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INTRODUCTION

India is today one of the most preferential country for investment in the world, whereas ranked as the third place among the world for FDI destination after China and USA. In 2003, India ranked sixth on the list. According to Goldman Sachs Global economic paper of October 2003 Dreaming with BRICS: the future predictions that over next 50 years Brazil, Russia, India and China could become a much larger force in the world economy. Now India is favoured place unlike China in the past. Initially several steps have taken to facilitate increased FDI inflows.


LITERATURE REVIEW

The literature review has the aim to give an insight in the theoretical framework which is the basis of this research. In the first part the FDI concept will be described in general. Second part will be in detail about economic growth of India. Third part is based on FDI role in Indian economic growth. At last the discussions about "Does FDI stimulating economic growth of India"

Foreign direct investment (FDI) is meant as investment that is made to acquire a lasting management interest in an enterprise operating in a host country other than that of the investor, the investor's purpose being an effective role in the organization. It is the sum of equity capital, reinvestment of earnings, other long-term capital, and short-term capital as shown in the balance of payments (World Bank, "Global Development Finance 2002")

Foreign direct investment reflects the objective of obtaining a lasting interest by a resident in an economy other than that of the inventor. The lasting interest implies the existence of long term relationship between the direct investor and the enterprise and significance degree of influence of the management of the enterprise. Direct investment involves both the initial transaction between the two entries and all subsequent capital transaction between them and among affiliated enterprises both incorporation. [RE: IMF balance of payment manual, 5th edition, 1993.]

FDI plays an extra ordinary and growing rate in global business. It can provide a firm with new market and marketing channels, cheaper production facilities, access to new technology, products, skills and financing. The host country or the foreign firms which receives the investment, it can provide a source of new technology, capital, processes, product, organization technologies and management skills, and such can provide a strong impact to the economies development. FDI can be classically defined as "A company from one country making a physical investment into building a factory in another country." Direct investment is buildings machinery and equipments are in contrast with making a portfolio investment, which is considered an investment, which is considered an indirect investment. [RE: Jeffrey P. Graham and P.Barey.]

In 1990's global flow of foreign direct investment increase some sevenfold sparing economist to explore FDI from a micron or trade to analyze the microeconomics of FDI. Treating, FDI as a unique form of international capital flow between two countries. By examine the determinants of the aggregate flows of FDI at the bilateral, source host country level. Drawing an a wealth of fresh data, they provide new theoretical models and empirical technique that illuminate the vital country pair characteristics that drive these flows unique, foreign direct investment examines, FDI between developed and developing countries, and are not just between developed countries. Among many others insight [RE: Foreign direct investment, Assaf Razin and Efraim Sadka.]

When I thought to identify how foreign direct investment can make a contribution to develop significantly more powerful and more varied than conventional measurements indicate. The bad news reveals that foreign direct investments can also distort host economies and polities with consequences substantially more adverse than critics and cynics have imaged. This principle controversies and debate about FDI in manufacturing and debates about FDI in manufacturing and assembly, extractive industries and infrastructure and analysis it also identifies how developing and developed countries, multilateral lending agencies and civil society can work in concert to harness foreign direct investment to promote the growth and welfare of developing countries. [RE: Theodore H. Moran, centre for global development, 2006.]

FDI is a component of a country's national financial accounts, Foreign direct investment is investment of foreign assets into domestic structures, equipment and organization. It does not include foreign investment into the stock markets (Mike Moffat).

The International Monetary Fund(IMF) defines foreign direct investment can be defined in two ways-

  1. The "lasting interest "implies the existence of a long term relationship between direct investor and direct investment enterprise,

  2. The "direct investment" implies the acquisition of at least 10 percent of the ordinary shares or voting power of an enterprise abroad.

Foreign Direct Investor refers to an individual, an incorporated or unincorporated public or private enterprise, a government, a group of related individuals, or a group of related incorporated and or unincorporated enterprises which has a direct investment enterprise that is, a subsidiary, associate or branch-operating in a country other than the country or countries of residence of the foreign direct investors or investors.(OCED,1996)

There are few common misconception (IMF,2003)

  • FDI does not necessarily imply control of the enterprise since only 10 percent ownership is required to establish a direct investment

  • FDI involves only one investor or a "related group" of investors.

  • FDI is not based on nationality or citizenship of direct investors; it is based on investor's residency.

  • Lending from unrelated parties abroad that are guaranteed by direct investors is not FDI.
  • FDI is thought to be more useful to a country than investment in the equity of its companies because equity investment are potentially "hot money" which can leave at the first sign of trouble, whereas foreign direct investment is durable and generally useful whether things go well or badly.


