M SC.

BUSINESS ECONOMICS LONDON METROPOLITAN BUSINESS SCHOOL

FINAL DISSERTATION ON ROLE OF FOREIGN DIRECT INVESTMENT ON ECONOMIC GROWTH: A CASE STUDY WITH SPECIAL REFERENCE TO CHINA AND INDIA SUMITTED BY JOSE PHILIPOSE VARGHESE (09046537) MAY 2011 This project is submitted in part fulfilment of the requirement for the completion of M.Sc Business Economics at the London Metropolitan University. The work is the sole responsibility of the candidate.

SUPERVISOR NISHAAL GOOROOCHURN

ACKNOWLEDGEMENT

It is a great opportunity to do a dissertation on the topic The role of Foreign Direct Investment on economic growth: a case study with special reference to India and China. The undertaking of the same had enlightened my knowledge on the relationship of FDI and economic growth. It also provides enough knowledge on the pros and cons that an FDI undertaking brings to the host country. My heartfelt thanks to the God almighty for all the help bestowed, without which this project would not have been successful. I express my sincere gratitude to Mr. Nishaal Gooroochurn, Faculty Guide, London Metropolitan University for his valuable guidance for the successful completion of this study I wish to express my deep gratitude to my parents and friends who helped me and supported me to complete this project. Finally I would like to thank all those who helped me directly and indirectly for successful completion of the project.

JOSE.P.V

TABLE OF CONTENTS Chapter 1

PAGE

1. Introduction...9

1.2 Motivation and purpose of the study...10 1.3 Objectives....10 1.4 Brief outline of the study.11 Chapter 2 2.1 Review of Literature...........13 2.2 Definition of FDI17 2.3 General theories and concepts of FDI18 2.3.1 Ownership Specific Advantage...19 2.3.2 Location Specific Advantage..19 2.3.3 Internalisation Specific Advantage.20 2.4 Types of FDI..20 2.4.1 Horizontal Foreign direct investment.20 2.4.2 Vertical FDI21 2.4.3 Greenfield Investment.22 2.4.4 Mergers and Acquisition.22 2.5 Determinants of FDI...23 2.5.1 Economic factors.23 2.5.2 Government policies24 2.5.3 Strategy of MNEs...26 2.6 Impact of FDI in host country development...29 2.6.1 Impacts of FDI.30

CHAPTER 3 3.1 FDI inflow in CHINA.35 3.1.1 The impact of FDI in Chinese economy...36 3.2 FDI inflow in India..37

CHAPTER 4 4 Methodology and Data collection .42 4.1 Graphical analysis...42 4.2 Regression analysis.44 CHAPTER 5 5.1 Findings and Conclusion.50 APPENDIX...52 REFERENCE...54

LIST OF TABLES

PAGE

Table: 2.1.1. The table below shows some relevant studies done on FDI and Economic growth15 Table: 2.5.1. The table below shows the major determinants of FDI and selected relevant studies done on it 27
Table : 4.2.1.1. Regression model summary for CHINA......52 Table : 4.2.1.2. Regression Coefficient estimation table for CHINA52 Table : 4.2.2.1 Regression model summary for INDIA.53 Table : 4.2.2.2 Regression coefficient summary for INDIA.53

LIST OF FIGURES
Figure: 4.1.1 FDI and GDP growth rate in CHINA..42 Figure: 4.1.2 FDI and GDP growth rate in INDIA...43

ABBREVIATIONS FDI Foreign Direct Investment GDP Gross Domestic Product LPG Liberalization, Privatization and Globalization MNCs Multinational Corporations OECD Organisation for Economic C0-operation and Development UNCTAD- United Nations Conference on Trade and Development OSA Ownership Specific Advantage LSA Location Specific Advantage ISA Internalisation Specific Advantage TNCs Transnational Corporations MNEs Multinational Enterprises SPSS Statistical package for social sciences FERA Foreign Exchange Regulation ACT

ABSTRACT The purpose of the study is to empirically determine the impact of FDI on economic growth of INDIA and CHINA. Both being the greatest and the rapid growing economy, had witnessed a huge inflow of capital in several forms during the past few decades. Why such an inflow and what had inculcated the investors to adopt such a project in these countries? This paper, hence pinpoints in brief, the reason for such a massive undertaking by the multinationals. The thesis undertaken also investigates the significant role of FDI among the other determinants of economic growth in these countries. For the purpose datas for the last 39 years are taken into consideration. Methodology used consists of graphical representation and regression analysis. Graphical analysis is used to show the relationship between FDI and economic growth in INDIA and China. From the graph it is clear that there is a positive relationship between FDI and GDP in China and they move in the same direction, while it is opposite in the case of India. To prove this a linear regression method is used with the help of SPSS. The results so obtained suggest that FDI has a positive impact on China and a less, but a positive impact on Indias economic growth.

