CHAPTER 1

INTRODUCTION
Over the past two decades, many countries around the world have experienced
substantial growth in their economies, with even faster growth in international
transactions, especially in the form of foreign direct investment (FDI). The share of
net FDI in world GDP has grown five-fold through the eighties and the nineties,
making the causes and consequences of FDI and economic growth a subject of evergrowing interest. This report attempts to make a contribution in this context, by
analyzing the existence and nature of causalities, if any, between FDI and economic
growth. It uses as its focal point India, where growth of economic activities and FDI
has been one of the most pronounced.
DEFINITION OF FOREIGN DIRECT INVESTMENT :Foreign direct investment (FDI) is defined as "investment made to acquire lasting
interest in enterprises operating outside of the economy of the investor. The FDI
relationship, consists of a parent enterprise and a foreign affiliate which together
form a transnational corporation (TNC). In order to qualify as FDI the investment
must afford the parent enterprise control over its foreign affiliate. The UN defines
control in this case as owning 10% or more of the ordinary shares or voting power of
an incorporated firm or its equivalent for an unincorporated firm.
HISTORY OF FDI IN INDIA.
At the time of independence, the attitude towards foreign capital was one of fear
and suspicion. This was natural on account of the previous exploitative role played
by it in draining away resources from this country.
The suspicion and hostility found expression in the Industrial Policy of 1948 which,
though recognizing the role of private foreign investment in the country,
emphasized that its regulation was necessary in the national interest. Because of
this attitude expressed in the 1948 resolution, foreigncapitalists got dissatisfied and
as a result, the flow of imports of capital goods got obstructed. As a result, the
prime minister had to give following assurances to the foreign capitalists in 1949:
1. No discrimination between foreign and Indian capital:The government o India will not differentiate between the foreign and Indian
capital. The implication was that the government would not place any restrictions or
impose any conditions on foreign enterprise which were not applicable to similar
Indian enterprises.
2. Full opportunities to earn profits:The foreign interests operating in India would be permitted to earn profits without
subjecting them to undue controls. Only such restrictions would be imposed which
also apply to the Indian enterprises.

3. Gurantee of compensation:If and when foreign enterprises are compulsorily acquired, compensation will be
paid on a fair and equitable basis as already announced in governments statement
of policy.
Though the Prime Minister stated that the major interest in ownership and effective
control of an undertaking should be in Indian hands, he gave assurance that there
would be no hard and fast rule in this matter.
By a declaration issued on June 2, 1950, the government assured the foreign
capitalists that they can remit the he foreign investments made by them in the
country after January 1, 1950. in addition, they were also allowed to remit whatever
investment of profit and taken place.
Despite the above assurances, foreign capital in the requisite quantity did now flow
into India during the period of the First plan. The atmosphere of suspicion had not
changed substantially. However, the policy statement of the Prime Minister issued in
1949 and continued practically unchanged in the 1956 Industrial Policy Resolution,
had opened up immense fields to foreign participation. In addition, the trends
towards liberalization grew slowlyand gradually more strong and the role of foreign
investment grew more and more important.
The government relaxed its policy concerning majority ownership in several cases
and granted several tax concessions for foreign personnel. Substantial liberalization
was announced in the New Industrial Policy declared by the government on 24th
July 1991 and doors of several industries have been opened up for foreign
investment.
Prior to this policy, foreign capital was generally permitted only in the those
industries where Indian capital was scarce and was not normally permitted in those
industries which had received government protection or which are of basic and/or
strategic importance to the country. The declared policy of the government was to
discourage foreign capital in certain inessential consumer goods and service
industries.
However, this provision was frequently violated as a number of foreign
collaborations even in respect of cosmetics, toothpaste, lipstick etc. were allowed
by the government. It was also stated that foreign capital should help in promoting
experts or substituting imports.
The government also laid down that in al those industries where foreign capital
investment is allowed, the major interest in ownership and effective control should
always be in Indian hands (this condition was also often relaxed).
The foreign capital investments and technical collaborations were required to be so
regulated as to fit into the overall framework of the plans. In those industries where
foreign technicians and managers were allowed to operate as Indians with requisite

