in raw materials, components and spare parts to run

their business.

3. MNC’s manipulation of transfer prices, occurring during the process of export and

import.

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CHAPTER 3

FOREIGN DIRECT INVESTMENT IN CHINA AND

INDIA

34

3.1. FDI INFLOWS IN CHINA

China being isolated for 30 years, decided to open its economy again in the late 1970’s. The

period between 1980’s – 1990’s witnessed an increase in the level of FDI inflows, through

varied economic reforms. Major types of FDI that are prevailing in China according to Yuan

(2005) are: 1) contractual joint ventures 2) Equity joint ventures 3) joint exploration 4)

wholly foreign – owned enterprises5) share company with foreign investment. All the above

mentioned FDI’s are considered as the fruits of well implemented economic reforms. The

analysis of the Chinese history reveals the actual facts to the readers.

The first stage of the reforms kick-started in 1979, with the establishment of joint venture law

and the formation of Special Economic Zones. The main aim of the policy was to attract

foreign capital or investment through incentives and low tax regimes. During this period, the

number of Contractual joint ventures was more in comparison to the Equity Joint Ventures,

which accounted 86% to the total number of FDI projects. At the end of this period about

1399 investment projects was approved with an accrued contract capital of 4958 million

dollars (Dunning and Narula,1996). In 1984 – 89 the concept of SEZ’s was again recalled

and upgraded, thereby formulating tax advantaged economic development zone and open

coastal economic zones respectievely. The newly improved business environment triggered

an increase in FDI by 50% and 120% in 1984 and 85 respectievely(Dunning and

Narula,1996). Meanwhile during this period the FDI inflow to manufacturing sector and

service sector was worth noticing. The inflow to the manufacturing sector rose by 33% from

14%, but the considerable flow to the service sector got decreased. The magnificent growth

of FDI inflow that was visible during 1984 – 85 came to an in 1986, because of the changes

involved in both general business scenario and market situation. In order to improve

investment environment, the state council executed another reform called ’22 regulations’ or

the so called ‘provisions for the encouragement of foreign investment.’ The new economic

policy had given the investors more confidence, and resulted in a increase inward FDI more

than 36% during 1987 – 1988. The FDI inflow to manufacturing sector again rose to 56%

from 33% (in 1984- 88) during this period. The service sector again experienced a 5% decline

in FDI, because of Chinese selective FDI policies. These reforms and the growth were again

hindered during the period between 1988 – 91, because of a political crisis that took place

between student activists and the government military officials in Tianameen Square

(Margaret M.price, 1994)). In order to accelerate investment activities, overall economic

restructuring was made. The 1979 joint venture was renewed and rules regarding the

35

elimination of contract duration in some Joint Ventures were made. The period of 1990’s and

2000’s can be considered as the golden era of Chinese economic growth, several reformation

such as opening of inland cities, liberalization of service sector and infrastructural

development was made. The early 1990’s recorded a negligible ratio of increase in the flow

of FDI to the total domestic investment, which was 7% in 1992. The FDI inflow steadily

increased after this period, thus projecting a figure of 17% in 1996(Zhang, 2006).The overall

FDI projects during 1996 also rose to 70%, 90% and 134% respectively, which was more

when compared to that of 1992 (Dunning and Narula,1996).

After a long 15 years of negotiation, China on 11th of November 2001, became an official

member of WTO. This had given china the opportunity again to restructure the economic

reforms. This in turn had improved business environment a lot. According to Yuan (2006),

china during the post WTO period had made significant changes in the economic policies,

one among such policies was the reduction of tariff rate and establishment of direct trading

rights for foreign firms. This along with Chinese membership in WTO had given more

confidence for the investors which as a consequence lead to better FDI inflows (Xiaobao

Dang, 2008).

