FDI Inflows: Compliments or Substitutes?

The composition of FDI is heavily concentrated in the service industry, which may reflect the region’s comparative advantage in this sector. But it may also indicate that FDI into other prominent sectors, such as manufacturing, is low due to insufficient infrastructure and inappropriate investment climate which restrict FDI inflows to these sectors

Developed economies are the major contributors of FDI inflows to India. They include European Union, United States, Japan, South Korea and Singapore. India experienced a 44 percent decline in FDI between 2008 and 2010 post the financial crisis. India’s absolute FDI inflows rebounded in 2011 and witnessed more modest growth in 2012. However, the inward FDI relative to the size of its economy is quite low when compared to other countries’ of similar size.

The service sector in India manifested a strong recovery after the financial crisis. Most of India’s FDI inflows are centered on the service sector, including financial services, banking, insurance, non-financial and business services, outsourcing, research and development, courier services, technical testing and analysis. Telecommunication in general and telephone services in particular is another sector which attracts maximum FDI inflows. Many international IT firms have invested in India during the last decade. Post financial crisis, real estate has experienced a drastic fall in FDI while robust growth returned to infrastructure construction.

The automobile industry is a significant contributor of India’s total inward FDI, although inflows weakened in 2011. The sector is characterised with immense prospects to attract FDI. The pharmaceutical and chemical industries have great potential for attracting more FDI for India. The pharmaceutical sector was opened to 100 percent FDI a decade ago, but inward FDI has taken off only recently. In the chemical industry, inward FDI flows have registered steady growth in the past few years.

FDI can impact various factors including GDP, domestic investment and employment in emerging Asian economies which may be categorised in two ways. FDI can act as a substitute by crowding out domestic investment or by displacing domestic investment. FDI act as a compliment by generating domestic investment by way of crowding in impact only in few countries. FDI’s role as a compliment or substitute in the economy depends on many factors including the quality of FDI, domestic regulatory environment etc.

In order to verify whether FDI acts as a substitute or compliment, World Bank data of major South Asian countries (2003-2013) was subjected to multiple techniques of data analysis. The level of FDI inflows to GDP, the Growth rate of GDP and Domestic Investment were the three variables considered. A technique under panel data analysis namely Seemingly Unrelated Regression has been used to verify if FDI causes crowding in or crowding out effect. The coefficients derived from panel data analysis of major South Asian countries point towards strong Crowding Out effect of FDI Inflows by displacing domestic investment. It implies that additional one dollar of FDI displaces roughly seven dollars of domestic investment from the South Asian countries.

The same analysis performed individually for India indicates the recent trend that FDI started to displace domestic investment. It was expected that the mild crowding in effect observed in the past decades may not prolong in India due to divergent issues such as the change in rules stipulated for the entry of FDI. Great caution will have to be paid in this regard since displacement of domestic investment will have serious adverse repercussions on the GDP.

According to UNCTAD report, foreign affiliates of Trans National Corporations have generated direct employment for about 69 million which included a significant number of people of developing countries in 2011. Indirect employment created by foreign affiliates through enterprises, subcontractors or service providers is estimated to be one to two times the number of direct employment created. In forthcoming two decades, more than one million new workers are estimated to enter the South Asian labour market each month as potential job seekers. To   provide them decent jobs as well as to improve their living standards and reduce poverty, South Asian countries will have to rely on private investment more than just public investment. The right type of FDI has a major role in provision of employment, to increase GDP and to spurt domestic investment.

Further liberalization of FDI policies is essential to attract high inflows. The advanced economies tend to move faster toward FDI liberalization and they have more FDI-friendly policies. Nonetheless, investment in India faces significant barriers.

The factor which resulted in poor FDI flows to South Asia is cited to be the September 11 terrorist attacks which reflected poor perceptions among foreign investors of the stability of the investment climate. A sound macroeconomic environment, legal and regulatory policies, appropriate institutions and basic infrastructure are needed for attracting high FDI inflows.

The composition of FDI is heavily concentrated in the service industry, which may reflect the region’s comparative advantage in this sector. But it may also indicate that FDI into other prominent sectors, such as manufacturing, is low due to insufficient infrastructure and inappropriate investment climate which restrict FDI inflows to these sectors. At present Government of India has to take great caution with regard to FDI inflows so as to ward off the possibility of intensifying the crowding out effect.

 (The author is a Professor of Department of Economics at University of Mumbai)

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