    Foreign direct investment reflects the objective of obtaining a lasting interest by a resident entity in one economy ("Direct investor") in an entity that resident in an economy other than that of the investor ("direct investment enterprise").The lasting interest implies the existence of a long term relationship between the direct investor and the enterprise and a significant degree of influence on the management of the enterprise.

    Foreign Direct investment involves both the initial transaction between the two entities and all subsequent capital transaction between them and among affiliated enterprises, both incorporated and un incorporated (OECD Benchmark(1996).

    According to Borensztein al,(1998) FDI as an important part to the transfer of technological contribution to growth is higher when compare to domestic investment. Findlay(1978) postulates that FDI increase the rate of technical progress in the host country through a undesirable effects from the more advanced technology, management practices ..etc used by foreign firms

    Athreye and Kapur (2001) have emphasized that since the contribution of FDI to Domestic capital formation is quite small, growth-led FDI is more likely than FDI-led growth. This is so as increased economic activity expands the market size, offering greater opportunities for foreign investment to reap economics of scale in a large market economy like India.

    FDI is thought to bring certain benefits to national economics. Basically FDI invested in two categories: Greenfield investment to build new capacity, acquisition of assets of existing local firms commonly referred as "mergers and acquisitions". This benefit more to country's growth by increasing productivity through new production facilities or M&A should be based on assumption that the new owners and management expect to operate the company more efficiently than previous management.

    Country growth condition will be pointed out through investigation as a major factor in determining to what extent FDI helps productivity 'spillovers', not just by increasing the production of companies and the economy as a whole. This conditions should helpful to all ways which include human capital( work force well educated and trained), effective organization and positive business climate for eg: financial markets, political stability, and efficiency of government services. These things grouped under the heading of "absorptive capacity" vary substantially across all regions and countries.

    Attracting FDI is important for the any country economic growth. However its based on implicit assumption that inflows of FDI will bring certain benefits to country's growth. They are following which related to FDI success and failures,


    STIMULATION OF NATIONAL ECONOMY

    FDI is thought to bring certain benefits to national economies. It can contribute to Gross Domestic Product (GDP), Gross Fixed Capital Formation (total investment in a host economy) and balance of payments. There have been empirical studies indicating a positive link between higher GDP and FDI inflows (OECD a.), however the link does not hold for all regions, e.g. over the last ten years FDI has increased in Central Europe whilst GDP has dropped. FDI can also contribute toward debt servicing repayments, stimulate export markets and produce foreign exchange revenue. Subsidiaries of Trans-National Corporations (TNCs), which bring the vast portion of FDI, are estimated to produce around a third of total global exports. However, levels of FDI do not necessarily give any indication of the domestic gain (UNCTAD 1999). Corporate strategies e.g. protective tariffs and transfer pricing can reduce the level of corporate tax received by host governments. Also, importation of intermediate goods, management fees, royalties, profit repatriation, capital flight and interest repayments on loans can limit the economic gain to host economy.

    Therefore the impact of FDI will largely depend on the conditions of the host economy, e.g. the level of domestic investment/savings, the mode of entry (merger & acquisitions or Greenfield (new) investments) and the sector involved, as well as a country's ability to regulate foreign investment (UNCTAD 1999).


    STABILITY OF FDI

    FDI inflows can be less affected by change in national exchange rates as compared to other private sources (portfolio investments or loans). This is partly because currency devaluation means a drop in the relative cost of production and assets (capital, goods and services) for foreign companies and thereby increases the relative attraction of a "host" country. FDI can stimulate product diversification through investments into new businesses, so reducing market reliance on a limited number of sectors/products (UNCTAD 1999). However, if international flows of trade and investment fall globally and for lengthy periods, then stability is less certain. New inflows of FDI are especially affected by these global trends, because it is harder for a foreign company to de-invest or reverse from foreign affiliates as compared to portfolio investment.

    Companies are therefore more likely to be careful to ensure they will accrue benefits before making any new investments. Examples of regional stability are mixed, whilst FDI growth continued in some Asian countries e.g. Korea and Thailand, during the 1996/97 crisis, it fell in others e.g. Indonesia. During Latin America's financial crisis in the 80's many Latin American countries experienced a sharp fall in FDI (UNGA 1999), suggesting that investment sensitivity varies according to a country's particular circumstances.