skills and experience were not available, vital importance was to be accorded to the
training and employment of Indians in the quickest possible manner.
One of the remarkable features of globalization in the 1990s was the flow of private
capital in the form of foreign direct investment. FDI is animportant source of
development financing, and contributes to productivity gains by providing new
investment, better technology, management expertise and export markets. Given
resource constraints and lack of investment in developing countries, there has been
increasing reliance on the market forces and private sector as the engine of
economic growth
TYPES OF FDI :
BY DIRECTION:Inward
Inward foreign direct investment is when foreign capital is invested in local
resources. Outward
Outward foreign direct investment, sometimes called "direct investment abroad", is
when local capital is invested in foreign resources.
BY TARGET :Greenfield investment
Direct investment in new facilities or the expansion of existing facilities. Greenfield
investments are the primary target of a host nations promotional efforts because
they create new production capacity and jobs, transfer technology and know-how,
and can lead to linkages to the global marketplace. The Organization for
International Investment cites the benefits of greenfield investment (or insourcing)
for regional and national economies to include increased employment (often at
higher wages than domestic firms); investments in research and development; and
additional capital investments. Criticism of the efficiencies obtained from greenfield
investments include the loss of market share for competing domestic firms. Another
criticism of greenfield investment is that profits are perceived to bypass local
economies, and instead flow back entirely to the multinational's home economy.
Critics contrast this to local industries whose profits are seen to flow back entirely
into the domestic economy.
Mergers and Acquisitions
Transfers of existing assets from local firms to foreign firms takes place; the primary
type of FDI. Cross-border mergers occur when the assets and operation of firms
from different countries are combined to establish a newlegal entity. Cross-border
acquisitions occur when the control of assets and operations is transferred from a
local to a foreign company, with the local company becoming an affiliate of the
foreign company. Unlike greenfield investment, acquisitions provide no long term
benefits to the local economy-- even in most deals the owners of the local firm are
paid in stock from the acquiring firm, meaning that the money from the sale could
never reach the local economy. Nevertheless, mergers and acquisitions are a
significant form of FDI and until around 1997, accounted for nearly 90% of the FDI
flow into the United States. Mergers are the most common way for multinationals to

do FDI. Horizontal FDI

Investment in the same industry abroad as a firm operates in at home.
Vertical FDI
Backward Vertical FDI
Where an industry abroad provides inputs for a firm's domestic production process.
Forward Vertical FDI
Where an industry abroad sells the outputs of a firm's domestic production.
BY MOTIVE :FDI can also be categorized based on the motive behind the investment from the
perspective of the investing firm:
Resource-Seeking
Investments which seek to acquire factors of production that are more efficient than
those obtainable in the home economy of the firm. In some cases, these resources
may not be available in the home economy at all (e.g. cheap labor and natural
resources). This typifies FDI into developing countries, for example seeking natural
resources in the Middle East and Africa, or cheap labor in Southeast Asia and
Eastern Europe.
Market-Seeking
Investments which aim at either penetrating new markets or maintaining existing
ones. FDI of this kind may also be employed as defensive strategy; it is argued that
businesses are more likely to be pushed towards this type of investment out of fear
of losing a market rather than discovering a new one. This type of FDI can be
characterized by the foreign Mergers and Acquisitions in the 1980s y Accounting,
Advertising and Law firms.
Efficiency-Seeking
Investments which firms hope will increase their efficiency by exploiting the benefits
of economies of scale and scope, and also those of common ownership. It is
suggested that this type of FDI comes after either resource or market seeking
investments have been realized, with the expectation that it further increases the
profitability of the firm.. Typically, this type of FDI is mostly widely practiced
between developed economies; especially those within closely integrated markets
(e.g. the EU).
Strategic asset seeking
A tactical investment to prevent the loss of resource to a competitor. Easily
compared to that of the oil producers, whom may not need the oil at present, but
look to prevent their competitors from having it.
CLASSIFICATION OF FOREIGN DIRECT INVESTORS :-