Dissertation word count: 12902

CHAPTER 1 INTRODUCTION

1. INTRODUCTION The recent studies conducted on FDI shows that the relevance of FDI inflows for the economic growth is very important and the policy makers adopted more liberalized approach to gain the benefit out of it. It is argued that FDI inflow has got so many effects on a growing economy. The role of FDI in creating employment, transferring technology, creating spillover effects and other activities that can act as a fuel for economic growth is quite worth noticing. Studies done by Alfero (2003), Blomstrom et.al (1994) and Borenstein (1998) suggests that a country inorder to attract FDI inflows should possess some relevant factors like better labour market, balance of payment, technology and infrastructure, stable policies etc. These factors act as a determinant to the flow of FDI in the host country. The thesis explicitly covers the theory relating to the importance of FDI, the factors determining its growth and FDI impact on host country development. The country of concern in the thesis is India and China. China opened its economy during 1979 by adopting open door policy. The growth since then was so remarkable and astonishing. The relationship between FDI inflow and GDP growth was so uniform and upward after 1980 indicating the major role of FDI inflows on GDP growth rate of China. Many researchers argued that this inflow of FDI was mainly due to the liberalized approach made by the Chinese economy. The recent economic reforms that it had made, indulged several multinational giants to invest in the host country. The introduction of open door policy and Chinas WTO entry are such reforms that can be highlighted while discussing about FDI. The paper thus examines the role of FDI, which it had played during this significant time period in CHINA for this massive growth. Indias economic growth after the introduction of the famous LPG (Liberalisation, Privatisation and Globalisation) concept was remarkable. The paper therefore explores the irregular start up of FDI in INDIA and also evaluates the development that it had brought about in the economy. Thesis does not provide a comparative analysis, but it shows the relevant role of FDI on economic growth in both the countries. The role of other determinants with regard to FDI is also discussed and analysed briefly. The datas from the periods 1970 to 2009 is taken for the analysis to check the rate of FDI inflows. For the purpose regression analysis is employed to calculate the relevance of FDI in China and India. The analysis showed a positive effect on

China and a less positive effect on India, thus indicating that FDI has a major role in Chinas growth and a minor role on Indias growth rate. 1.2. MOTIVATION AND PURPOSE OF THE STUDY Indian and Chinese economies were partially closed and were under the control of stringent rules and regulations during 1970s and 80s. The growth that had happened in these geographical areas was astonishing during 1990s. There are several factors that had contributed for such an economic outburst. The role of FDI as such a factor is significant. Many researchers say that it is due to the various economic strategies of each country for e.g., open door policy of China and opening of Indian economy by introducing the Liberalization, privatisation and globalization or the LPG concept that attracted such a huge investment, which was actually true. Even during the recession time both the economy had performed well and even attracted more investment and capital. The level of inflow in both the countries was astonishing and varying, which is quiet exciting to study. The main frame of the study is to analyse the economic strategies of each countries and to find the factors which are lacking on the part of the straggler. The purpose of the study is to create a model of both the countries and to analyse the pros and cons that exist in both economies and to find ways to overcome the problem of laggards through an effective empirical analysis. The study also intends to reveal a path for the less developed and other developing economys, which might emerge in the next few decades. There are only few research works that are from the Indian point of view. This study is also aimed to fill those gaps. 1.3. OBJECTIVES 1. To evaluate the contribution of FDI in economic growth (in INDIA and CHINA) 2. To find the nature of contribution made by these investment. 3. To evaluate the rate of inflow of these investment in INDIA and CHINA 4. To study the significance of FDI with other economic growth indicators.

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1.4. BRIEF OUTLINE OF THE STUDY The paper is divided into four chapters. The first part covers the introduction, motivation and purpose of the study. The second chapter covers the review of literature and the theoretical aspects of FDI including its definitions, types, determinants and impacts of FDI. The third chapter covers the FDI trends and related strategies adopted in China and India to attract FDI inflows. The fourth chapter deals with the methodology and empirical analysis of the study of concern. It includes graphical representation and regression analysis to find the inflow of FDI and also to discover the relationship between both FDI and GDP in China and India. After doing the graphical analysis, a regression equation is formulated. The equation consists of some variables that exert direct impact on GDP growth. The main purpose of the equation is to find the contribution of FDI, the primary variable of concern and also to analyse the impact of other variables on GDP growth rate in India and China. The last chapter covers the findings and conclusion.