On the whole from the above analysis, Chinese FDI history can be divided into 5 stages. 1)

1979- 1983 – experiment stage 2) 1984 – 1991 – growth stage 3) 1992 – 1993 – peak stage 4)

1994- 200 – adjustment stage 5) 2001 – present – post WTO stage. The reform undergone

during these stages was the critical factors that led to such a huge productivity boom in China

(Xiaobao Dang, 2008).

3.1.1. The impact of FDI in Chinese economy

China’s run to the second most desirable investment places in the world was begun in from

the year 1978, through various economic reforms, since then the economy had attained a

steady growth. One of the main agenda behind these economic reforms was the attraction of

FDI. This case study of china explicitly projects the significant role of FDI in economic

growth. “ Foreign capital has played a largely positive role in china’s economic development

during the reform “ (Machanna, August 15 2010). According to Zuliu and Mohsins Khan

(IMF report, 1997) capital investment plays a vital role in economic growth and it becomes

more potant when accompanied by economic reforms or market oriented reforms.

36

The most prominent advantage of FDI in china was the sudden increase in export and import

trade. The Chinese market share in the international trade increased to 6.1% from 1.6%

during the period 1985 to 2000.

The other prominent impact of FDI on Chinese economy was the creation of job

opportunities, technological spillovers and capital contribution.

The FDI also facilitated the transition towards a market system from a centrally controlled

system. This in turn had given few valuable benefits to china, which includes the formation

of a market mechanism, production restructuring, up-gradation in the domestic enterprises

competitiveness and Chinese economic integration with the global economy (Zhang, 2006).

3.2. FDI INFLOWS IN INDIA

The importance of FDI India’s economic growth is indispensable. The economic survey of

2001-2002 by the Indian government had pinpointed several benefits of FDI on Indian

economy, which are as follows: it encourages domestic investment for achieving higher

economic growth; FDI is beneficial for both consumers and domestic industries in many

ways; FDI brings along with it the benefits of technological up-gradation; fuller utilization of

resources; and access to better managerial skills, which in turn helps the Indian industries to

become highly competitive in the global market. FDI also helps in opening export markets,

which enables access towards better goods and services (Swapna s. Sinha, 2007).

To study the impact of FDI in Indian economy, it is necessary to analyse the period before

liberalization and period after liberalization of 1991. The governmental policies towards FDI

have been changing from the post independence period. To study these variations, we can

divide the period into four distinct faces. The period of gradual liberalization of attitude –

which was from independence to 1960’s; the period of most selective stance from 1960’s to

1970’s; the period of less or limited liberalization of policies, which was from 1980’s to

1990’s. The period after 1991, the economy was opened and the concept ‘LPG’

(Liberalization, Privatization and Globalization) was introduced (Dunning and Narula, 1996).

After independence, India adopted several developmental plans – of them the strategy of

import substituting industrialization was the first. The aim of the strategy was to improve the

productivity and capability of the heavy industries (Shujiro and Fukunari, 2006). During this

37

period the FDI inflow was increasingly receptive. The Foreign Investment policy issued by

the Prime Minister in 1949 considered FDI is necessary to accumulate capital and also

needed to secure more technical, scientific and industrial knowledge. To do this, foreign

investors were given the assurance of fair reimbursement in the event of acquisition and no

restriction on the payment of profits and dividends (Shujiro and Fukunari, 2006). The FDI

policies in India was again liberalised during 1957 – 58 followed by the foreign exchange

crisis, the policy included more incentives and concessions. In the late 1960’s government

focussed on several industries, which include drugs, aluminium, heavy electrical equipments

textiles etc and opened the economy for them in order to increase FDI inflows. In order to

promote FDI in India, the government even started Indian investor centres with offices in

various investor countries. The result for these amendments as a measure to attract FDI was

overwhelming. A large number of foreign enterprises including foreign drug companies

showed interest in establishing branches in the country. The inflow of FDI during this period

was better when compared to that of early 1950’s. The FDI accumulation in the country

during 1948 – 1964 was multiplied from Rs2560 million to Rs5655million (Dunning and

Narula, 1996).

