Impact of FDI on the growth rates in agriculture in India

Abstract

Foreign direct investment (FDI) is taken as one of the key factor of rapid economic growth and development. FDI, it is believed to stimulate domestic investment, human capital, and transfers technology. It is associated qualities which causes the faster economic development in the host countries. India, for instance was one of the poorest economies after the post independence era, but yet achieved economic growth with substantial amount of FDI inflows and become one of the fastest emerging economies in the world in a half century and witnessed unprecedented levels of economic expansion, along with countries like China, Russia, Mexico and Brazil.

This paper evaluates the impact of FDI in India’s economic growth employing macro economic time series data from 2000-2010 on the growth of Agricultural, Manufacturing and Service sectors of the Indian economy as well as the economy as a whole. This study uses the endogenous growth model to explore the role of FDI in economic growth. The role of FDI in economic growth is not statistically significant; however, the interaction between FDI and human capital, export and domestic capital is of utmost importance.

This study supports the findings of Laura Alfaro (2003) in the study of which shows that the benefits of FDI vary greatly across sectors by examining the effect of foreign direct investment on growth in the primary, manufacturing, and services sectors.

Objective:

The objective of this study is to compare the difference in growth rates among the Agricultural, Manufacturing and Service Sectors of the Indian Economy due to the uneven flow of Foreign Direct Investment in these sectors. The research work also aims at analysing the growth of Indian economy from 2000 to 2010 based the inflows of Foreign Direct Investment and the factors such as Government Spending, Inflation, GDP Per capita, Trade Openness and Human Capital Formation affecting it.

Introduction:

The United Nations 1999 World Investment Report defines FDI as ‘an investment involving a long term relationship and reflecting a lasting interest and control of a resident entity in one economy (foreign direct investor or parent enterprise) in an enterprise resident in an economy other than that of the foreign direct investor ( FDI enterprise, affiliate enterprise or foreign affiliate).

In the recent years, Foreign Direct Investment (FDI) policies have become one of the central economic policies for the developing countries, learned from the experiences of newly industrialised countries (NICs) like South Korea, Singapore, Hong Kong and Taiwan which promoted FDI as the catalyst of rapid economic growth in the early stages of their economic development. Empirical studies on the impact of FDI on economic growth have shown positive impact in the host countries. Hence, it has become an area of great interest with empirical determinants of policy implications for enhanced FDI inflows and the mechanism through which it facilitates growth and structural change in recipient countries.

The role of FDI in economic growth in the developing countries is that FDI generate more benefits to the recipient countries rather than just full filling the short-term capital deficiency problems. Transfer of technologies and its spill over effect to the local firms will make the local firms more competitive and high standards which is necessary to compete with the foreign products. Another, spill over effect of MNEs is that MNEs may provide training and labour management which may make them available to the economy in general. The training to local suppliers by MNEs may increase the high standard production and managerial standards.

The relationship between foreign direct investment and economic growth is one of the well studied subjects in the field of development economics. Especially, after the advent of endogenous growth model (Borenzteins, et al, 1995, Balasubramanyam, et al, 1996) made this relationship more vital for long run economic growth. The research interest in this field has increased after 1990s wave of globalisation and massively increased FDI across the globe and economic growth of FDI receiving countries.

According to UNCTAD (2009) foreign direct investment has potential to generate employment, raise productivity, transfer skills and technology, enhance export and continue to the long term economic development of the world’s developing countries. FDI is also the largest source of external financing for developing countries.

Foreign Direct Investment is directly linked to the international trade of the country which provides the opportunities to integrate the local economy with the world economy. Enormous literatures on significance of FDI has shown positive role in the economic growth (Borenztein, et al 1995, De Mello, 1996 and Balasubramanyam, 1996). However, there are controversies as some academics argue that the relationship between FDI and growth is non-linear. This is a complex issue whether FDI cause growth or growth causes the increase of FDI. Multinational companies go across the world with the objectives maximizing profits. Hence, countries are providing most suitable investment environment to MNEs to attract the investment. Policy reforms, political stability, domestic growths, increased domestic entrepreneurial skills might cause to grow the FDI in host countries.