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CAHAPTER 2 REVIEW OF LITERATURE

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2.1. REVIEW OF LITERATURE Caves (1996), suggests that the underlying principle to attract heavy foreign investment starts from the belief that FDI brings numerous positive effects. This include employee training, productivity gains, technology transfer, improved managerial skills, improved international production networks, introduction of innovative ideas to the host countries, employment opportunities etc. Ndikumana and Verick (2008), Andreas (2006) and Lumbila (2005), suggests that FDI has significant positive effect on economic growth. Romer (1993), argues there exist a wide Idea Gaps between poor and rich countries. He views that foreign investment can facilitate technological transfer and business know- how to less-developed or poorer countries and, as a consequence, FDI might boost host countries firms productivity and hence increases economic growth. A relative study done by Blomstrom (1986) concludes that Mexican sectors with a high degree of foreign investment show high productivity growth. FDI is also characterized by immense positive spillovers. As per the study of Lipsey and Sjoholm (2005), FDI has positive spillover effects. Some economists found that FDI exerts varying effects. For instance the study conducted by Theodore, Edward and Magnus (2005) suggests that FDI can have varying effects that is both positive and negative effect. Some economists were of the opinion that it has got more positive effect, but FDI inflow depends on several factors in the host countries. Alfero (2003) admits that FDI inflow to certain sectors induces economic growth according to him the economy achieves more growth when, FDI inflows to the manufacturing sector is high when compared to that of primary sector. Many factors in the host countries such as labour market, capital market, technology, balance of payment etc also are adversely affected through FDI inflow which in turn acts as a fuel for economic growth, Lall (2002). Another study done by Blomstrom et.al (1994) states that, those countries that have a certain level of income can take up new technologies and enjoy its benefits through FDI. However some research works had proved the importance of human capital in attracting the FDI. The studies conducted had revealed that an educated workforce or human capital can only understand the importance of innovation and technology diffusion and thus supports the inflow of FDI to their economy. Borenstein (1998), in his study found out the relative importance of FDI and human capital in economic growth. He also suggests that an economy may need a minimum stock of human capital to understand the positive effects of FDI. For instance, another study done by Borenztein, De-Gregorio and Lee (1998), states that FDI has a positive effect in the host country when the economy has a highly educated workforce who welcomes FDI
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spillover effects. Carkovic and Levine (2002), also argues about the importance of educated workforce in attracting FDI and hence increasing growth. The significant role of FDI, in bringing foreign technology towards the host country is indispensable. Borenstein et.al (1998) postulates that, FDI plays a vital role when it comes to technological transfer, which in turn might contribute to larger economic growth than domestic investment. Findlay (1978) in his studies sees that the rate of technical progress in the host country can be increased by the inflow of FDI through a contagron effect. In a debate regarding to the importance of FDI, De Gregorio (2003) contributes that FDI brings in knowledge expertise and technologies that are not available in the host country; thereby increasing productivity growth through out the economy. In his study on Latin American economy, he found out that FDI is thrice more efficient than domestic investment, when it comes to economic growth. A similar study conducted by De Mello (1997) suggests that there is a positive correlation and it boosts investment levels, thereby creating a space for economic growth. Explanations regarding FDI and its relative importance on long- term and short-term economic growth is quite importance at this juncture. Neo-classical economists postulate that FDI persuades economic growth by increasing the amount of capital per person. However, this may not influence long- run growth due to diminishing returns to capital. Sauchez-Robles and Bengos (2003) emphasizes that, even though the correlation between FDI and economic growth is positive, a host country in order to benefit from long term FDI inflows must require economic stability minimum human capital and liberalized markets. The other interesting study done by Bende- Nabende et.al (2002) found that long term impact of FDI on productivity is more positive for less economically advanced countries and negative for economically advanced countries. Rome (1986) and Lucas (1988) claims that FDI also influences long- run variables such as Human capital and Research and development. FDI when analysed in short- term aspect, it is more beneficial than long-term (Andeolu B Ajamoaler, 2007). Durham (2004) contributes that FDI effects are more conditional on the absorbtive capability of host countries. Obwana (2001) quotes in his study relating to the determinants of FDI and growth on Uganda, that parameters like political stability, macro economic and policy consistency are so important in attracting FDI inflows. To add to this, the study done by Bhasin et al. 1994, Love and Lage- Hidalgo, 2000 and Lipsey 2000) is

