Locational Determinants of Foreign Direct Investment in India: a Time Series Analysis

IntroductionFigure: 2
Foreign direct investment (FDI) is probably one ofFigure 2 shows that the FDI inward and outward
the most significant factors leading to thevalues for the year 2004 to 2006, and figure 3
globalization of the international economy. FDI inflowsshows the comparative statement of FDI inwards
to the developing countries increased remarkably inand outwards of India and China for the year 1990
the 1990s and now accounts for about 40 per centto 2000. This information made the clear picture of
of global FDI.the importance of the locational determinants for
Similar trends have also been observed in India.attracting foreign direct investments towards the
Foreign direct investment in India has expandedhost country. As is evident from these figures India
rapidly following the liberalization program initiated inhas only very recently emerged as a destination for
the early 1990s. The immediate challenge before theFDI since the pre-reform years were marked with a
Congress Government constituted in 1991 was tosharp antipathy toward foreign capital unless under
overcome the severe economic crises and direct thecertain conditions. Reliable data on actual FDI inflows
economy towards a sustained growth. Acceleratinginto different sectors is not available. On the basis of
economic growth through liberalization and“approvals” data it appears that much of the
globalization necessitated not only dismantling theFDI is directed towards infrastructure and energy
stringent rules and regulations but also inviting foreignsectors. More approvals were made in the
capital and technology. It also meant restructuring itsnonmanufacturing sector as compared to the
trade regime to prepare the economy for greatermanufacturing sector. Metallurgy, power and fuel
integration with the global economy.sectors recorded the most growth with falls in
Gradually the interaction and interdependence oftransport, industrial machinery and food processing.
economic and foreign policies intensified during theFigure: 3
first half of 1990s. It situates the process ofThe services sector (including telecommunications)
economic liberalization in the wider context of foreignincreased its share during 1992-94 but this growth
policy to explore the interaction between economicsslackened off due to shortfall in demand. Since
and politics in India during the period of 1990-1995.several key subjects (such as education, health,
The major policy shift from the IS strategy towardsroads (except national highways), electricity, property
a more outward oriented economy led by exportrights etc.) lie within the jurisdiction of individual
development has attracted the interest of foreignstates, the progress of administrative reforms at the
investors in India. Figure 1 shows this trend in thelevel of state governments is an important
level of annual inflows of both actual FDI for thedeterminant of state level economic performance in
period 1997-2004several years including State domestic product
Figure: 1 Actual FDI (Net) 1997-2004growth, investment, infrastructure and attractiveness
Source: Economic survey 2004-2005,( http:as FDI destinations.
indiabudget.nic.in)In the past decade FDI approvals varied considerably
Aggregate FDI inflows into India were somewhatover the geographical span of India. Four states
lower during 2003-04 as compared to that duringnamely Karnataka, Maharashtra, Tamilnadu and
2002-03. The reduction is attributable to a smallGujarat accounted for over one-third of total FDI
decline (US$379 million) in fresh equity capital inflowsapprovals. The shares of these individual states were,
in 2003-04. Reinvested earnings during 2003-04 atrespectively, 7.6%, 13.7%, 6.7% and 5.3%. The
US$1.8 billion were more or less the same as inshares of other major states were considerably
2002-03. FDI flows into India, on BOP basis, afterlower: West Bengal (3.7%), Andhra Pradesh (4.2%),
rising sharply from 1999-2000, have been showing aMadhya Pradesh (4.5%) and Orissa (3.8 %). The
decline since 2001-02. FDI (net) undertaken by Indianshares of Kerala, Haryana, Punjab and Rajasthan
enterprises overseas, was also lower at US$1.3 billionwere comparatively smaller whereas the flow of FDI
during 2003-04, compared to US$1.8 billion in 2002-03.into populous states such as Bihar and Uttar Pradesh
India seems a quite attractive location to manyhas been virtually negligible. The rate of approval
foreign multinational enterprises (MNEs) due toincreased considerably and that influenced on the FDI
favorable factors such as high economic growth, fastflows to India. The USA is the largest investor in
growing population, English speaking people, lowerIndia with investment of over
cost for workers etcRs. 570 billion (as on 2002).
Earlier there have been relatively few empiricalIt would be easier if we could see the sector wise
studies which have examined location decisions ofcomparison of FDI and the corresponding GDP values.
MNEs choosing India as an investment location.Figure 4 shows the comparative information for the
Previous studies have relied more on collection ofrecent period. From that we could understand the
primary data using managerial perceptions forsectoral real growth rates in GDP for the year 2000
measuring the explanatory factors. The rapid growthto 2005. The lower contribution of industry to GDP
of FDI and its increasing importance, it is critical forgrowth relative to services in recent years is partly
both the public and private sectors to have asbecause of its lower share in GDP, and does not
complete an understanding of the macroeconomicadequately capture the signs of industrial resurgence.
