Foreign Direct Investment Flows to India 1 FDI inflows to India remained sluggish, when global FDI flows to EMEs had recovered in 2010- 11, despite sound domestic economic performance ahead of global recovery. The paper gathers evidence through a panel exercise that actual FDI to India during the year 2010-11 fell short of its potential level (reflecting underlying macroeconomic parameters) partly on account of amplification of policy uncertainty as measured through Kauffmann‟s Index. FDI inflows to India witnessed significant moderation in 2010-11 while other EMEs in Asia and Latin America received large inflows. This had raised concerns in the wake of widening current account deficit in India beyond the perceived sustainable level of 3.0 per cent of GDP during April-December 2010. This also assumes significance as FDI is generally known to be the most stable component of capital flows needed to finance the current account deficit. Moreover, it adds to investible resources, provides access to advanced technologies, assists in gaining production know-how and promotes exports. A perusal of India‟s FDI policy vis-à-vis other major emerging market economies (EMEs) reveals that though India‟s approach towards foreign investment has been relatively conservative to begin with, it progressively started catching up with the more liberalised policy stance of other EMEs from the early 1990s onwards, inter alia in terms of wider access to different sectors of the economy, ease of starting business, repatriation of dividend and profits and relaxations regarding norms for owning equity. This progressive liberalisation, coupled with considerable improvement in terms of macroeconomic fundamentals, reflected in growing size of FDI flows to the country that increased nearly 5 fold during first decade of the present millennium. Though the liberal policy stance and strong economic fundamentals appear to have driven the steep rise in FDI flows in India over past one decade and sustained their momentum even during the period of global economic crisis (2008-09 and 2009-10), the subsequent moderation in 1 This is a research study prepared in the Division of International Trade and Finance of the Department of Economic and Policy Research, Reserve Bank of India.
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Foreign Direct Investment Flows to India1
FDI inflows to India remained sluggish, when global FDI flows to EMEs had recovered in 2010-
11, despite sound domestic economic performance ahead of global recovery. The paper gathers
evidence through a panel exercise that actual FDI to India during the year 2010-11 fell short of
its potential level (reflecting underlying macroeconomic parameters) partly on account of
amplification of policy uncertainty as measured through Kauffmann‟s Index.
FDI inflows to India witnessed significant moderation in 2010-11 while other EMEs in
Asia and Latin America received large inflows. This had raised concerns in the wake of
widening current account deficit in India beyond the perceived sustainable level of 3.0 per cent
of GDP during April-December 2010. This also assumes significance as FDI is generally known
to be the most stable component of capital flows needed to finance the current account deficit.
Moreover, it adds to investible resources, provides access to advanced technologies, assists in
gaining production know-how and promotes exports.
A perusal of India‟s FDI policy vis-à-vis other major emerging market economies
(EMEs) reveals that though India‟s approach towards foreign investment has been relatively
conservative to begin with, it progressively started catching up with the more liberalised policy
stance of other EMEs from the early 1990s onwards, inter alia in terms of wider access to
different sectors of the economy, ease of starting business, repatriation of dividend and profits
and relaxations regarding norms for owning equity. This progressive liberalisation, coupled with
considerable improvement in terms of macroeconomic fundamentals, reflected in growing size of
FDI flows to the country that increased nearly 5 fold during first decade of the present
millennium.
Though the liberal policy stance and strong economic fundamentals appear to have driven
the steep rise in FDI flows in India over past one decade and sustained their momentum even
during the period of global economic crisis (2008-09 and 2009-10), the subsequent moderation in
1 This is a research study prepared in the Division of International Trade and Finance of the Department of
Economic and Policy Research, Reserve Bank of India.
investment flows despite faster recovery from the crisis period appears somewhat inexplicable.
Survey of empirical literature and analysis presented in the paper seems to suggest that these
divergent trends in FDI flows could be the result of certain institutional factors that dampened
the investors‟ sentiments despite continued strength of economic fundamentals. Findings of the
panel exercise, examining FDI trends in 10 select EMEs over the last 7 year period, suggest that
apart from macro fundamentals, institutional factors such as time taken to meet various
procedural requirements make significant impact on FDI inflows.
This paper has been organised as follows: Section 1 presents trends in global investment
flows with particular focus on EMEs and India. Section 2 traces the evolution of India‟s FDI
policy framework, followed by cross-country experience reflecting on India‟s FDI policy vis-à-
vis that of select EMEs. Section 3 deals with plausible explanations of relative slowdown in FDI
flows to India in 2010-11 and arrives at an econometric evidence using panel estimation. The last
section presents the conclusions.