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more important, they found that determinates like factor prices, market size of the host country and balance of payments are significant in attracting FDI inflows. In the case of India and China the economic growth which they achieved is largely due to the post liberalization periods of each country. The factors like political stability, policy consistency and other factors like better labour force etc also had played a vital role in attracting such a huge inflow, hence making them the most desirable place for investment. A study done by Pradeep Agarwal (2000) on five South Asian countries relating to foreign direct investment, argues that the role of FDI on GDP growth rate was negative during Pre1980s and slightly positive during 1980s and strongly positive during 1990s. He found out that this high inflow of FDI is largely due to a strong market oriented policies and open international trade strategies of these countries. According to a study done by Zhang (2006) on FDI and economic growth in China, states that FDI promotes economic and this positive growth is achieved overtime. Xiaobuo Dang (2008) asserts that FDI has got significant role in increasing economic growth and determinants like infrastructure and political environment plays a crucial role in exerting a pull on FDI inflows. Table: 2.1.1. The table below shows some relevant studies done on FDI and Economic growth
AUTHOR YEAR OF STUDY METHODOLOGY USED Agarwal.P 2000 Time series cross sectional analysis of panel data from five South Asian countries Panel data analysis Prior 1980s period- FDI inflow on GDP growth rate was negative. Early 1980s- mildly positive. Early 1990s- positive. FDI enhances economic growth in developing economies when compared to that of the developed economies. FDI has got a significant role in economic growth. He also pinpoints the importance of local financial market in achieving this economic growth through. FDI promotes growth and FINDINGS

Andreas. J

2005

Alfaro.et.al

2004

Panel data cross country regression

Balasubramanyam

1997

Panel data cross country

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regression

is more efficient in export promoting regimes rather than import substituting ones. FDI has got positive correlation with economic growth in the host country. He argued about the sufficient absorptive capability of the host country and found out that FDI contributes to economic growth. He argues that sufficient human capital is necessary in the host country to achieve this growth. FDI exerts a positive impact on growth, that is independent of other growth determinants (educated workforce, infrastructure, markets and liberalized policies) They found out that there exists heterogeneity across developing economies regarding the impact of FDI and other variables on economic growth. Foreign investment has got major role in enhancing economic development in Uganda. FDI gas got positive effect on the host countrys economic growth. FDI has got positive impact on GDP growth rate in Africa. FDI has significant role in Economic growth in

Sauchez-Robles and Bengos

2002

Panel data analysis

Borensztein et.al

1998

Panel data cross country regression. Instrumental variable regression.

Carkovic and Levine

2002

Generalized method of moments panel estimator.

Nair-Reichert and Weinhold

2001

Panel data analysis. mixed, fixed and random co-efficient approach

Obwona

2001

Two stage least square estimation method

Ram and Zhang

2002

Panel data cross country regression

S.Adewumi

2006

Graphical analysis, regression and granger causality

Xiaohong Ma

2009

Regression analysis

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China
Source: Created by the author.

2.2. DEFINITION OF FDI A clear cut definition of FDI is very difficult (Haluk sezer (Piggot and Cook, 2006). Definitions of FDI were formulated depending on its international characteristics and MNCs activities in host countries and some authors even contrast it with portfolio investment. The definition thus evolved and recognized, often has two common elements such as, involvement of two countries which quite often described as the multinational FDI character, and the other elements which is basically related to the issue of ownership and management which makes it entirely different from portfolio investment. FDI is therefore considered as the ownership and management of production activities abroad, whereas foreign portfolio investment is the transfer of financial capital, loan or equity from one country to another. FDI stand aside due to its complexity, because it involves transfer of managerial and organisational ability and technical know-how. The definition of FDI is not isolated. The FDI being a part of MNCs activities, a single and isolated definition is not possible. Therefore the definition of MNCs is some what similar to that of MNCs (Haluk sezer (Piggot and Cook, 2006). Despite of its difficulty many definitions have evolved. According to the IMF balance of payment manual defines FDI as an investment that is made to acquire a lasting interest in an enterprise operating in an economy other than that of the investor, the investors purpose being to have an effective voice in the management of the enterprise Imada Moosa (2002). Haluk sezer (Piggot and Cook, 2006) defines FDI as the acquisition, establishment or increase in production facilities by a firm in a foreign country. This definition thus cover all three elements of FDI such as mergers and acquisitions, greenfield investment and reinvestment. Robert E. Lipsey (1999) defined, FDI as the investment that involves some degree of control of the acquired or created firm which is in any other country apart from investors country (S. Adewumi, 2006)

