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Literature Review On Fdi And Economic Growth Economics Essay

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Published: Mon, 5 Dec 2016

A number of studies have analyzed the relationship between FDI inflows and economic growth, the issue is far from settled in view of the mixed findings reached. Most of these studies have typically adopted standard growth accounting framework for analyzing the effect of FDI inflows on growth of national income along with other factors of production. Within the framework of the neo-classical models (Solow, 1956) the impact of the FDI on the growth rate of output was constrained by the existence of diminishing returns in the physical capital. Therefore, FDI could only exert a level effect on the output per capita, but not a rate effect. In other words, it was unable to alter the growth rate of output in the long run. It is not surprising, thus, that FDI was not considered seriously as a drive engine of growth by mainstream economics.

In the contrast, the New Theory of Economic Growth, however, concludes that FDI may affect not only the level of output per capita but also its rate of growth. This literature has developed various arguments that explain why FDI may potentially enhance the growth rate of per capita income in the host country, the identified channels to boost economic growth include increased capital accumulation in the recipient economy, improved efficiency of locally owned host country firms via contract and demonstration effects, and their exposure to fierce competition, technological change, and human capital augmentation and increased exports. However, the extent to which FDI contributes to growth depends on the economic and social condition or in short, the quality of environment of the recipient country (Buckley, Clegg, Wang, & Cross, 2002). This quality of environment relates to the rate of savings in the host country, the degree of openness and the level of technological development. Host countries with high rate of savings, open trade regime and high technological product would benefit from increase FDI to their economies.

Many empirical works are available in the economic literature showing the causal relationship between FDI and growth. At the firm level, several studies provided evidence of technological spillover and improved plant productivity. At the macro level, FDI inflows in developing countries tend to “crowd in” other investment and are associated with an overall increase in total investment. Most studies found that FDI inflows led to higher per capita GDP, increase economic growth rate and higher productivity growth (see e.g. De Mello 1997, Kumar and Siddharthan 1997, & Saggi 2000, for recent reviews of literature).

FDI increases technical progress in the host country by means of a contagion effect, (Findlay, 1978) which eases the adoption of advanced managerial procedures by the local firms. Similarly (De Gregorio, 1992) analyzed a panel of 12 Latin American countries in the period 150-1985. His results suggest a positive and significant impact of FDI on economic growth. In addition the study shows that the productivity of FDI is higher than the productivity of domestic investment. While, (Fry, 1992) examined the role of FDI in promoting growth by using the framework of a macro-model for a pooled time series cross section data of 16 developing countries for 1966-88 period. The countries included in the sample are Argentina, Brazil, Chile, Egypt, India, Mexico, Nigeria, Pakistan, Sri Lanka, Turkey, Venezuela, and 5 Pacific basin countries viz. Indonesia, Korea, Malaysia, Philippines, Thailand. For his sample as a whole he did not find FDI to exert a significantly different effect from domestically financed investment on the rate of economic growth, as the coefficient of FDI after controlling for gross investment rate was not significantly different from zero in statistical terms. FDI had a significant negative effect on domestic investment suggesting that it crowds-out domestic investment. Hence FDI appears to have been immiserizing. However, this effect varies across countries and in the Pacific basin countries FDI seems to have crowded-in domestic investment.

FDI inflows had a significant positive effect on the average growth rate of per capita income for a sample of 78 developing and 23 developed countries as found by (Blomström et.al, 1994). However, when the sample of developing countries was split between two groups based on level of per capita income, the effect of FDI on growth of lower income developing countries was not statistically significant although still with a positive sign. They argue that least developed countries learn very little from MNEs because domestic enterprises are too far behind in their technological levels to be either imitators or suppliers to MNEs. In this regard, another study was conducted by (Borensztein, et.al, 1995) he included 69 developing countries in his sample. The study found that the effect of FDI on host country growth is dependent on stock of human capital. They infer from it that flow of advanced technology brought along by FDI can increase the growth rate only by interacting with country’s absorptive capability. They also find FDI to be stimulating total fixed investment more than proportionately. In other words, FDI crowds-in domestic investment. However, the results are not robust across specifications.