The attitude towards FDI during the late 1960’s by the government was more of a restrictive

one. FDI proposals which accompanied technological transfer and investment, which is more

40% foreign ownership was only accepted. Different items were specified by the government

to the foreign collaborators for the royalty payments and for the duration of technology

transfer agreements. The government also had putforth to the foreign investors, to use Indian

consultancy services wherever it is available. The year 1973 was characterised by with the

establishment of new FERA and limitations in the activities of foreign companies was made –

which concentrated only on selected high priority industries. According to new FERA, the

foreign companies having 40% had to register with Indian corporate legislation, exceptions

from the 40% limit was given only for high- priority sectors, which was concentrating on

exports (Shujiro and Fukunari, 2006). This restrictive environment had stagnated the FDI

inflows. The FDI inflow recorded during 1974- 1980 was only Rs163 million. Liquidation of

FDI stock in non-manufacturing sector due to government takeover of several companies and

fresh inflows to the manufacturing sector were worth noticing during this period. The share

of manufacturing sector in the FDI stock increased to 86.9% in 1980 from 40.5% in 1964

(Dunning and Narula, 1996).

38

As a part of modernisation, India’s FDI perspectives began to change in the1990’s. There was

overall freedom in the import of capital goods and technological transfer, this in turn exposed

Indian industry to have competition with foreign investors or companies. The other changes

adopted during this period include; numerous incentives, exemption from foreign equity

restrictions under FERA to 100% export oriented units – for the purpose new export

processing Zones were established and also brought the liberalization rules for the approval

of industrial licensing. The rules regarding lump sum technical fees and royalties were

released and taxes were also decreased. India’s growth rate during 1980’s was far better than

that of previous decade, which projected an average growth of nearly 6% (Shujiro and

Fukunari, 2006). The stock of FDI also got tripled during this period to 27 billion. The share

of services, plantations and manufacturing sectors to the total FDI stock increased, while the

share of chemicals and metal products got declined. Besides UK, US and Germany, Japan

also started their investment in India during this period (Dunning and Narula, 1996).

Indian scholars pointed out that the economic policies of 1970’s – 1980’s in some way or the

other was responsible for the crisis of 1990- 91. The economic environment of pre-

liberalisation period was more or less closed in nature. Policies during this period were

mainly for the protection of the domestic firms. Inward orientation and import substitution

was the main backbone of development strategy during this period. Because of the above said

unfavourable economic reforms, FDI inflow was less and dint had much role to play with

upliftment of Indian Economy. The share of FDI during 1970- 80 to India’s GDP was

on .033% (K R Gupta, 2000).

1991 till date is considered as India’s post liberalization period. It started of with the

liberalization of investment and trade policies under the short form ‘LPG’ (Liberalization,

Privatization and Globalization). The government reduced most of the products tariff rates.

The recorded average tariff rate on import during 1990-91, 1994-95 and 1997-98 was 87, 25

and 20% respectively. They also had made reforms in old policies like discontinuation in

technological requirements for FDI in India. A wide variety of sectors mostly consumer

goods sectors were opened for the foreign investment. Previous FDI requirements (except for

24 consumer goods industries), like export earnings balance the dividend payment for over

the first 7 years from the date of commercial production was dropped and profit repatriation

by the foreign- managed firms were eased. In the mid 1990’s India became the member of

Multilateral Investment Guarantee Agencies, as a consequence, all the government

approvements were insured against nationalization. The government also allowed 100%

39

equity in high technology and export oriented industries. In order to deal with large

investment proposals, a Foreign Investment Promotion Board was set up. It deals with

foreign investments which exceeds foreign equity of 51%. During this period Reserve Bank

of India was also authorized to give approvals to projects in the high priority areas, where

foreign equity did not exceed 50% in mining sector and 51% in other sectors. This open

attitude by the government enabled FDI inflow to get tripled and it recorded US$ 10 billion

per year (A Mattoo and R M Stern, 2003).