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OECD has provided an extensive definition of FDI (OECD Benchmark Definition of Foreign Direct Investment, 2008, 4th edition) Foreign Direct Investment occurs when a business located in one country (the direct investors) invests in a business located in another country (the direct investment enterprise) with the objective of creating a strategic and a lasting relationship. Within an effective policy framework FDI can assist host countries in developing local businesses, promoting trade and contributing to technology transfer. Similarly, it can provide greater market access to businesses in home countries. Governments, businesses and other stakeholders need reliable FDI statistics to inform and support their decisions for investments worldwide. By keeping in mind all the above said definitions, we can define FDI as the investment made by a firm (MNCs) in another country to utilize the resources available in that country so as to expand internationally and to gain long-term profits. 2.3. GENERAL THEORIES AND CONCEPTS OF FDI A specific and a neat theory for FDI is difficult, because of the complexity it has. Economist had even struggled to give an exact definition for FDI. The theories thus formed are considered as the theories of MNCs and therefore it is inseparable from the firms theory. Another difficulty involved is its multidimensional aspects, it involves capital theory, international finance theory, firms theory, distribution theory, trade theory and also it covers some aspects of politics and sociology. Due to these characteristics it is impossible to recognize a single neat theory of FDI (Haluk sezer (Piggot and Cook, 2006)) The rising importance of FDI in this global scenario over the last few decades, made the economists and the researchers to identify and generate some important explanations for FDI. These explanations thus generated, is considered as the conclusion of several findings. Because of the existence of substantial overlap in these explanations, we can group them into three genuine categories, traditional, modern and radical theories. For the purpose of the case study, it is however important to go through the types of FDI and the factors that determine the flow of such FDIs in the host country. To understand these general theories of FDI mentioned above, it is useful to discuss the OLI paradigm by Dunning (1977, 1981). MNCs while taking up foreign investment projects will go through some advantages that the host country possess. Dunning explained these

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advantage variables as; Ownership advantage (O), Locational advantage (L) and Internalization specific advantage. L- type advantage is the external factor of the firm, while O- type and I- type advantage are internal aspects of the firm. Of these advantages, Ltype is considered as the most relevant one for FDI flows from developed to developing economies in common and mainly to transition countries. (Marco.Neuhaus, 2006). 2.3.1. Ownership Specific Advantage or OSA (H.Sezer (Piggot and Cook, 2006), M.Neuhaus, 2006) Ownership specific advantages are the knowledge based and firm specific assets that the firm possess, but which are not available to its competitors. These advantages constitute cost benefits and lead to market power. They mainly arise due to imperfections that exist in factor and commodity markets. Imperfections in factor market include management expertise, patents, trade secrets, difference in the accessibility to capital market, trade marks and brands, while in the commodity markets appear in the form of promotional skills, collusion and product differentiation. Imperfect market situation arise due to several factors such as; economies of scale and government policies regarding interest rates, taxes etc. these imperfections in the market gives rise to several OSAs which can be categorized as follows: Monetary and financial advantage these include access to capital market to get cheaper capital. Industrial organization advantages arising from Research and development and Economies of scale in an oligopolistic market. Technical advantage advantages in holding patent rights, management expertise etc. Access to raw materials.

2.3.2. Location Specific Advantage or (LSA) (Haluk sezer (Piggot and Cook, 2006)) These are those advantages that the company possess, when it locates it production facilities or activities in a particular geographical region. Such advantages can be categorized as follows: Imperfections in foreign labour market - MNCs shift their product activities to areas, were they can get cheap work force. Access to minerals and raw materials in host regions.

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Trade barriers these induces MNCs to start or set up production or business in certain areas. For example, Japanese companies interest in Europe to avoid Common External Tariff.

Government economic policies government may in turn change economic policies to attract FDI flows. The case study undertaken proves the same fact that the liberalized policies of China and India have opened the economy and as a consequence it increased FDI inflows.