Inflows of FDI can be important vehicle for technological change and human capital. Blomstrom et al (1994, 1996) emphasized FDI that induced human capital augmentation and economic growth by the help of the technology transfer, accumulation of human capital and knowledge spill over in the FDI receiving countries.

There are two ways to deliver goods and services to foreign markets: international production and trade. This means that there should be some interrelationship between the two. This is confirmed by the positive correlation between world Foreign Direct Investment (FDI) and world exports. Thus, economic growth and trade and investments are interconnected.

Foreign Direct Investment and Economic Growth

Foreign Direct Investment plays important role in economic growth as FDI not only increase the capital stock in the country but also brings the technology which increases the productivity of the resources. The massive increase in FDI in India from 1990 to 2010 raises important queries about the possible impact of FDI in economic growth. The studies of Borenzstein et al. (1995) and Balasubramaniyam, et al. (1996) demonstrate that FDI induces human capital and transfer technologies and this spillover effect of knowledge lead the economic growth in the host countries. They argue that the effect of FDI remains permanent in the host country because of the development in the infrastructures of the host country. Therefore, there exist the long rung relationship between level of GDP and foreign capital stock.

Depicted below are the trends in FDI, GDP and Inflation in the post liberalisation period in India.

Source: http://www.tradingeconomics.com/

Source: http://www.tradingeconomics.com/

Source: http://www.tradingeconomics.com/

The cumulative effect of FDI,GDP and Inflation factors determine the growth of an economy.

The sectoral breakup of flow of FDI in India is as follows:

Source: Adapted from the data given on http://www.indiaonestop.com/FDI/sectorwisefdiinflows%282000-2009%29.htm

Hence it is clear that the major share of FDI flows into the Service Sector.

The share of each of the sectors in GDP is as below:

Source: Adapted from the data given on http://business.mapsofindia.com/india-gdp/sectorwise/

It is clear from the above two depictions that the service sector has majority share in GDP as well as FDI, followed by Manufacturing and then Agriculture.

The research aims at comparing the difference in growth rates of these sectors due to the flow of FDI.

Current state of the literature related to the proposed topic:

Economic policymakers in most countries go out of their way to attract foreign direct investment (FDI). A high level of FDI inflows is an affirmation of the economic policies that the policymakers have been implementing as well as a stamp of approval of the future economic health of that particular country. There is clearly an intense global competition for FDI. India, for its part, has set up the “India Brand Equity Foundation” to try and attract that elusive FDI dollar.

According to UNCTAD (2010), India has emerged as the second most attractive destination for FDI after China and ahead of the US, Russia and Brazil.

While there is an intense “global race” for FDI, how important is FDI to a country’s economic growth? It is certainly a difficult ask to separate and quantify the complex package of resources that FDI confer to the host country. There have been a number of macro studies attempting to determine the nexus between FDI and growth.

The massive literature on role of FDI on economic growth has shown various types of affects (positive, negative or insignificant) of FDI in various countries. This study aims to explore the impact of FDI on the growth rates of sectors in Indian economy.

Berry and Kearney(2006) the most common character through which spillover are understood to operate include technology transfer, demonstration effects (through management skills and training to export) and greater competition(leading to productive efficiency). A significant presence of MNEs can bring about fundamental changes in industrial structure, particularly for smaller and medium sized countries. If foreign MNEs operate in sectors that are imperfectly correlated with those dominated by indigenous firms, FDI can help create a better diversified economy.

Chung et al (2003) Technology transfer occurs when there is contact between foreign and local firms. Japanese auto transplants increased production process in North American significantly influenced the industry’s productivity growth during this period (1982-1991).

Caves (1974) argued that FDI also improves the allocative and technical efficiency through competitive pressure. Foreign entrants break down entry barriers, compete for factor inputs and customers and reduce the market power of entrenched firms.

Zhang et al (2004) studied on impact of MNEs behavior through FDI on international trade and vice versa. They used Granger causality co integration approach to observe the direction of FDI and trade linkage of Chinese economy in 1980- 2003 period. They found that more imports lead higher level of FDI, more FDI leads to more exports and more exports FDI. This virtuous process reflects China’s open door policy.