40

CHAPTER 4

EMPERICAL ANALYSIS

41

4. METHODOLOGY AND DATA COLLECTION

In the previous section, we discovered that what fraction of FDI flows to India and China.

The strategies and policies they have adopted also played an immense role in attracting such

an inflow. The current section examines the contribution of FDI on Chinese and Indian

economy. The data for FDI inflows and other variables are from the data base of UNSTAD.

The data undertaken for the study covers a period of 39 years starting from 1970 to 2009.

The section for the purpose is divided into two. The first section deals with graphical

representation. This method is adopted to explain the relationship between the growth rates of

the primary variable of concern, FDI and GDP for India and China as a whole. The second

section presents the regression analysis for the aggregate for India and China as a whole.

4.1. Graphical analyses

The purpose of the analysis is to show the affiliation between the growth rate of GDP and

FDI. If the GDP growth rate is related to that of FDI, then it might be due to FDI determining

of GDP, the growth rate of FDI at any time t is calculated as (FDIt – FDIt-i) / FDIt-1. Similar

method is employed to calculate GDP growth rate. The analysis also shows the recent trends

in FDI inflows in INDIA and CHINA.

Figure: 4.1.1. FDI and GDP growth rate in CHINA

42

relationship between GDP growth and FDI change in

CHINA

0

24

68

1012

14

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2009

year

perc

en

tag

e o

f ch

an

ge

FDI

GDP

The figure 4.1.1for china shows that the FDI inflow during the time period from 1970 to 1982

was some what zero and it might be due to the closed nature of economic activity during

those days (Zhang 2006). The trend started to change since 1980 onwards and this might

largely due to the liberalization policies which they adopted during those days. An important

point to be noted during the period 1982 to 1990 was that both FDI and GDP was going at the

same rate and was almost parallel. After 1990 there witnessed a sudden increase in the rates

of FDI but the GDP growth rate during those period was less, but positive. The period from

1998 to 2000 is also worth noticing because FDI growth rate plunged to almost 4% from 5%

and it was almost constant till the year 2001. This sudden slow down in the FDI inflow

during this time was largely due to the Asian crisis of 1997. However the directions of both

the lines were moving in the same direction from the period 1980 onwards. After 2000 the

FDI inflow again started to rise, but experienced little fall back during 2002 and 2005

respectively. The GDP line shows that the economic growth rate was enormous from 2000 to

2009 respectively, but FDI experienced a steep fall during the period 2007 to 2008 and this is,

might be as a consequence of global financial crisis. On the whole the relationship between

FDI flow and GDP growth rate was positive and the graph shows both the lines were,

somewhat moving in the same direction.

Figure: 4.1.2 FDI and GDP growth rate in INDIA

43

The figure 4.1.2 for India shows that, the variable FDI and GDP growth is not moving at the

same proportion, which might indicate that FDI does not play a relevant role in economic

growth. The period ranging from 1970 to 1993 suggest that the inflow of FDI was minute and

during the period 1978 to 79 it went to negative, but the GDP growth was less but was

positive. The FDI growth during 1994 to 1999 was positive and went to a maximum of 3%. It

again declined during 1999 to 2002, this might be as consequences of Asian financial crisis.

The important point to be noted that at any point till 2006 both FDI and GDP growth rate was

not more than 5%. There witnessed sharp rise in FDI inflows during 2006 to 07 and it rose

almost to 12% which was actually double the growth of the previous periods, but the

relationship of FDI and GDP during that period shows, that FDI has got only less importance

in the economic growth of India. After experiencing a small fall back during 2007 it again

went upward to a maximum of 24% in 2008, which was enormous when compared to that of

2007, but at the same time GDP also increased but not at significant level compared to that of

FDI. The graph shows that in the beginning of 2009 the FDI inflows went down very sharp to

21% from 24% while the GDP growth decreased and became constant. However the period

from 2006 to 2008 can be considered as a golden period for FDI inflows in India.