A foreign direct investor may be classified in any sector of the economy and could
be any one of the following an individual;
a group of related individuals;
an incorporated or unincorporated entity;
a public company or private company;
a group of related enterprises;
a government body;
an estate (law), trust or other social institution; or
any combination of the above.
DIFFERENT FDI INCENTIVES :low corporate tax and income tax rates
tax holidays
other types of tax concessions
preferential tariffs
special economic zones
EPZ - Export Processing Zones
Bonded Warehouses
Maquiladoras
investment financial subsidies
soft loan or loan guarantees
free land or land subsidies
relocation & expatriation subsidies
job training & employment subsidies
infrastructure subsidies
R&D support
derogation from regulations (usually for very large projects) BENEFITS OF FDI :Attracting foreign direct investment has become an integral part of the economic
development strategies for India. FDI ensures a huge amount of domestic capital,
production level, and employment opportunities in the developing countries, which
is a major step towards the economic growth of the country. FDI has been a
booming factor that has bolstered the economic life of India, but on the other hand
it is also being blamed for ousting domestic inflows. FDI is also claimed to have
lowered few regulatory standards in terms of investment patterns. The effects of FDI
are by and large transformative. The incorporation of a range of well-composed and
relevant policies will boost up the profit ratio from Foreign Direct Investment higher.
Some of the biggest advantages of FDI enjoyed by India have been listed as under:
Economic growth- This is one of the major sectors, which is enormously benefited
from foreign direct investment. A remarkable inflow of FDI in various industrial units
in India has boosted the economic life of country.
Trade- Foreign Direct Investments have opened a wide spectrum of opportunities in
the trading of goods and services in India both in terms of import and export
production. Products of superior quality are manufacturedby various industries in
India due to greater amount of FDI inflows in the country.

Employment and skill levels- FDI has also ensured a number of employment
opportunities by aiding the setting up of industrial units in various corners of India.
Technology diffusion and knowledge transfer- FDI apparently helps in the
outsourcing of knowledge from India especially in the Information Technology sector.
It helps in developing the know-how process in India in terms of enhancing the
technological advancement in India.
Linkages and spillover to domestic firms- Various foreign firms are now occupying a
position in the Indian market through Joint Ventures and collaboration concerns. The
maximum amount of the profits gained by the foreign firms through these joint
ventures is spent on the Indian market.
DETERMINANTS OF FDI :Nowadays, virtually all countries are actively seeking to attract FDI, because of the
expected favourable effect on income generation from capital inflows, advanced
technology management skills and market know-how.
The key determinants and factors associated with the extent and pattern of FDI in
developing host countries: attractiveness of the economic conditions in host
countries; the policy framework towards the private sector, trade and industry, and
FDI and its implementation by host governments; and the investment strategies of
MNEs.
As a consequence of globalization and economic integration, one of the most
important traditional FDI determinants, the size of national markets, has decreased
in importance. At the same time, cost differences between locations, the quality of
infrastructure, the ease of doing business and the availability of skills have become
more important (UNCTAD 1996). Traditional economic determinants, such as natural
resources and national market sizefor manufacturing products sheltered from
international competition by high tariffs or quotas, still play an important role in
attracting FDI by a number of developing and developed countries as well as
economies in transition.
For foreign investors, the host country policies on the repatriation of profits and
capital and access to foreign exchange for the import of intermediaries, raw
materials and technology are particularly important. The pattern of recent FDI flows
supports the conclusion that liberal policies on technology, which tend to go hand in
hand with more liberal policies in general, serve to attract more and better foreign
investments.
KEY DETERMINANTS OF FDI
Economic conditions
Markets
Size; income levels; urbanization; stability and growth prospects; access to regional

markets; distribution and demand patterns.

Resources
Natural resources; location.
Competitiveness
Labour availability, cost, skills, trainability; managerial technical skills; access to
inputs; physical infrastructure; supplier base; technology support
Countrys policies
Private sector
Promotion of private ownership; clear and stable policies; easy entry/exit policies;
efficient financial markets; other support.
Macro policies
Management of crucial macro variables; ease of remittance; access to foreign
exchange.
Trade and industry
Trade strategy; regional integration and access to markets; ownership controls;
competition policies; support for SMEs
FDI policies
Ease of entry; ownership, incentives; access to inputs; transparent and stable
policies.
MNE strategies
Risk perception
Perceptions of country risk, based on political factors, macro management, labour
markets, policy stability.
Location, sourcing, ,
integration transfer.
Company strategies on location, sourcing of products/inputs, integrationof affiliates,
strategic alliances training , technology
FDI IN DEVELOPED AND DEVELOPING COUNTRIES :The ten largest developing and developed host countries economies for FDI for
2001, and their inward FDI flows between 1997 and 2001. Among developing
economies, China, Mexico, and Brazil had the largest inward flows, while among
developed countries, the US, the UK, France, and Belgium and Luxembourg were the
largest recipients of FDI flows. In assessing the relationship between taxation and
FDI in these diverse countries, it is important to keep in mind several factors
concerning FDI. First, FDI in the service sector, and particularly in finance, has
increased at a greater rate than FDI in manufacturing. According to the World Bank
(2003), the world stock of inward FDI increased at an annual rate of 12.2 percent in