    SOCIAL DEVELOPMENT

    FDI, where it generates and expands businesses, can help stimulate employment, raise wages and replace declining market sectors. However, the benefits may only be felt by small portion of the population, e.g. where employment and training is given to more educated, typically wealthy elites or there is an urban emphasis, wage differentials (or dual economies) between income groups will be exacerbated (OECD a). Cultural and social impacts may occur with investment directed at non-traditional goods. For example, if financial resources are diverted away from food and subsistence production towards more sophisticated products and encouraging a culture of consumerism can also have negative environmental impacts. Within local economies, small scale and rural businesses of FDI host countries there is less capacity to attract foreign investment and bank credit/loans, and as a result certain domestic businesses may either be forced out of business or to use more informal sources of finance (ECOSOC 2000).


    INFRASTRUCTURE DEVELOPMENT AND TECHNOLOGY TRANSFER

    Parent companies can support their foreign subsidiaries by ensuring adequate human resources and infrastructure are in place. In particular "Greenfield" investments into new business sectors can stimulate new infrastructure development and technologies to host economies. These developments can also result in social and environmental benefits, but only where they "spill over" into host communities and businesses (ECOSOC 2000). Investment in research & development (R&D) from parent companies can stimulate innovation in production and processing techniques in the host country.

    However, this assumes that in-house investment (in R&D, production, management, personnel training) will result in improvements. Foreign technology/organizational techniques may actually be inappropriate to local needs, capital intensive and have a negative effect on local competitors, especially smaller business that are less able to make equivalent adoptions. Similarly external changes in suppliers, customers and other competing firms are not necessarily an improvement on the original domestic-based approaches (UNCTAD 1999).


    "CROWDING IN" OR "CROWDING OUT"

    "Crowding in" occurs where FDI companies can stimulate growth increase and decrease in domestic business within the economy. Whereas "Crowding out" is structure where parent companies dominate local markets, stifling local competition and entrepreneurship. This is reason for policy chilling or regulatory arbitrage where government regulations, such as labour and environmental standards, are kept artificially low to attract foreign investors, this is because lower standards can reduce the short term operative costs for businesses in that country. Exclusive production concessions and preferential treatment to TNCs by host governments can both restrict other foreign investors and encourage oligopolistic (quasi-monopoly) market structure (ECOSOC 2000, UNCTAD 1999).

    Empirical data for these scenarios is variable, but crowding out is thought to be more common in specific sectors. For example, in industries where demand or supply for a product or service is highly price elastic (market sensitive) and capital intensive. Hence regulation brings additional costs of compliance and is therefore much more likely to influence a company's decision to invest in that country (OECD b).


    SCALE AND PACE OF INVESTMENT.

    It may be difficult for some governments, particularly low income countries, to regulate and absorb rapid and large FDI inflows, with regard to regulating the negative impacts of large-scale production growth on social and environment factors (WWF 1999). Also a high proportion of FDI inflows in developing economies are commonly aimed at primary sectors, such as petroleum, mining, agriculture, paper-production, chemicals and utilities. Primary sectors are typically capital and resource intensive, with a greater threshold in economies of scale and therefore slower to produce positive economic "spill over" effects (OECD a). Thus, in the short term, low income economies will have less capacity to mitigate environmental damages or take protective measures, imposing greater remediation costs in the long term, as well as potentially irreversible environmental losses (WWF 1999, OECD b).


    IS IT FDI SUSTAINABLE GROWTH?

    If FDI is to take a greater role in building developing country economies, further assessment of the factors which influence and are influenced by FDI flows is necessary. Foreign companies are thought to be attracted to recipient countries for a whole range of factors, e.g. political stability, market potential & accessibility, repatriation of profits, infrastructure, and ease of currency conversion. Privatization and deregulation of markets are seen as central means to attract FDI, however this can leave the poorest or most indebted countries open to destabilizing market speculation (ECOSOC 2000). National legislation can support better investment security for local markets, fair competition and corporate responsibility through defining equitable, secure, non-discriminatory, transparent investment practices (WSSD 1995, Habitat II 1996). Whilst there is concern that increased regulation could deter new foreign investors, there is evidence, such as in Eastern Europe, that tighter regulation of corporate, environmental and labour standards has not affected FDI growth (ECOSOC 2000). Where low income and developing economies are successful in attracting FDI, they require considerable support to ensure that they can adapt to rapid and large inflows of FDI, and that these flows positively benefit domestic economic stability (WSSD 1995). This means developing strategies which encourage greater and longer term domestic investment and saving, as well as higher returns on investment capital. The development of an international multilateral rule-based trading and investment system has been advocated widely. However, whilst the abandoned Multilateral Agreement on Investment would have provided greater rights for companies and investors, it gave limited support for the social, economic and environmental concerns of host countries. Furthermore, regulation of investment is only as effective as a country's ability to enforce it. The cost of implementation may be prohibitive for many countries, hence bilateral and multilateral support, along side multi-stakeholder participation, is vital for the formulation of such agreements (ECOSOC 2000, Habitat II 1996).