Both the graph gives us an insight into the flow of FDI in these countries and the relevance of

FDI on economic growth. Most significant thing to be noted is that the graphs do not explain

the impact of FDI on economic growth of these countries but only shows the relationship

between these variables. Another important fact is that, these investment inflows became

more strong and positive after the adoption of liberalization policies in these countries.

Therefore the graph supports the findings of Agarwal (2000), Zhang (2006) and Dang (2008),

that growth in these countries were periodical and it largely occurred as a result of more

liberalized policies. It is astonishing to see how the growth rate went upward after opening up

their economy (especially the early1990 period and the post 1990 period is worth noticeable

in both the countries – China and India respectively).

4.2. REGRESSION ANALYSIS

The method used for the empirical analysis on this dissertation involves linear regression

analysis. The variables concern for the study involves GDP, which is considered as the

dependent variable, while FDI inflow is taken as the independent variable of interest. The

study also covers the relevance of other variables that contribute to the total GDP. The

analysis is done in two different parts, one part predominantly for China and the other for

44

India. For the purpose two equations are formulated by including independent variables like

FDI, exports and labour force for China along with the dependent variable GDP. Meanwhile

in the equation for India independent variable like FDI, Labour force and workers remittance

receipts from abroad are also included. This is done with an intention to study the impact of

these variables along with FDI on economic growth of these countries respectively.

Labour and employment plays major role in the economy. Often large entrepreneurs are

largely directed towards to those countries where they avail skilled labour at a cheap rate for

their business. Besides labour also contribute a major portion in the total GDP. The study,

therefore analysis their contribution in accordance with FDI.

Workers remittance level is another important factor that contributes to GDP growth rate. The

importance of the same is increasing day by day in India and China. The number of people

who are working in another country remits a part of their wages or business activities to their

country of origin in a way of savings. The exchange rate and the conversion procedure also

plays a major role which again add to the total GDP. The study therefore analysis their

contribution as well, to the total GDP in India.

Net export is another most important variable considered for the thesis. Net export is the

difference between total import and export. It is also referred to as balance of trade of a

country. It is also considered as a major part of national account (current) in the balance of

payment of a country. The correlation of net exports and national asset position is immense,

that an increase or decrease in net exports will have a direct impact on the later, causing it to

change.

As mentioned earlier, for the purpose of the thesis, a linear regression model is used. The

results are so obtained with the use of SPSS (statistics package for the social sciences), a

software similar to E-views. This is commonly used by the management students and

corporate official all around the world to determine a precise analysis of the problem. The

study done by S.Adewumi (2006) and Xiaohong Ma (2009) had used similar analysis to find

the impact of FDI on economic growth in Africa and China respectively. S.Adewumi (2006)

had used three methods such as graphical, regression and granger causality, while Xiaohong

Ma (2009) employed only regression model to do the analysis. The finding so obtained from

both studies was some what positive in nature. The correct precision and the compatibility of

regression method used in both the studies can be taken as a base to formulate a multiple

regression model to analyse the problem concerned for the thesis.

45

Multiple linear regression model is used to determine the impact of one or more independent

variable on a dependent one. It allows analysts to examine the effect of more than one

independent variables on dependent variable (xinyan, xinogang su, 2009).

The equation for the model for China is formulated as follows:

GDP= α + β1 FDI + β2 LBR + β3 Nx+ εt ………………………………. (1)

Were GDP = Average annual growth rate of real per capita

FDI = Measured as a percentage of GDP, in US dollar millions,

LBR = Annual average of the labour force, given in percentage,

Nx = Measured as a percentage of GDP, in US dollar Millions

Here the variable GDP is the gross domestic product, while FDI is the foreign direct inflows,

while Nx and LBR represent net exports and labour force of China respectively.

The equation for the model for India is formulated below:

GDP = α + β1FDI + β2LBR + β3WR……………………… (2)

Were GDP = Average annual growth rate of real per capita.