Export-oriented strategy and the effect of FDI on average growth rate for the period 1970-85 for the cross-section of 46 countries as well as the sub-sample of countries that are deemed to pursue export-oriented strategy was found to be positive (Balasubramanyam et.al, 1996) and significant but not significant and sometimes negative for the sub-set of countries pursuing inward-oriented strategy. Accordingly (Sanchez-Robles, 1998) explored empirically the correlation among public infrastructure and economic growth in Latin America in the period 1970-1985. She also found a positive and significant impact of FDI on the economic growth of the countries of this area.

Another economist (De Mello 1999) also conducted time series as well as panel data estimation. He included a sample of 15 developed and 17 developing countries for the period 1970-90. The study found strong relationship between FDI, capital accumulation, output and productivity growth. The time series estimations suggest that effect of FDI on growth or on capital accumulation and total factor productivity (TFP) varies greatly across the countries. The panel data estimation indicates a positive impact of FDI on output growth for developed and developing country sub-samples. However, the effect of FDI on capital accumulation and TFP growth varies across developed (technological leaders) and developing countries (technological followers). FDI has a positive effect on TFP growth in developed countries but a negative effect in developing countries but the pattern is reversed in case of effect on capital accumulation. De Mello infers from these findings that the extent to which FDI is growth-enhancing depends on the degree of complementarity between FDI and domestic investment, in line with the eclectic approach given by (Dunning, 1981). The degree of substitutability between foreign and domestic capital stocks appears to be greater in technologically advanced countries than in developing countries. Developing countries may have difficulty in using and diffusing new technologies of MNEs.

Findings of (Xu, 2000) for US FDI in 40 countries for the period 1966-94 also support the finding of De Mello that technology transfer from FDI contributes to productivity growth in developed countries but not in developing countries, which he attributes to lack of adequate human capital. (Agosin and Mayer, 2000) analyzed the effect of lagged values of FDI inflows on investment rates in host countries to examine whether FDI crowds-in or crowds-out domestic investment over the 1970-95 period. They conclude that FDI crowds-in domestic investment in Asian countries crowds-out in Latin American countries while in Africa their relationship is neutral (or one-to-one between FDI and total investment). Therefore, they conclude that effects of FDI have by no means always favourable and simplistic policies are unlikely to be optimal.

These regional patterns tend to corroborate the findings of (Fry, 1992) who also reported East Asian countries to have a complementarity between FDI and total investment. In another study by (Pradhan, 2001) found a significant positive effect of lagged FDI inflows on growth rates only for Latin American countries. He used a panel data estimation covering 1975-95 period for 71 developing countries. The study sheds light that the effect of FDI was not significantly different from zero for the overall sample and for other regions.

A number of early studies have generally reported an insignificant effect of FDI on growth in developing host countries. FDI may have negative effect on the growth prospect of the recipient economy if they give rise to a substantial reverse flows in the form of remittances of profits, particularly if resources are remitted through transfer pricing and dividends and/or if the transnational corporations (TNCs) obtain substantial or other concessions from the host country. For instance, Singh, (1988) found FDI penetration variable to have a little or no consequences for economic or industrial growth in a sample of 73 developing countries. In the same way (Hien, 1992) reported an insignificant effect of FDI inflows on medium term economic growth of per capita income for a sample of 41developing countries.

For studies conducted in Pakistan a study was conducted by (Shabir and Mahmood, 1992) analyzed the relationship between foreign private investment FPI and economic growth in Pakistan. The study used the data for 1959-60 to 1987-88; the study concluded that net foreign private investment (FPI) and disbursements of grants and external loans (DISB) had a positive impact on the rate of growth of real GNP. However they did not treat FDI as a separate variable. Similarly (Ahmed, Butt, and Alam, 2003) examined the causal relationship between FDI, exports and output by employing Granger non-causality procedure over the period 1972 to 2001 in Pakistan. They found significant effect from FDI to domestic output, in contrast to the above mentioned studies.

Studies from the Indian perspective

Bary Rose Worth, Anand Virmani and Susan Collins (2007) study empirically India’s economic growth experience during 1960-2004 focusing on the post 1973 acceleration. The analysis focuses on the unusual dimensions of India’s experience: the concentration of growth in the service production and the modest level of human and physical capital accumulation. They find that India will need to broaden its current expansion to provide manufactured goods to the world market and jobs for its large pool of low skilled workers. Increased public saving as well as rise in foreign saving, particularly FDI could augment the rising household saving and support the increased investment necessary to sustain rapid growth.