Chakraborty and Basu (2002) study showed two-way link between foreign direct investment and growth for India using structural co integration model with victor error correction mechanism. They found strong evidence of GDP Granger causing FDI flows for India, there was not significant role in the short run adjustment process of GDP. Short-run increase in FDI flows for India is labor displacing in nature. The technology transfer brought in by FDI causes an excess supply of labour creating downward pressure on unit labor cost.

Borenzstein et al (1995) introduced a new model showing the impact of FDI in economic growth using an endogenous model growth model. They analyzed FDI flows from industrialized countries to 69 developing countries during 1970-1989. They argued that due to the direct FDI there is increase in capital accumulation and in host countries and transfer of technology lead increases productivity which causes the economic growth of the host countries. Their result showed that FDI is an important vehicle of technology transfer, contributing more economic growth than domestic investment where they make a case of minimum threshold stock of human capital necessary to absorb foreign technologies and linkage between FDI and human capital and domestic investment are crucial to achieve the economic growth. Other subsequent studies by Subramanyam et al., (1996) within the growth theory frame work analyzed the role of FDI in growth process in the context of 46 developing countries with different trade policy regimes. From their cross-sectional panel data analysis, they found that countries that pursue all outwardly oriented trade policies are strongly benefited from FDI than those countries adopting an inward oriented policy.

De Mello (1996) based on neoclassical approach argue that FDI affects only level of income and leaves long run growth unchanged. They argue that technological progression and other external factors main source of economic growth. Their argument is that long-run growth arises because of technological progress and population growths both were exogenous. Hence, according to neoclassical models of economic growth, FDI will only be growth advancing if it affects technology positively and permanently.

Endogenous growth theorists believe that economic growth is generated from within a system as a direct result of internal process. Aghoin and Howitt(1998) the enhancement of nation’s human capital by investing more on human capital formation would lead to faster economic growth. The recent endogenous models show that FDI can affect growth endogenously growth models if it generates increasing returns in production via externalities and spillover effects Deme and Graddy (2006). In these models, FDI is considered to be an important source of human capital and technological diffusion.

According to Romer’s (1990) endogenous growth model; growth is driven by technological change from intentional investment made by profit maximizing firms. He argues that stock of human capital determines the rate of growth. In his view, there is increasing returns scale (IRS) in aggregate level where as constant returns to scale (CRS) in the firm level and firms don’t take account of spillover effect of externalities but economy as a whole experiences the increasing returns to scale which causes the endogenous growth. Endogenous growth theoreticians FDI and trade stimulate the technological diffusion and contribute economic growth.

Barell and Pain (1996) studied the econometric model of foreign direct investment and examined the extent to which the model explain the level of outward direct investment by U.S companies over last two decades. Their analysis show that market size and factor cost, both labor and capital are important factors in the investment decision because MNEs are trying to maximize the value of the firm by allocating the resources in right place.

Feder et al. (1983) analyzed export-led economic growth hypothesis. They argued that exports increase factor productivity because of the better utilization of resources and economies of scale. Some economists argue that open trade policies foster FDI because of the conducive economic climate for the MNEs. In this regard, Rodrizguez and Rodrik (1999) presented a skeptical view by linking between opentrade policies and economic growth. They argue that previous studies didn’t consider the institutional differences among countries in an upwardly biased estimate of trade and other policy restrictions. Their analysis showed that the relationship between average tariff rates and economic growth is only slightly negative and nowhere near statistical significance.

The issue whether FDI and trade trigger economic growth or economic development attracts FDI and trade is unsolved (Makki and Samwaru, 2004) since past studies were one sided i.e. analyzed the impact of FDI and trade on economic growth (Borensztein et al, 1995 and Balasubramanyam et al, 1996) or analyzed the effect of economic growth on FDI (Barrel et al, 1996).