Section 1: Trends in FDI Inflows
Widening growth differential across economies and gradual opening up of capital
accounts in the emerging world resulted in a steep rise in cross border investment flows during
the past two decades. This section briefly presents the recent trends in global capital flows
particularly to emerging economies including India.
1.1 Global Trends in FDI Inflows
During the period subsequent to dotcom burst, there has been an unprecedented rise in
the cross-border flows and this exuberance was sustained until the occurrence of global financial
crisis in the year 2008-09. Between 2003 and 2007, global FDI flows grew nearly four -fold and
flows to EMEs during this period, grew by about three-fold. After reaching a peak of US$ 2.1
trillion in 2007, global FDI flows witnessed significant moderation over the next two years to
touch US$ 1.1 trillion in 2009, following the global financial crisis. On the other hand, FDI flows
to developing countries increased from US$ 565 billion in 2007 to US$ 630 billion in 2008
before moderating to US$ 478 billion in 2009.
The decline in global FDI during 2009 was mainly attributed to subdued cross border
merger and acquisition (M&A) activities and weaker return prospects for foreign affiliates,
which adversely impacted equity investments as well as reinvested earnings. According to
UNCTAD, decline in M&A activities occurred as the turmoil in stock markets obscured the price
signals upon which M&As rely. There was a decline in the number of green field investment
cases as well, particularly those related to business and financial services.
From an institutional perspective, FDI by private equity funds declined as their fund
raising dropped on the back of investors‟ risk aversion and the collapse of the leveraged buyout
market in tune with the deterioration in credit market conditions. On the other hand, FDI from
sovereign wealth funds (SWFs) rose by 15 per cent in 2009. This was apparently due to the
revised investment strategy of SWFs - who have been moving away from banking and financial
sector towards primary and manufacturing sector, which are less vulnerable to financial market
developments as well as focusing more on Asia.
As the world economic recovery continued to be uncertain and fragile, global FDI flows
remained stagnant at US $ 1.1 trillion in 2010. According to UNCTAD‟s Global Investment
Trends Monitor (released on January 17, 2011), although global FDI flows at aggregate level
remained stagnant, they showed an uneven pattern across regions – while it contracted further in
advanced economies by about 7 per cent, FDI flows recovered by almost 10 per cent in case of
developing economies as a group driven by strong rebound in FDI flows in many countries of
Latin America and Asia. Rebound in FDI flows to developing countries has been on the back of
improved corporate profitability and some improvement in M&A activities with improved
valuations of assets in the stock markets and increased financial capability of potential buyers.
Improved macroeconomic conditions, particularly in the emerging economies, which
boosted corporate profits coupled with better stock market valuations and rising business
confidence augured well for global FDI prospects. According to UNCTAD, these favourable
developments may help translate MNC‟s record level of cash holdings (estimated to be in the
range of US$ 4-5 trillion among developed countries‟ firms alone) into new investments during
2011. The share of developing countries, which now constitutes over 50 per cent in total FDI
inflows, may increase further on the back of strong growth prospects. However, currency
volatility, sovereign debt problems and potential protectionist policies may pose some risks to this
positive outlook. Nonetheless, according to the Institute of International Finance (January 2011),
net FDI flows to EMEs was projected to increase by over 11 per cent in 2011. FDI flows into
select countries are given in Table 1.
Table 1 : Countries with Higher Estimated Level of FDI Inflows than India in 2010
Amount (US$ billion) Variation (Per cent)
2007 2008 2009 2010
(Estimates) 2008 2009
2010
(Estimates)
World 2100.0 1770.9 1114.2 1122.0 -15.7 -37.1 0.7
Developed Economies 1444.1 1018.3 565.9 526.6 -29.5 -44.4 -6.9
United States 266.0 324.6 129.9 186.1 22.0 -60.0 43.3
France 96.2 62.3 59.6 57.4 -35.2 -4.3 -3.7
Belgium 118.4 110.0 33.8 50.5 -7.1 -69.3 49.4
United Kingdom 186.4 91.5 45.7 46.2 -50.9 -50.1 1.1
where the a(i)s are individual specific constants, and the d(i)s are group specific dummy
variables which equal 1 only when j = i.
Panel has been estimated for the period 2000-01 to 2010-11 for 10 countries5.