FDI = Measured as a percentage of GDP, in US dollar millions,

LBR = Annual average of the labour force, given in percentage,

WR = Measured as a percentage of GDP, in US dollar millions.

Here the variable GDP is the gross domestic product, while FDI is the foreign direct inflows,

while LBR and WR represents labour force and worker’s remittance receipts of India

respectively.

The hypothesis for the empirical analysis is that the impact of FDI on economic growth of

India and China is positive. The confirmation of the above hypothesis can be made according

to the estimated value of β1 in the regression models. The hypothesis for the model is:

Ho: β1 = 0 (FDI inflow do not have any impact on economic growth), while

H1: β2 0

46

The result of the model for India and China is represented in the tables 4.2.1.2 and 4.2.2.2.

Durbin Watson test is also included in the analysis to find the autocorrelation in the error

term. If the DW value is near to zero, the autocorrelation will be positive, and if it is near to

2, then no autocorrelation. The‘t’ value is shown in the model to test the significance level of

the co-efficient estimates. There are 39 observations in each analysis for China and India. The

FDI inflow data’s for China for the year’s between 1970 to 1980 is not available because

China has opened its economy after a long period of the late 1970’s encouraged more FDI

inflows during 1980 onwards (Dunning and Narula, 1996). The labour force data for India

and China and workers remittance receipts data for India is only available from 1980

onwards. These limitations might have an impact on the regression results.

4.2.1. REGRESSION ANALYSIS OF CHINA

GDP = -253.901 + .564FDI + 3.747LBR + .086Nx

(-.998) (1.353) (1.023) (1.350)

R square = .140, DW = 1.023

1) From the analysis for the sample (see table 4.2.1.1 in appendix), β1 = .564 0, in other

words FDI has an independent variable has got a positive effect on the economic growth of

China. In other words a unit increase in FDI causes the GDP to increase by .564 percent in

China. The coefficient value for β2 is 3.744, it indicates that labour contribution to economic

growth is worth noticing and positive in China. Besides, β3 = .086 0 means net exports in

China also has got a positive impact, thereby indicating that a unit increase in exports causes

the GDP to increase by .49 percent in China. By comparing all the variables, we find that

FDI, LBR and Nx has got positive impact on China’s economic growth.

2) From the equation the t-value for FDI, LBR and Nx are 1.353, 1.025 and 1.350 which are

all positive and significant- but not that significant when compared to that 5% significance

level. Of all the variable again FDI has got more positive effect, indicating that FDI’s

contribution is more significant than the other variable.

47

4.2.2 REGRESSION ANALYSIS OF INDIA

GDP = -7.562 + .536FDI + .165LBR + .212WR

(-.084) (.581) (.144) (.267)

R square = .086 DW = 1.836

1) The analysis (see tables 4.2.2.1 and 4.2.2.2 in appendix) shows that β1 = .536 0,

indicating that co-efficient estimates of FDI is positive with the GDP growth rate of India.

The equation suggests that a unit increase in the FDI cause GDP to grow by .581 percent for

India. Besides the value of β2 and β3 are .144 and .267 respectively, showing that the nature

of contribution made by labour force and workers remittance are almost positive in nature. Of

all the variables the coefficient estimates of FDI is more positive, whereby indicating that

role of FDI in economic growth is quite significant.

2) The t-value for FDI, LBR and WR are .581. .144 and .267 respectively, which are all

positive but not significant at 5% significance level. Of the entire variables computed, FDI

has got highest effect on the GDP, even though it’s not significant. The study thus reveals

FDI has got relevance in the GDP growth of India, hence supporting our theory of concern

for the study.