2.3.3. Internalisation Specific Advantage or ISA It refers to the capability of the firms to utilize the ownership advantage internally rather than through markets (Nagesh Kumar, (Dunning and Narula,1996). It happens when the imperfection in the foreign markets make market solutions too costly (Haluk sezer (Piggot and
Cook, 2006))

The benefits of internalisation can be classified as follows: Vertical integration advantage such as price discrimination and transfer pricing Relevance of intermediate products for research activities. Benefits of training due to internalisation of human skills.

These above said OLI paradigm acts as a base for general theories of FDI. Now lets discuss about the major types of FDI and important factors that determines the FDI inflows. 2.4. TYPES OF FDI Researchers, based on the business activities of MNCs had formulated several types of FDIs. They are horizontal foreign direct investment, vertical foreign direct investment, Greenfield investment, mergers and acquisitions and benefit seeking FDIs. 2.4.1. Horizontal Foreign Direct Investments (J. Paul, 2008) It refers to MNCs regional (host country) diversification of established domestic products or services. Horizontal FDI occurs when MNCs goes to host countries to produce their existing products at their home country. Japanese MNCs for example adopt the same kind of

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investments with the belief to avoid risks by sharing their resources, knowledge and experiences. Horizontal FDI takes place when:

A firm achieve monopolistic characteristics in a spotted region. A firm competes in an infant industry Economies of scale supply numerous competitive advantages. A firm has enough human resources and capital to look after the diversified organization. A firm has the advantage of management expertise when compared to that of their competitors.

2.4.2. Vertical Foreign Direct Investment (J. Paul, 2008) Vertical foreign direct investment refers to investments made by a company in a particular industry abroad. In this the company will be responsible for the control of entire activities starting from raw materials to finished goods and distribution. Vertical FDI can be again divided into two such as, Forward vertical FDIK and Backward vertical FDI. Forward vertical FDI It is a sort of promotional activity made by the MNCs, in which it distributes home made goods or products abroad or it refers to the production of Final goods in the host using the intermediate goods from the home country. Forward Vertical Integration takes place when: The present distributors are unreliable. Limited availability of quality distributors The firm has both human resource and capital needed to run the new distribution business. The present distributors have high profit margins. There is an advantage of high stable production.

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Backward FDI It occurs when MNCs choose a particular region or foreign economy to produce intermediary materials, which can be used as inputs for its production in the home country. Backward vertical FDI takes place when: The present suppliers are unreliable The number of competitors is large and suppliers are relatively less. A firm competes in an infant industry or growing industry. The firm has sufficient human resources and capital to run the new supplying business. The firm needs a stable production situation which is more important. 2.4.3. Greenfield Investment It refers to firms investment in new facilities abroad or widening up of existing facilities (www.slideshare.net). It can also be defined as the starting up of a completely new operation in foreign country. This sort of investment is considered as the host nations primary target of promotional efforts, because it generates job opportunities, new production units and technology transfer. It also has got the advantage of integrating host country with the global market (www.slideshare.net) 2.4.4. Mergers and Acquisition (Banerjee, Nair, Agarwal, 2009) Mergers and Acquisition is considered as the primary source of FDI. In an Acquisition strategy, a firm joins with another established firm working in the host country to overcome the barriers of trade and business and makes the acquired firm a subsidiary business. For example Tata motors India acquired Jaguar a company in Britain, by doing so Tata had the advantage of supplying its home product abroad and also got the advantage of technological know-how from Jaguar for its home products. Apart from Greenfield investment, Merger and Acquisition generates cash flow within a short span of period, because by definition a firm does not have to start from base process by engaging in Merger and Acquisition. Another advantage of Mergers and Acquisition with that of Greenfield Investment is that it gets instant access to host country firms resources.

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FDI can again be classified into three based on the motivational factors and benefits of investing firms. They are as follows: Resource Seeking FDI in this the MNCs eyes on the resources available in the host countries (which some times that are not available in the home country) such as cheap labour, raw materials etc. Market Seeking FDI these are investments that are intended to penetrate a new market. Efficiency seeking FDI this strategy is adopted by the firms with an intension to increase their efficiency by utilizing the gains of economies of scale and scope. This is considered as the third step by the firms, after resource seeking and market seeking FDI. This strategy is adopted by the firms to gain more profits and can be mostly seen among the developing economies. For example; investments among EU nations. (www.slideshare.net)