Results
The estimated equation6 is shown below, with t-statistics shown in parentheses:
(2.6) (6.1) (2.3) (3.5)
4 As some specific economies among the emerging market economies that are believed to offer competition to
India, have been included in the sample, it cannot be treated as random sampling. 5 Panel is unbalanced as data on labour cost for all the countries were not available beyond 2008-09. However,
results for a balanced panel estimated for 2000-01 to 2008-09, were not significantly different from the results of
full period panel and inferences did not vary in any manner. 6 To account for the risk aversion during global financial crisis, dummy for 2009/2010 has been incorporated. Apart
from this, an India specific dummy for the period 2004/2005 has also been used.
(2.6) (4.1) (2.4)
R2 = .75, D.W. = 2.04
where
fy – foreign direct investment to GDP ratio; Openness – current flows to GDP ratio; Gdiff –
growth differential amongst the sample countries; dwages – change in labour cost; FDIEMERG
= size of FDI to emerging economies; IIPY – Net International Investment Position; Govt.
Effect – Index of Government Effectiveness (Kaufmann Index).
In line with a priori expectations, all the pull factors viz., openness, growth differential,
net international investment position and Kaufmann Index of Government Effectiveness were
found to be positively related. Labour cost, as expected, had inverse relationship with FDI
inflows. All the variables were statistically significant. Similarly, the push factor captured
through size of FDI flowing into emerging economies was also found to be positively related and
impact has been statistically significant.
GDP in PPP terms capturing size of the market was also examined. Although it was
statistically insignificant (not reported), its sign was in line with a priori expectations, i.e., bigger
the market size larger the FDI flows. Similarly, the sign for exchange rate although correct as per
a priori expectation, was statistically insignificant and has not been reported.
The results show that ten percentage points rise in openness, growth differential and IIP
cause 0.3, 0.8 and .2 percentage point rise in FDI to GDP ratio, respectively. Similarly, every
US$ 10 billion rise in the size of global FDI to emerging economies causes 0.09 percentage point
rise in FDI/GDP ratio. On the other hand, every US$ 10 rise in the wage rate is likely to reduce
the FDI ratio by .04 percentage points.
The Index denoting „Government Effectiveness (Gov. Effect) as expected has inverse
relationship with FDI flows implying that policy certainty could be a major determinant of FDI
inflows. As per our results, if Gov Effect Index rises by one point on the scale of -2.5 to 2.5, FDI
to GDP ratio rises by 4 percentage points.
Thus, the panel results show that higher the degree of openness, expected growth of the
economy, net international assets and size of FDI flows to EMEs, larger the size of FDI that
flows to the country. Similarly, higher the certainty of implementation of efficient and quality
policies, higher would be the flow of FDI. On the other hand, higher labour cost is likely to
discourage the flow of FDI to the country.
What caused dip in FDI flows to India during 2010-11?
Our empirical exercise portrays a range of factors that significantly impact the size of
FDI flows. With a view to segregate the impact of non-economic factors including government
policy, a contra factual scenario is generated for the year 2010-11 by updating values for all the
explanatory variables except for the Kaufmann Index. Estimated potential and actual FDI levels
are presented in the Chart 3 and contra factual scenario that assumes no deterioration in
government effectiveness index has been presented in Chart 3a.
It could be observed from Chart 3 that actual FDI to India closely tracked the potential
FDI path. The potential FDI level is the estimated level that should occur given the trends in
underlying fundamentals. In the year 2010-11, the actual FDI flows at 1.5 per cent of GDP are
marginally lower than the estimated level of 1.8 per cent of GDP. Chart 3a, presents a contra-
factual scenario where potential level of FDI flows for the year 2010-11 is worked out by
updating values of all the variables except „Govt. Effect‟. The latter is retained at preceding
year‟s level. In could be observed that in case of contra-factual scenario, in the year 2010-11,
gap between potential and actual level of FDI increased by more than 25 per cent. Since, the
contra factual estimated for 2010-11 updated value of all other variables except Govt. Effect, the
larger gap between potential and the actual in the year could be attributed to index of
Government Effectiveness7.
7 While determining various drivers of FDI, apart from value of FDI, impact in terms of number of FDI
proposals was also explored. It was found that results drawn in terms of value of FDI or in terms of number of
proposals are consistent. It was observed that when value of FDI declined, number of large size investment
proposals were also lower.
In other words, contra factual estimate of FDI for the year 2010-11 incorporates impact
of all the economic variables, viz., growth differential, openness, net IIP, labour cost and size of
„FDI to all emerging economies‟ whereas it keeps qualitative variable „Govt. Effect‟ unaltered.