Studying outward FDI by India Prof. Subramanyam and Prof. Bhuma (2006) find that government expenses and labour outflows have significant elasticity with respect to

Commenting on FDI and globalization trends in India, Francoise Hay (2006) says that since India opened up in 1991 within the framework of legal economic reforms, the FDI inflows were stimulated in industries and services benefiting from the many comparative advantages of the country. In parallel some Indian firms started to grow in importance and to invest abroad. They had the financial means, experience and ambition to acquire international recognition and they were encouraged by the Indian Government. He finds that the FDI from the Indian firms were principally addressed to the developing countries and Russia, however, the share of the industrialized countries was on the rise and the manufacturing and non-financial sectors accounted for the bulk of it.

In order to provide foreign investors a latest picture of investment environment in India, Peng Hu (2006) in his study analyses various determinants that influence FDI inflows to India including economic growth, domestic demand, currency stability, government policy and labour force availability against other countries that are attracting FDI inflows. Analyzing the new findings it is interesting to note that India has some competitive advantage in attracting FDI inflows, like a large pool of high quality labour force which is an absolute advantage of India against other developing countries like China and Mexico, to attract FDI inflows. In consequence this study argues that India is an ideal investment destination for foreign investors.

In their study on FDI and its economic effects in India, Chandana Chakraborty and Peter Nunnenkamp (2006) assess the growth implications of FDI in India by subjecting industry specific FDI and output to causality tests. Their study is based on the premise that the composition and type of FDI has changed in India since 1991 which has led to high expectations that FDI may serve as a catalyst to higher economic growth. They find that the growth effects of FDI vary widely across sectors. FDI stocks and output are mutually reinforcing in the manufacturing sector. They also find only transitory effects of FDI on output in the services sector which attracted the bulk of FDI in the post-reform period. These differences in the FDI growth relationship suggest that FDI is unlikely to work wonders in India if only remaining regulations were relaxed and more industries opened up to FDI.

Kulwinder Singh (2005) has analysed FDI flows from 1991-2005. A sectoral analysis in his study reveals that while FDI shows a gradual increase and has become a staple of success in India, the progress is hollow. The telecommunications and power sector are the reasons for the success of infrastructure. He comments that FDI has become a game of numbers where the justification for the growth and progress is the money that flows in and not the specific problems plaguing the individual sub sectors. He finds that in the comparative studies the notion of infrastructure has gone a definitional change. FDI in sectors is held up primarily by telecommunications and power and is not evenly distributed.

Mohan Guruswamy, Kamal Sharma et. al. (2005) discuss the retail industry in India in their study on FDI in the retail sector. They focus on the “labour displacing” effect on employment due to FDI in the retail sector. They say that though most of the strong arguments in favour of FDI in the retail sector are not without some merit, it is not fully applicable to the retailing sector and the primary task of the Government in India is still to provide livelihood and not create so called efficiencies of scale by creating redundancies.

Chandra Mohan (2005) in his study on FDI in India is of the view that India has not been able to attract a good level of FDI and he argues that the current level of FDI appears respectful due to a more liberal definition of FDI which was actually adopted to make our comparison with the Chinese FDI more comfortable. He says that the Government must not consider foreign investments sacrosanct. Instead he advises the Government to indulge in more proactive strategies to seek more FDI for which it must help in removing the procedural hassles at the state level. Also the government should make the investment climate more conducive along with a proper regulatory approach for the flagship investors which would encourage the risk-averse small manufacturing enterprises to turn out in larger numbers.

Examining India’s experience with capital flows, Ajay shah and Ila Patnaik (2004) discuss India’s policies towards capital flows in the last two decades. They point out that since the early nineties India has implemented policies aimed at liberalizing trade and deregulating investment decisions. Throughout most of this period India has maintained strong controls on debt flows and has encouraged FDI and portfolio flows. At the same time the Indian authorities have adopted a pegged nominal exchange rate. According to them, domestic institutional factors have resulted in relatively small FDI and large portfolio flows. They also point out that one of India’s most severe policy dilemmas during this period has been related to the tension between capital flows and currency regime. They agree that in spite of the progress achieved since the reforms were adopted the goal of finding a consistent way to augment investment using current account deficits has remained elusive.