2.5. DETERMINANTS OF FDI (Sanjay Lall, 1997) The determinants of FDI can be broadly divided into three set of factors, such as economic, government policies and MNCs strategies. 2.5.1 Economic Factors Market size globalization and trade liberalization had enhanced growth of world markets as well as the domestic markets. Evidence from various studies indicates that the size of the market plays a major role in attracting FDI flows. For instance the size of the domestic markets in China and India acts as a catalyst to attract huge FDI in these geographical regions. Similarly the growth of intra-regional trade and the prospective regional markets in south East Asian fuelled the growth of investments in these regions. Factors like skilled human capital, advance infrastructure, liberalized FDI policies and stable government policies acts as a magnet in attracting FDIs. This is more evident in the small states of Singapore and Hong Kong, were the above said factors prevails, thereby indicating that small economies can generate large amount of FDI. The available resources in the host country are another factor that the MNCs eyes for investment. The resources like petroleum and minerals are now the powerful determinants of FDI in some regions. The location as a part resource also has got upper hand in promoting

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FDI inflows. The fortunate regions that are closer to developed economy markets and the potential growing regions also enhance the inflow of FDI. Competitiveness and efficiency of the host country plays a significant role in drawing FDI. in this changing scenario, the role of skilled labours, better management and financial skills are very important. The MNEs have proficiency to bring along with them the skilled labours, but in practical it generates high costs for them. In order to avoid that, the MNCs look for those countries that can supply these sort of skilled employees. Apart from skilled workforce, the factors like better suppliers and good infrastructure also plays a vital role in directing the route for FDI inflows. Existence of a strong suppliers base enables the host countries to capture more spillover effects from TNCs and this in turn also lower the initial cost to the foreign entrepreneurs to set up facilities in that region. Taiwan for example has this advantage and it is able to attract more technological and high valueadded FDIs. Like strong supplier base, infrastructure also has its own role in drawing more FDIs. China for example has the capability to attract huge FDI because of their advanced infrastructure facilities when compared to that of India. A countries financial system also has got some relevance in this competing scenario for capturing FDI. An efficient national financial system is actually of less importance to TNCs, but it is of great importance for the domestic firms. Though it will be less important for MNCs in host country, but it is vital to create a better image in global market. Companies do often invest, in those place, were there is less risk and sound economy. 2.5.2 Government policies Political stability is the most crucial factors that the investors look for. Political environment characterized by minimum level of predictability and stability is necessary for the MNCs to set up facilities that can yield long term returns. Investors more often pay attention to the long term economic situation, were they can earn huge profits in the future when compared to that of short term policies like tax concessions. An efficient policy framework is very important for an host country to signal the foreign investors to invest, as a consequence it promote dynamic spillover effects, more employment

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opportunity, technological transfer and diffusion of better managerial skills to the host country. These contributions from FDI, therefore brings better economic growth. Privatization and Macro economic policies Privatization and FDI are considered as the two sides of the same coin. Evidence from Latin America, Africa and some of the Asian countries shows that privatization regimes, are successful in capturing investment flows to these areas. Privatization also had enhanced MNEs to diversify in those sectors (such as telecommunication and aviation) which they never had significant role. In many parts privatization is included in their policy agendas. Africa thus can be taken as an example for the same. Studies show that privatization policies in the developing countries during 1988-92 had stimulated about $49 billion in sales. During this period the privatization had accounted for about 7% of the total FDI inflows. The privatization is therefore becoming more relevant at this present scenario. Even the developing economy is concentrating on privatizing the infrastructure in order to increase the related FDI inflows. Like privatization another determinant of FDI is a well executed macro economic policies. A relatively well managed economy, characterized by realistic interest and exchange rates, low inflationary rates and well managed external debt, gives more confidence for the entrepreneurs to invest in that country. Countries which lack such a stable macro economic policies which are mentioned above suffers from recession and balance of payment problems, this relatively diverge foreign investment. Policies supporting private sector Policies such as openness to market forces and the private sector and well implemented accounting and legal framework encourages foreign investment. An environment which is basically liberal in nature, transparent, stable and better suitable for private sector sends positive impulse to MNEs to invest. Totally, a policy that has a business like attitude enhances better investment scenarios in the host country. Industrial and Trade Strategies These strategies provide a basic guideline for manufacturing activity and also for allocation of resources by local enterprises and MNCs. The mostly accepted trade strategy is the outward oriented one- this strategy provides MNCs the best settings to work efficiently. In
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the early days, the main drive for FDI inflows was made through the adoption of import substitution, now it has opened the doors for export oriented regimes. Economies thus adopted more liberalized trade policies to promote investments, because openness to the export market is considered as the best way for better resource allocation and for developing efficient capabilities and management practices. The liberalized trade has got numerous advantages; they act as a magnet to attract the attention of MNCs for FDI. The role of regional trading blocs is also important in attracting FDIs. In the countries characterised by low domestic and fragmented markets and poor infrastructure, regional integration can bring positive effects. Apart from trade liberalization industrial policies also plays vital role in attracting FDI inflows. The major elements of industrial policies are ownership requirements, technology support, entry, exit and growth regimes, labour market policies etc. generally policies towards market oriented, nondiscriminatory and liberal policies generate more FDI inflows. Evidence from Japan and India suggests the importance of liberal policies to import technology. Firms should be allowed liberal policies to import new technologys depending on their perception of market forces along with a genuine support from the government in all aspects. Japan adopted similar technology and was successful. India, followed a quite stringent and controlled policies on technology imports, which resulted in lower FDI inflows. Recent studies gives the conclusion that, liberal policies on technology coincided with liberal policies in general, can attract better and more foreign direct investments. 2.5.3. Startegy of MNEs Strategies adopted by MNEs often acts as a vital determinant of FDIs in developing countries. There are several factors that determine this sort of MNEs strategies. The mostly discussed among them are the host country risk factors and corporate level approaches to various international operations. Country Risks While going for an investment project, the MNEs analyse the host country environment. The results of such analysis are very confidential and circulated on a limited basis. Factors like macro management, labour market, stable policy and other political factors are considered as a benchmark for studying the country risk, before committing for an investment project.