Keeping „Govt. Effect‟ unaltered means that had there been no amplification in policy
uncertainty over the preceding year‟s level, FDI inflows to India would have been more than 35
per cent higher than that was actually received.
Thus, empirical results corroborate our assertion made in the analytics presented above
that the qualitative factors play an important role in attracting FDI flows, and slowdown in FDI
flows in the absence of any deterioration in the macro economic variables could probably be on
account of such qualitative factors.
Section 4: Conclusions
An analysis of the recent trends in FDI flows at the global level as well as across
regions/countries suggests that India has generally attracted higher FDI flows in line with its
robust domestic economic performance and gradual liberalisation of the FDI policy as part of the
cautious capital account liberalisation process. Even during the recent global crisis, FDI inflows
to India did not show as much moderation as was the case at the global level as well as in other
EMEs. However, when the global FDI flows to EMEs recovered during 2010-11, FDI flows to
India remained sluggish despite relatively better domestic economic performance ahead of global
recovery. This has raised questions especially in the backdrop of the widening of the current
account deficit beyond the sustainable level of about 3 per cent.
In order to analyse the factors behind such moderation, an empirical exercise was
undertaken which did suggest the role of institutional factors (Government‟s to implement
quality policy regime) in causing the slowdown in FDI inflows to India despite robustness of
macroeconomic variables.
A panel exercise for 10 major EMEs showed that FDI is significantly influenced by
openness, growth prospects, macroeconomic sustainability (International Investment Position),
labour cost and policy environment.
A comparison of actual FDI flows to India vis-à-vis the potential level worked out on the
basis of underlying macroeconomic fundamentals showed that actual FDI which has generally
tracked the potential level till 2009-10, fell short of its potential by about 25 per cent during
2010-11. Further, counter factual scenario attempted to segregate economic and non-economic
factors seemed to suggest that this large divergence between actual and potential during 2010-11
was partly on account of rise in policy uncertainty .
Apart from the role of institutional factors, as compared to other EMEs, there are also
certain sectors including agriculture where FDI is not allowed, while the sectoral caps in some
sectors such as insurance and media are relatively low compared to the global patterns. In this
context, it may be noted that the caps and restrictions are based on domestic considerations and
there is no uniform standards that fits all countries. However, as the economy integrates further
with the global economy and domestic economic and political conditions permit, there may be a
need to relook at the sectoral caps (especially in insurance) and restrictions on FDI flows
(especially in multi-brand retail). Further, given the international experience, it is argued that
FDI in retail would help in reaping the benefits of organised supply chains and reduction in
wastage in terms of better prices to both farmers and consumers. The main apprehensions in
India, however, are that FDI in retail would expose the domestic retailers – especially the small
family managed outlets - to unfair competition and thereby eventually leading to large-scale exit
of domestic retailers and hence significant job losses. A balanced and objective view needs to be
taken in this regard. Another important sector is the generation, transmission and distribution of
electricity produced in atomic power, where FDI is not permitted at present, may merit a revisit.
In this context, it may be noted that electricity distribution services is a preferred sector for FDI.
According to UNCTAD four out of top ten cross-border deals during 2009 were in this segment,
which led to increase in FDI in this sector even in the face of decline in overall FDI. Similarly,
the demands for raising the present FDI limits of 26 per cent in the insurance sector may be
reviewed taking into account the changing demographic patterns as well as the role of insurance
companies in supplying the required long term finance in the economy.
Against this backdrop, it is pertinent to highlight the number of measures announced by
the Government of India on April 1, 2011 to further liberalise the FDI policy to promote FDI
inflows to India. These measures, inter alia included (i) allowing issuance of equity shares
against non-cash transactions such as import of capital goods under the approval route, (ii)
removal of the condition of prior approval in case of existing joint ventures/technical
collaborations in the „same field‟, (iii) providing the flexibility to companies to prescribe a
conversion formula subject to FEMA/SEBI guidelines instead of specifying the price of
convertible instruments upfront, (iv) simplifying the procedures for classification of companies
into two categories – „companies owned or controlled by foreign investors‟ and „companies
owned and controlled by Indian residents‟ and (v) allowing FDI in the development and
production of seeds and planting material without the stipulation of „under controlled
conditions‟. These measures are expected to boost India‟s image as a preferred investment
destination and attract FDI inflows to India in the near future.
References:
Ahluwalia, M. S. (2011), “FDI in multi-brand retail is good, benefits farmers”, The Times of
India, http://timesofindia.indiatimes.com/business/india-business/FDI-in-multi-brand-retail-