    SOCIALLY RESPONSIBLE INVESTMENT

    Ethical and socially responsible FDI can be encouraged through national, bilateral and international investment guidelines and regulation e.g. consumer rights, information provision, commercial probity, labour standards and corporate culture (UNCTAD 1999). Several institutions have developed or are currently working on responsible practice. The ILO has 180 conventions referring to social responsibility and it also has more specific "Tripartite Declaration of Principles" (1977), concerning TNCs and social policy2. UNCTAD has developed a "Code of Restrictive Business Practices". Eradication of poverty and reduction of gender inequality, where women make up nearly 70% of the worlds poorest, should be prioritized. Whilst governments may seek FDI for labour intensive sectors, those sectors which require greater skills are likely to require investment in domestic training and education. Access to FDI for poorer communities and small to medium enterprises can be promoted by fostering credit/loans and capacity building programs to improve their bargaining power (WCW 1995, WSSD 1995). Intellectual property right agreements between host countries and foreign investors can also be strengthened to ensure domestic technology transfer and skills development are better incorporated (UNCTAD 1999).


    SENVIRONMENTAL PROTECTION

    Greater efforts need to be made to assess the linkages between environmental impacts and FDI, although it may be difficult to isolate FDI impacts from other activities. Authorities and businesses can apply Environmental Management Systems (EMS) to assess the potential impacts of FDI ventures, e.g. ISO 4001 which details techniques such as Life-Cycle-Analysis, Environmental Impact Assessments (EIA) and Environmental Audits. These all require investment in inspection, monitoring, regulation and enforcement to ensure effective implementation. The resources required to effectively adopt these approaches are often lacking in many developing countries, suggesting a vital need for targeted international assistance (UNCTAD 1999). Greater environmental commitment can also bring long term corporate gains e.g. greater efficiency and better quality of practice (OECD b).


    INDIAN ECONOMY IN BRIEF

    One of the world's largest economies, India has made tremendous strides in its economic and social development in the past two decades and is poised to realize even faster growth in the years to come. After growing at about 3.5 percent from the 1950s to the 1970s, India's economy expanded during the 1980s to reach an annual growth rate of about 5.5 percent at the end of the period. It increased its rate of growth to 6.7 percent between 1992–93 and1996–97, as a result of the far-reaching reforms embarked on in 1991 and opening up of the economy to more global competition. Its growth dropped to 5.5 percent from 1997–98 to 2001–02 and to 4.4 percent in 2002–03, due to the impact of poor rains on agricultural output.

    But, thanks to a lavish monsoon that led to a turnaround in the agriculture sector, India's economy surged ahead to reach a growth rate of 8.2 percent in 2003–04. This is very much in line with growth projections cited in India's Tenth Five-Year Plan, which calls for increasing growth to an average of 8 percent between 2002–03 and 2006–07 (India, Planning Commission, 2002 a). Such sustained acceleration is needed to provide opportunities for India's growing population and its even faster-growing workforce.


    Embarking on a new growth path. India has a rich choice set in determining its future growth path. Figure 1 shows what India can achieve by the year 2020, based on different assumptions about its ability to use knowledge, even without any increase in the investment rate. Here, total factor productivity (TFP) is taken to be a proxy for a nation's learning capability. Projections 1, 2, 3, and 4 plot real gross domestic product (GDP) per worker (1995 U.S.dollars) for India assuming different TFP growth rates from 2002 to 2020. Projection 4 is an optimistic scenario that is based on the actual TFP growth rate in Ireland in 1991–2000. Ireland is an example of a country that has been using knowledge effectively to enhance its growth. All things being equal, the projected GDP per worker for India in scenario 4 in 2020is about 50 percent greater than in scenario 1. Knowledge can make a difference between poverty and wealth. Which growth path India embarks on in the future will depend on how well the government, private sector, and civil society can work together to create a common understanding of where the economy should be headed and what it needs to get there. India can no doubt reap tremendous economic gains by developing policies and strategies that focus on making more effective use of knowledge to increase the overall productivity of the economy and the welfare of its population. In so doing, India will be able to improve its international competitiveness and join the ranks of countries that are making a successful transition to the knowledge economy.