The recent study on role of FDI in economic by Kim and Hwang (2000) focused on spillover effects in different six sub sectors. They examine the effects by using random effects model employing the annual data for the period of 1970. They find that FDI played a negligible role through out Korea’s economic development. Despite the quantitative insignificance of FDI, they accepted the qualitative role of FDI on Korean economy by knowledge spillover from foreign firms.

Dhakal et al. (2007) conducted a research on relationship between FDI and economic growth using granger causality test for 9 Asian countries where they find there is no direct causal relationship in two countries, causality ran from growth to FDI in 5 countries including South Korea and causality ran from both sides in two countries.

Kim and Seo (2003) analysed the dynamic relationship between FDI and economic growth and domestic investment in Korea for the period of 195-1999 using vector auto regression model. They found that there some positive effects of FDI on economic growth but insignificant. However, their findings show that domestic investments negatively affected by FDI shock, and FDI does not crowd out domestic investment in Korea.

In a recent survey of the literature, Hanson (2001) argues that evidence that FDI generates positive spillovers for host countries is weak. In a review of micro data on spillovers from foreign-owned to domestically owned firms, Gorg and Greenwood (2002) conclude that the effects are mostly negative.

Lipsey (2002) takes a more favorable view from reviewing the micro literature and argues that there is evidence of positive effects. Surveying the macro empirical research led Lipsey to conclude, however, that there is no consistent relation between the size of inward FDI stocks or flows relative to GDP and growth. He further argues that there is need for more consideration of the different circumstances that obstruct or promote spillovers.

This study revisits the FDI and economic growth relationship by examining the role FDI inflows play in promoting growth in the main economic sectors, namely Agricultural, manufacturing, and services. Often-mentioned benefits, such as transfers of technology and management know-how, introduction of new processes, and employee training tend to relate to the manufacturing sector rather than the agriculture or mining sectors.

For example, the theoretical work of Findlay (1978) and Wang and Bloomstrom (1992) that models the importance of FDI as a conduit for transferring technology, relates to the foreign investment inflows to manufacturing or service. He warned that in the absence of linkages, foreign investments could have limited effect in spurring growth in an economy.

About the consequences in potential linkages effects differences in manufacturing and agriculture, Hirschman (1958:110) wrote, “the absence of direct linkage effects of primary production lends these views (enclaves) a plausibility that they do no have in the case of foreign investment in manufacturing.” More recently, the theoretical work on linkages, by Rodiguez-Clare (1996), shows that multinationals’ intensive use of intermediate goods enhances production efficiency in host economies. In this framework, increased demand for inputs leads to a positive externality to other producers owing to an increase in variety. Greater varieties of inputs, however, seem to be more relevant to the manufacturing than to the agricultural sector.

In addition, FDI’s potential to create linkages to domestic firms, as Albert Hirschman (1958) described in his seminal book on economic development, might also vary across sectors. Hirschman (1958:109) emphasized that not all sectors have the same potential to absorb foreign technology or to create linkages with the rest of the economy. He noted, for example, “linkages are weak in agriculture and mining.” However, seem to be more relevant to the manufacturing than to the agricultural sector.

Markusen and Venables (1999) analyze the effect of foreign firms on the development of domestic firms in the industrial sector. In their model, foreign companies compete with domestic producers while creating additional demand for domestically produced intermediate goods through linkages with local suppliers. This can lead to domestic firms entering into the intermediate goods sector, which can result in lower costs that, reflected in lower final prices that increase demand, can benefit domestic firms producing final goods.

Proposed Research Work:

Statement of Problem

Today, India stands as one of the fastest emerging economies in the world. The country has a land of 3,287,240 Sq Km with 1,188,859,000 populations. India enjoys a per capita income of US $757 (World Bank, 2009) as compared to US $ 318 in the pre liberalisation era. This study explores the role of FDI in this remarkable growth of India as well as the growth of every sector of the Indian economy.

FDI has been seen one of the big resources for industrial development in India over the years. FDI stock increased to US $ 34.577 billions in 2009 from US $ 236.690 millions in 1990 (WIR, 2009) and has gained the name of ‘The Asian Tiger’. It is interesting to explore the impact of FDI on the rapid growth of Indian economy.