manufacturing and
13.8 percent in services between 1988 and 1999. In developing countries, the
difference in the annual increase in the composition of the inward stock of FDI was
even more marked: a 19.6 annual growth rate in manufacturing versusa 28.2
percent annual growth rate in services. The potentially important role of the
financial sector is evident in the data for Belgium and Luxembourg in Table 2. While
obviously small countries, in 2000 Belgium and Luxembourg overtook Germany and
came close to overtaking the US in total FDI inflows.
Second, the composition of FDI can differ significantly from country to country,
sometimes even within regions. Brazil, for instance, has seen greater inflows in the
tertiary (service) sector than the secondary (manufacturing) sector in every year
from 1996 to 2002. Mexico, while having significant inflows in the tertiary sector,
had higher inflows in manufacturing in every year from 1994 to 2000.
Third, FDI inflows are geographically diverse both across host countries and within a
given host country. Hence, host countries need to keep in mind different home
country tax systems when evaluating the effects of tax policy. For instance, the bulk
of FDI inflows into Mexico come from the United States. While the US is also a
significant provider of FDI in Brazil, a large part of FDI inflows in Brazil have come
from Western Europe. Moreover, the geographic origin of flows into Brazil have
changed significantly during the 1990s, with Spain, France, and the Netherlands
currently the largest investors from Western Europe.
Fourth, developing countries are usually characterized by greater FDI inflows than
outflows, while developed economies inflows and outflows tend to be closer, with
FDI outward stocks often greater than inward stocks. For instance, during the period
1985-1995, developed economies inflows average $127.5 billion annually, while
annual outflows averaged $181.7 billion. During this same period, developing
economies inflows averaged $50.1 billion annually and outflows averaged $21.5
billion. In 2000, Chinas inflows were $40.8 billion while outflows were only $0.9
billion. In some sense, then, the challenges facing developing and developed
economies are different.
Fifth, it is important to recognize at the outset that taxes usually are notthe most
important factor in attracting FDI, although they can have marginal impacts. A
number of studies have shown that an attractive investment climate including
factors such as the rule of law and low levels of corruption, good infrastructure,
agglomeration economies, as well as geographic proximity, are the most important
factors at work. Moreover, the reputation of a country is important. Are a countrys
policies likely to be time consistent that is, will tax or other incentives granted
today be honored in the future, or may a government renege on future promises,
perhaps even confiscating a companys assets? Country risk is important and may
be endogenously determined by government policies (Eaton and Gersovitz).
Finally, it should be noted that FDI often has an uneven impact within a country. For

instance, NAFTA is generally thought to have impacted Mexico unevenly, increasing

incomes more along the wealthier northern border than in the poorer southern
states. This can have important political ramifications as those that lose or do not
gain as much will tend to be opposed to policies that might benefit the country as a
whole.
Why Does India Attracts the Maximum FDI Inflows?
India is potentially active in terms of investments and provides a galore of
opportunities to the foreign players into the market. Foreign companies who aspire
to become a global player would grab the opportunities, India provides in terms of
investments. The foreign companies enjoy the rights to set up branch offices,
representative offices, and also carry out outsourcing activities in terms of software
developmental programmes in India. All these have opened up innumerable options
for the foreign investors to expand their businesses at a global level. These are
some of the factors which led to FDI Inflows in India. Market Potential in India for
Attracting FDI InflowsIndia is claimed to be the fifth largest economy across the globe and ranks third in
the Gross Domestic Product in the entire Asia, which is one of the most significant
factors responsible for FDI Inflows in India. India is also known to be the second
largest country amongst all other developingcountries. Besides, India belongs to
those rarest of countries, which offer growth and earning opportunities through
various industrial units. India offers maximum opportunities for foreign investments,
which have been a major cause behind the flourishing economy of the country. The
FDI Inflows in Indian market as accounted for the year 2006-07, stood at USD 2,171
million.