48

CHAPTER - 5

FINDINGS AND CONCLUSION

49

5.1. FINDINGS AND CONCLUSION

FDI inflows in India and China was periodical, and the relevance of the same is increasing

year by year. China being isolated for more than 30 years opened its economy on the late

1970’s, since then the flow was astonishing. China at present is the main FDI attracting zone

in entire Asia and India is in second place according to the recent studies. India on the other

hand opened its economy in 1991 with the introduction of Liberalization, Privatization and

globalization policies, since then the inflow was quite good. The pre- liberalization period of

both the countries were of a closed nature, giving due importance to domestic firms. After

realising opportunities and possible benefits the policy makers in both the countries decided

to open the economy. The main aim of this research is to examine the role of FDI in

economic growth in CHINA and INDIA. The study is so aligned that, it gives due importance

to both empirical and theoretical aspects to give the readers an insight into the strategies,

intervention, role of FDI and partially the role of other factors of growth that are prevailing in

INDIA and CHINA, which enabled them to achieve such a rapid economic growth.

The graphical analysis of China as a whole shows that the relationship between FDI and GDP

growth rate was remarkable and both the variables are going at the same upward direction,

indicating that FDI might have a significant effect on GDP growth rate in China.

The graphical analysis of India shows that there is only very minute relationship between FDI

and GDP growth rate. The direction of flow of both the variable are not equal and vary at

certain periods, FDI as a variable might not have a significant role in the in the economic

growth of India.

The main point to be noted is that the graphs do not explain the impact of FDI on economic

growth of these countries but only shows the recent trend in FDI inflow and the affiliation

between these variables.

Regression equation is formulated after doing the graphical analysis. For the purpose linear

regression method is used to calculate the impact and the role of FDI on GDP growth of

China and India. There are 39 observations in each analysis for China and India. The FDI

inflow data’s for China for the year’s between 1970 to 1980 is not available because China

has opened its economy after a long period of the late 1970’s encouraged more FDI inflows

during 1980 onwards (Dunning and Narula, 1996). The labour force data for India and China

50

and workers remittance receipts data for India is only available from 1980 onwards. These

limitations might have an impact on the regression results.

Empirical results for China suggests that FDI as an independent variable has a favourable

impact on the GDP growth rate of China. The other variable such as labour force and exports

also has got positive relation with GDP, thereby indicating that all the variables contributes

positive to economic growth in CHINA.

Empirical results for India suggests that FDI as a primary variable has got a positive relation

between GDP growth rate, indicating that FDI is relevant in contributing to the growth of

GDP growth rate in India. Of all the variables computed FDI is more positive but not that

significant at 5% significance level.

Recent statistical figures shows that FDI inflows are increasing yearly and it might have a

major role in the contribution of GDP growth rate of both the countries in the nearing future.

51

APPENDIX

A1.1. Regression analysis for China

Table : 4.2.1.1 Model Summary(b)

Model R R SquareAdjusted R

SquareStd. Error of the Estimate

Durbin-Watson

1 .374(a) .140 .040 2.83087 1.023

a Predictors: (Constant), nx, fdi, lbr

b Dependent Variable: gdp

Table : 4.2.1.2 Coefficients(a)

Model

Unstandardized Coefficients

Standardized Coefficients

t Sig.B Std. Error Beta

1 (Constant)

-253.901 254.464 -.998 .328

fdi .564 .417 .335 1.353 .188

lbr 3.747 3.657 .289 1.025 .315

nx .086 .064 .308 1.350 .189

a Dependent Variable: gdp

52

A1.2 Rgression analyis for India

Table : 4.2.21 Model Summary(b)

Model R R SquareAdjusted R

SquareStd. Error of the Estimate

Durbin-Watson

1 .293(a) .086 -.020 2.15592 1.836

a Predictors: (Constant), wr, lbr, fdib Dependent Variable: gdp

Coefficients(a)

Table : 4.2.2.2

Model

Unstandardized Coefficients

Standardized Coefficients

t Sig.B Std. Error Beta1 (Constant

)-7.562 90.431 -.084 .934

fdi .536 .923 .218 .581 .566

lbr .165 1.145 .031 .144 .886

wr .212 .795 .099 .267 .792

a Dependent Variable: gdp

53

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