Despite the natural resources availability in the country, economic policies and political environment also influence the inflow of foreign investments in the countries. The theoretical concept of impact of FDI is that FDI does not only bring capital but also it brings technology, knowledge and due to the spill over effect development of process remains for the long run. FDI works as the catalyst for the economic growth of a country, especially for the developing countries. FDI is not only a single factor determining the economic growth, rather foreign trade, domestic investment, employment level, government consumption are also major factors affecting growth. On the other hand, stock of human capital is factors determining the level of FDI inflow besides the resources available in the host countries. How the growth is affected by these variables? Does high level of FDI increase the higher level of economic growth? What would be the interaction between FDI and Trade, human capital and domestic investment? The study examines the effect of this variable in economic growth.

Purpose of this study

At a theoretical level, FDI brings both capital and technology which makes the local firms more competitive and encourages the economic development in the faster way.

The spill over effect of foreign companies will have a long-term effect in the host countries. In the practical level, this study explores the role of FDI in economic growth in India. This study explores, whether FDI plays a role in economic growth or not? Another reason for the study is to compare the rate of growth of the key sectors of the Indian economy.

India is able to attract a significant amount of FDI among Asian countries. This study verifies the theoretical model of endogenous growth theory of economic growth by using the macro economic figures of India. The present study examines the empirical assessment of the impact of FDI in difference of growth rates of Agricultural, Manufacturing and Service sectors of India as well as the growth of the economy as a whole over the period of 2000-2010.

Scope of the Study

Foreign Direct Investment has emerged as a major macro economic indicator of the growth of an economy. In recent years, the Indian Economy has opened up to foreign flows at a tremendous rate. These foreign inflows have contributed to the overall development of the economy in areas like technology, innovations and human capital formation but are being hindered by high rates of inflation, low yields, lack of infrastructure, skilled labour as well as low per capita GDP in various sectors.

The study is aimed at analyzing the impact of FDI on the growth in various sectors considering the control factors. The research will also provide insights into the lop-sided flow of FDI in some sectors as compared to others. The impact of flow of FDI on the growth of Indian economy will also be estimated over the period of 10 years from 2000-2010. The study tries to explore the question whether high level of FDI cause higher level of economic growth.

Research Methodology

This section describes the research methodology of the study which explains the conceptual framework, research design, data collection method and data analysis methods of the study.

The main objective of the study is to compare the difference in growth rates among the Agricultural, Manufacturing and Service Sectors of the Indian Economy over the period of 2000 to 2010. India received a huge amount of FDI and achieved high economic growth rate with gradual liberal trade policy regimes. This study analyzes the linkage between FDI and economic growth in India.

Conceptual Frame work

Basically, the conceptual frame work of the study is derived from the works of Borensztein et al. (1998), Carkovic and Levine (2002), and Alfaro et al. (2003). They have shown the impact of FDI on economic growth in the following linkage.

Source: Adapted from How does foreign direct investment affect economic growth?

References and further reading may be available for this article. To view references and further reading you must purchase this article.

E. Borensztein, J. De Gregorio and J-W. Lee

According to their argument, Foreign Direct Investment accelerates capital accumulation in host country by increasing total investment and lowering the cost of innovation and indirectly by crowding in domestic investment and scarce resources of the economy and productivity is enhanced by technology transfer but it is constrained by human capital in the host economy. They argue that FDI develops stock of human capital. There should be a linkage between domestic investment and human capital to achieve the higher productivity.

Research Methodology and Model

The present study is focused on the compare the difference in growth rates among the Agricultural, Manufacturing and Service Sectors of the Indian Economy over the period of 2000 to 2010. Only secondary data are used for the analysis of the research objectives. The uneven inflow of foreign capital and growth of certain sectors in the economy in India has attracted the research interest on it.

This study employs the endogenous growth theory as developed by Balasubramanyam, Salisu and Sapsford, 1996 and Borensztein, Gragorio and Lee 1998. This model assumes that FDI contributes to economic growth directly through new technologies and other inputs as well as indirectly through improving human capital, infrastructure and institutions and country’s level of productivity depends on FDI, trade and domestic investment. The impact of overall FDI inflows on economic growth can be based on the following equation:

Growth= β0 + β1 Initial GDP + β2 Controls + β3 FDI + vi

Here Growth is the dependent Variable which equals per capita GDP, FDI and the control factors.