determinants of this phenomenon as possible. BuildingFirst, growth of industrial sector, from a low of 2.7
on the prior literature the focus of this paper is onper cent in 2001-02, revived to 7.1 per cent and 7.4
the location-related determinants of FDI. This isper cent in 2002-03 and 2003-04, respectively, and
undertaken by means of a time series analysis ofafter accelerating to over 9.5 per cent in the next
major locational factors impacting upon the level oftwo years, touched 10.0 per cent in 2006-07. Second,
FDI inflows for the period of 1997-2004.growth of industry, as a proportion of the
corresponding growth in services, which was 78.9 per
Locational determinants of foreign direct investmentcent on an average between 1991-92 and 1999-2000,
A firm becomes multinational mainly for threeimproved to 88.7 per cent in the last seven years.
reasons. They are Ownership advantages,Figure: 4
Location-specific advantages and Internalization. InSectoral real growth rates in GDP at factor cost
this study, we focus on the location-specific(At 1999-2000 prices)
advantages of the host country as determinants ofIndustrial growth would have been even higher, had it
FDI in order to account for the geographicalnot been for a relatively disappointing performance of
distribution of FDI inflows across transition economies.the other two sub-sectors, namely, mining and
Large market size, proximity to home market,quarrying; and electricity, gas and water supply.
low-cost labor and favorable tax treatment in theIndustry has never consistently grown at over seven
host country are all considered as locationpercent per year for more than three years in a row
advantages. At the same time, we also address tobefore 2004-05. Every year, manufacturing, according
transition specific issues such as changes into the monthly Index of Industrial Production (IIP)
macroeconomic and institutional environments.available until December 2006, has been growing at
Location-specific advantages are further classified bydouble digit rates every month since March 2006.
three types of motives of FDI.The information from the above table can be
First, market-seeking investment is undertaken tocompared with the actual FDI inflows of India in the
sustain existing markets or to exploit new markets.same time. Figure 5 gives the year wise comparison
For example, due to tariffs and other forms ofof the FDI values for the year 1991 to 2006.
barriers, the firm has to relocate production to theThe advance estimates (AE) of gross domestic
host country where it had previously served byproduct (GDP) for 2006-07, released by the Central
exporting.Statistical Organization (CSO) on February 7, 2007,
Second, when firms invest abroad to acquireplaces the growth of GDP at factor cost at constant
resources not available in the home country, the(1999-2000) prices in the current year at 9.2 per cent.
investment is called resource- or asset-seeking.Growth in 2005-06, initially estimated by the CSO at
Resources may be natural resources, raw materials,the AE stage at 8.1 per cent in February 2006, was
or low-cost inputs such as labor.revised upwards to 8.4 per cent at the revised
Third, the investment is rationalized orestimate stage in May 2006 and further to 9.0 per
efficiency-seeking when the firm can gain from thecent in the quick estimates released by the CSO on
common governance of geographically dispersedJanuary 31, 2007
activities in the presence of economies of scale and
scope.Conclusion
This study mainly focusing on the host country basedAs far as the economic interpretation of the model is
factors. The host country factors or elements can beconcerned, the size of the domestic market is
grouped in two categories, First group comprises ofpositively related to foreign direct investment. The
natural resources, most kinds of labour, and proximitygreater the market, the more customers and the
to markets. Second group comprise of a range ofmore opportunities to invest. Since FDI is mostly in
environmental variables that act as a function ofthe form of physical investment, investors would
political, economic, legal, and infra-structural factors ofprefer the markets with better infrastructure. The
a host country.attractiveness of the host market also affects the
FDI positively and significantly. In many ways
The model and the variablesIndia’s principal problem remains that of boosting
Though the literature on the subject has suggestedits rate of saving and investment from the current
several possible explanatory variables, it is notabout 23% of GDP to over 30% of GDP in order to
possible to include all of them. The main criteria formake growth prospects take a quantum jump and
reducing the number of variables are as follows:become comparable with the high growth phases of
(i) Relation and importance of the variable for India,the Chinese and East Asian economies. FDI becomes
(ii) Availability of data;important in its own right if it makes contributions
(iii) Degrees of freedom;towards technology progress; productivity spillovers
The economic model is specified as:and consolidating niche export markets. This paper
FDI = f (MS, OE/FT, I, DMA, EE, IE) ------------ (1)emphasizes the view that an enlightened FDI policy is
Where FDI = Foreign direct Investment,to be seen as part of a general policy of enhancing
MS = Size of domestic market,investment in this economy under conditions of
OE/FT = openness of the economy to foreign trade,sustained production efficiency.
I = Infrastructure of the host country,
DMA = Domestic market Attractiveness,Reference:
EE = External economic stability,1) Economic Liberalization and India's Foreign Policy
IE = Internal economic stability.Chan-Wahn Kim. Delhi, Kalpaz
The economic theory suggests that a positive2) John H. Dunning’s “GLOBALIZATION
relationship between FDI and size of domesticINDUCED CHANGES AND THE ROLE OF FDI
market, openness of the economy to foreign trade,POLICIES”
and infrastructure of the country. While a negative3) Website: http:/indiabudget.nic.in
relationship between FDI and External economic4) Government of India (2002) “Report of the
stability, internal economic stability. The larger theSteering Committee on Foreign Direct
market size, the more demand for the products orInvestment” Planning Commission, August.
services to be provided by the FDI.