    India also needs to boost foreign direct investment (FDI), which can be a facilitator of rapid and efficient transfer and cross-border adoption of new knowledge and technology. FDI flows to India rose by 24 percent between 2002 and 2003, due to its strong growth and improved economic performance, continued liberalization, its market potential, and the growing competitiveness of Indian IT industries. Even so, in 2003, India received $4.26 billion in FDI, compared with $53.5 billion for China (Box 1)! But India's stock is rapidly rising:

    theForeign Direct Investment Confidence Index by A. T. Kearney (2004) shows that China and India dominate the top two positions in the world for most positive investor outlook and likely first-time investments, and are also the most preferred offshore investment locations for business process outsourcing (BPO) functions and IT services.

    Successful economic development is a process of continual economic upgrading in which the business environment in a country evolves to support and encourage increasingly sophisticated ways of competing. A good investment climate provides opportunities and incentives for firms—from microenterprises to multinationals—to invest productively, create jobs, and expand. As a result of investment climate improvements in the 1980s and 1990s, private investment as a share of GDP nearly doubled in China and India. But India needs to continue to foster a good investment climate that encourages firms to invest by removing unjustified costs, risks, and barriers to competition. One reason for India's less competitive markets is excessive regulation of the entry and exit of firms, which face stiffer requirements for obtaining permits and take much longer to get under way than do the firms in many other country. The answer will be determined in large measure by how well both countries utilize their resources. Restrictions on the hiring and firing of workers are also a major obstacle to doing business in India. In addition, enforcing contracts is a major problem: for example, it takes more than a year to resolve a payment dispute.

    So, to strengthen its overall economic and institutional regime, India should continue to address the following related to its product and factor markets and improving its overall infrastructure:

    • Speeding up trade reform by reducing tariff protection and phasing out tariff exemptions. This will help Indian firms gain access to imports at world prices and would also help to encourage exports further.

    • Encouraging FDI and increasing its contribution to economic growth by phasing out remaining FDI restrictions and increasing positive linkages with the rest of the economy.

    • Stimulating growth of manufactured and service exports. In so doing, India could drive down global costs in services, just as China drove down global costs in manufacturing.

    • Strengthening intellectual property rights (IPRs) and their enforcement. India has passed a series of IPR laws in the past few years, and their enforcement will be key to its success in the knowledge economy.

    • Simplifying and expediting all procedures for the entry and exit of firms, for example, through "single window" clearances.

    • Reducing inefficiencies in factor markets by easing restrictions on hiring and firing of workers.

    • Improving access to credit for small and medium enterprises.

    • Addressing problems in the use and transfer of land and updating bankruptcy procedures.

    • Ensuring access to reliable power at reasonable cost by rationalizing power tariffs and improving the financial and operational performance of state electricity boards.

    • Addressing capacity and quality constraints in transport by improving public sector performance and developing speedy, reliable door-to-door transport services (roads, rail, and ports) to enhance India's competitiveness.

    • Improving governance and the efficiency of government, and encouraging the use of ICTs to increase government's transparency and accountability.

    • Using ICTs for more effective delivery of social services, especially in health and education, empowering India's citizens to contribute to and benefit from faster economic growth.

    PREVIOUS RELATED STUDIES

    There exists a large theoretical and empirical literature about the impact of multinational enterprises (MNEs) and foreign direct investment (FDI) on growth in developing countries. In the 1960s and 1970s MNEs were often considered as responsible of persisting or even widening inequalities between industrialized and less developed countries. In recent years a much more optimistic view on the role of MNEs has prevailed. This change reflects both important economic events and theoretical developments. On the one side the debt crisis which started in 1982 left many developing countries with very limited access to foreign financial resources; this made FDI, which is essentially equity and not debt, an attracting form of foreign capital. On the other side the emergence of "endogenous growth" theories stressed the importance of human capital accumulation and technological externalities in the development process. In this respect MNEs, which can rely on the most advanced production and organization methods, are seen as a natural and powerful vehicle of technology transfer to less developed economies. While the classical paper of Findlay (1978) represents a first formal example of the potential link between foreign direct investment and technology transfer, the models of the so called "new growth theory" provide a very useful tool in order to analyze how the introduction of new inputs and technologies influences the production function of a given economy and how externalities affect the research efforts of economic agents and the diffusion of knowledge. Thus, not surprisingly, endogenous growth theory constitutes the predominant theoretical framework within which recent research studies the impact of FDI on growth (e.g. Borensztein et al., 1999, Martin and Ottaviano 1999, etc.).