For most of the variables in the regression, the values represent the average of the period for which sector FDI is available. The variables are determined as follows:

Output levels and growth: Output level and growth data reflect the growth of real per capita GDP (in constant 1995 US$). Source: World Bank Development Indicators (2001).

Foreign Direct Investment: FDI inflows are generally defined as the measure of the net inflows of investment needed to acquire a lasting management interest (10 percent or more of voting stock) in an enterprise operating in an economy other than that of the investor. FDI by sector as a % of GDP was used in the regression analysis. Sources: For OECD countries, the International Direct Investment Statistics Year Book (2001); FDI by sector for other countries in the sample was calculated using UNCTAD’s World Investment Directory (7-volume series 1992-2000).

Government Spending: Comprises general government final consumption expenditure as a percentage of GDP. Source: World Bank Development Indicators (2001).

Inflation: Percentage changes in the GDP deflator. Source: World Bank Development Indicators (2001).

Institutional Quality (INSTQUAL): Institutional Quality is measured as the average of the 12 sub-indices of Political Risk as measured by the International Country Risk Guide: Government Stability, Socio Economic Conditions, Investment Profile, Internal Conflict, External Conflict, Corruption, Military in Politics, Religion in Politics, Law and Order, Ethnic Tensions, Democratic Accountability, and Bureaucracy Quality. Source: International Country Risk Guide (ICRG).

Inflation: Percentage changes in the GDP deflator. Source: World Bank Development Indicators (2001).

Openness: Trade Openness is defined as the average of exports and imports as a percentage of GDP. Source: World Bank Development Indicators (2001).

Private credit (PRCREDBANK): The value of credits by financial intermediaries to the private sector divided by GDP, this variable excludes credits issued by central and development banks and credit to the public sector as well as cross claims of one group of intermediaries on another. Source: Levine et al. (2000).

Schooling: Average years of secondary schooling of the total population. Source: Barro and Lee (1996) and World Bank Development Indicators (2001).

The same equation can be used to determine the economic growth in each of the sectors of the Indian economy.

Based on the results obtained, relevant conclusions can be drawn about the growth rates in the Agricultural, Manufacturing and Service Sectors of the Economy and the difference between them. Analysis of the FDI over the period of 10 years can also be derived by employing the equation to each year.

The stock of efficient human capital is required to absorb the technologies brought by FDI and it determines whether the potential spillover effect is realized. The host country requires sufficient number of human capital to utilize the technologies brought by FDI, meaning that higher the level of human capital in the host country, higher the effect of FDI in economic growth of the host country. The study assumes a positive relationship between FDI and GDP growth rate as well as a positive interaction between FDI and human capital in accelerating the economic growth. The issue relating to the interaction between FDI and domestic investment; it is assumed that there is positive interaction between FDI and domestic investment because FDI has is considered as an important medium for transferring capital, technologies and host countries that encourages the domestic investment level.

This study uses the time series data for the period of 2000-2010 for the analysis of the objectives and uses the multivariate regression analysis (OLS) for the analysis of data.

Data Collection Method and Sources

The research is based on Secondary sources of Data Collection.

Detailed information on FDI by sector for India is available in OECD’s International Direct Investment Statistics Yearbook (2009). The OECD data can be complemented with information obtained from the World Investment Report seven volume series by UNCTAD, each volume of which contains FDI information for countries from different regions (e.g., Asia and the Pacific, Africa, Latin America, and the Caribbean, etc.).

The per capita growth rate of output is measured as the growth of real per capita GDP in constant dollars using data from the World Bank’s World Development Indicators (WDI) (2009). Inflation, measured as the percentage of change in the GDP deflator and used as a proxy for macroeconomic stability, is taken from WDI (2009) as well. In order to capture institutional quality and stability, data from the International Country Risk Guide (ICRG), a m