Commenting on FDI in India, P.L Beena et. al. (2004) agree to the fact that India has come a long way since 1991 as regards the quantum of FDI inflows is concerned, though there is a view that the MNCs are discouraged from investing in India by bureaucratic hurdles and uncertainty of the economic reforms. However, they feel that very little discussion has taken on the experience of the MNCs and the relationship between their performance and experience with the operating environment and the extent of spillovers in the form of technology transfers. The importance of the former is that the satisfaction of the expectations of the MNCs that are already operational within India is an important precondition for growth in FDI inflow. Transfer of technology and know how on the other hand is at least likely to have an impact on India’s future growth and the quantum of FDI inflow. They argue that to the extent that India’s future growth will depend on the global competitiveness of its firms, the importance of such spillovers can be paramount.

V.N. Balasubramanyam and Vidya Mahambre (2003) in their study of FDI in India conclude that FDI is a very good means for the transfer of technology and know how to the developing countries. They do not find any reasons to regard China as a role model for India. They agree with the advocacy of the policies designed to remove various sorts of distortions in the product and factor markets. These are policies which should be adopted in the interests of both the domestic and foreign investment. A level playing field for one and all may be a much better bet than specific policies geared to the promotion of FDI. The study suggests that India may be better placed than in the past to effectively utilize licensing and technical collaboration agreements as opposed to FDI.

Raghbendra Jha (2003) has made his study on the recent trends in FDI flows in India. He finds that FDI flows to India have not been commensurate with her economic potential and performance. With FDI becoming a significant component of investment recently, accounting practices in India lagged behind international norms. However, the GOI revised its computation of FDI figures in line with the best international practices, which has led to a substantial improvement in FDI figures. The author, however, says that the quality of FDI as manifest in technological spillovers, export performance etc. is more important than its quantity.

There have been a lot of studies on FDI and the determinants for its flow. It is generally agreed that low capital output ratio and high labour productivity are the two attractive reasons for the flow of FDI. It is also commonly held that high wage is a deterrent to the flow of FDI. In his study, Birendra Kumar and Surya Dev (2003) show, with the data available in the Indian context, that the increasing trend in the absolute wage of the worker does not deter the increasing flow of FDI. To explain this intriguing phenomenon the authors have considered the ratio of wage to the value a worker adds. It is found that this ratio is declining though the absolute wages are increasing. It is this decline in the ratio that correspondingly promises more return on the capital invested and, therefore, is held as an important reason for the flow of FDI; not withstanding the increase in absolute labour wage. This ratio in his study is taken as a definition for the measure of the bargaining power of labour. The study undertaken here implies that the bargaining power of the labour cannot be ignored as a determinant for the flow of FDI.

T.N Srinivasan (2001) in his study evaluates India’s transition from an inward oriented development strategy to greater participation in the world economy. While tariff rates have decreased significantly over the past decade, he finds India still as one of the more autarkic countries. Despite improvement over the past in export performance, India still continues to lag behind its South and East Asian neighbors. Secondly official debt flows have largely been replaced by FDI and portfolio investment flows in 1990s. He argues that India’s participation in the future round of multilateral trade negotiations would benefit India. He says that further reforms are required in labour and bankruptcy laws, real privatization and fiscal consolidation.

Studying export growth in India, Kishore Sharma (2000) finds that export growth in India has been much faster than GDP growth over the past few decades. Several factors have contributed to this phenomenon including FDI. However, despite increasing inflows of FDI in recent years there has been no attempt to assess its contribution to India’s export performance – one of the channels through which FDI influences growth. Using annual data from 1970-1998, he investigates the determinants of export performance in India .Results suggest that the demand for Indian exports increases when its export prices fall in relation to the world prices. Further the real appreciation of the rupee adversely affects the Indian exports. Export supply is positively related to domestic relative price of exports and higher domestic demand reduces export supply. Foreign investment appears to have statistically no significant impact on export performance although the coefficient of FDI has a positive sign.


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