    The position according to which MNEs play a positive role in the development process is shared by a large part of the academic world and basically by the most important international organizations. As a matter of fact, many developing countries have designed policies in order to attract foreign investment from industrialized countries. But curiously, as noted by de Mello (1997) in his survey about FDI and growth in developing countries, "whether FDI can be deemed to be a catalyst for output growth, capital accumulation and technological progress is a less controversial hypothesis in theory than in practice…". The available empirical literature on the impact of FDI on growth provides contrasting results not only about the existence of a significant link between foreign direct investment and growth rates (of the recipient economy), but also about the sign of such relationship. For ex. in Bornschier (1978) and Dutt (1997) growth rates are negatively related to foreign capital stocks but in Dutt (1996) the same relationship turns out to be positive. Blomström et al. (1992) find a significant positive impact of FDI inflows on growth; in Hein (1992) no significant relationship emerges; the coefficient of FDI is significantly positive or not significant in Balasubramanyam et al. (1996), while in other papers such influence is positive or negative according to the level of development of the recipient country (as in Borensztein et al., 1999, and deMello, 1999).The presence of diverging results is due to econometric issues and to sampling differences. As far as econometrics is concerned, an inadequate treatment of the endogeneity problem characterizes much of the existing empirical literature on international capital flows and growth. To the extent towhich factors like the available stock of infrastructures, the market size, the presence of skilled labor, etc. are recognized to be fundamental determinants of foreign capital inflows to developing countries, we should expect that growth itself is conducive to higher levels of inward FDI.

    This means that a positive correlation between FDI flows and growth says nothing about the underlying causal relationship. Even when a researcher takes care to account for the endogeneity bias, it is not easy to find suitable instrumental variables that are variables which are correlated with FDI flows but not with growth. Anyway, differences in samples are likely to play a key role in explaining why empirical analyses provide contrasting estimates of the sign of the impact of FDI on growth. As noted above, in some recent contributions the influence of foreign capital on growth is positive when the recipient has attained a given level of development (as measured by per-capita income or by the available stock of human capital). Results contained in Borensztein et al. (1999) and also in Blomström et al. (1992) move in this direction. The "development threshold hypothesis" is clearly related to the notion of "absorption capacity", which is commonly referred to in the literature on aid and growth.

    In other words, recipient economies can take advantage of the potential positive externalities associated to the presence of foreign MNEs provided that the technological gap is not too large. Otherwise, MNEs can represent "technological enclaves in the host country, characterized by significant productivity and plant size differentials, and limited productivity spillovers" (de Mello,1997).

    There may be other factors which can discriminate between positive and negative experiences with FDI. Balasubramanyam et al. (1996) find that the influence of MNEs depends on the trade policy regime followed by host countries; the impact of FDI flows is significantly positive in economies which pursue an "export promotion" (EP) strategy and not significant in countries which are characterized by an "import substitution" (IS) policy. This is immediately understandable in a theoretical context of export-led growth. The idea that trade policy choices may determine the impact of FDI dates back to the work of Bhagwati (1973) and to the literature on immiserizing growth.

    Bhagwati (1973) shows that for a small open economy importing a capital intensive good, inward tariff-induced FDI may have a negative impact on host-country welfare. Brecher and Diaz Alejandro (1977) explain that the variation in welfare deriving from tariff-induced FDI inflows may be theoretically decomposed in three parts,

    • The loss in consumption and production deriving from tariff-created distortions (given the initial factor endowments),

    • The loss or gain associated to the accumulation of capital and

    • The loss determined by the repatriation of foreign profits.

    They show that, under certain circumstances, effects (2) and (3) alone necessarily imply a net loss,so that the theoretical hypothesis considered by Bhagwati is actually "the only outcome that canresult from a tariff-induced inflow of untaxed capital from abroad" (Brecher and Diaz Alejandro, 1977). Balasubramanyam et al. (1996) observe also that, when developing economies implement policies in order to protect national industries from foreign competition, a wedge between social and private returns to capital arises and the resulting international specialization of the economy does not reflect its comparative advantage. As a consequence, in a protectionist environment the spillovers associated to FDI are likely to be limited, as the allocation of capital takes place in an economy in which prices are distorted. In conclusion, both differences in the development level and in the trade policy strategy may theoretically help explain how the influence of foreign direct investment on host country growth may vary over different economies.

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