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The table below shows the major determinants of FDI and selected relevant studies done on it Table: 2.5.1
Factors determining FDI inflows in a host country Author Economic Factors: Market size, growth perspect and stability, entry and exit, distribution and taste & preferences, urbanisation etc. Resources location and natural resources Competitiveness labour availability, skills, infrastructure, supplier availability, finance, technological support etc. Traxler and Woitech (2000) Pistoresi (2000) Locationa specific and policy related determinants of FDI in Latin America and Asia Labour market regimes as a determinant of location FDI and Exchange rate volatility Cheng and kwan (2000) Topic of study Determinants of location in China Findings Found out that major determinants of FDI are market size, better infrastructure and preferential policies. FDi inflows depends on political and economic factors Selected relevant studies done on the determinants of FDI.

Entrepreneurs do not consider labour market as high priority factor for FDI With enough exchange rate volatility, firms can earn more profit by opening numerous plants There is causality between real exchange rate to FDI in big countries. FDI depends on host country charectristics and inflows vary between member countries.

Sung and Lapan (2000) Policies of government: Macro policies access to forex, ease of remittance and management of crucial macro variables. Private sector permission of private ownership, stable policies, better financial market, easy entry and exit etc. Industry and Trade regional integration, trade strategies, liberalized Kosteletou and Liargovas (2000)

Relationship between FDI and real exchange rate

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technology import policies etc. FDI policies transparent and stable policies, ease of entry, better incentive, ownership etc.

Clegg and Scott (1999)

Link between FDI and European integration

FDI depends on host country characteristics and inflows vary between member countries. FDI inflows are affected by tax burden and fiscsal policies

Schoeman et.al (2000)

Impact of fiscal policy on FDI in South Africa

Strategies of MNCs Risks involved country risk factors, labour markets, stability of policy. Location, sourcing and integration.

Lehmann (1999) Ramcharran (1999)

Role of country risk relationship

Economic and political risks decreases FDI inflows

Cleeze (2000)

Factors that determine location of Japanese FDI in UK

Wage differences are not important, but production growth is important

List and Co (2000)

Relationship between location and environment regulations

Environmental policies do have impact on FDI inflows.

Source: Imad A Moosa, (2002), page: 63, S.Lall, (1997), page: 18.

2.6. IMPACT OF FOREIGN DIRECT INVESTMENT IN HOST COUNTRY DEVELOPMENT

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Most of the economies in the world try to attract FDI with the hope that it will have a significant positive effect on the economy. Based on this paradigm, many research works and case studies have been done to explore the contribution of FDI on economic growth. Many had come with a mixture of conclusion, stating that it has both positive and negative effect. For instance the study conducted by Theodore, Edward and Magnus (2005) suggest that FDI can have varying effects that is both positive and negative effect. Some say economist were of the opinion it has got more positive impact, but depends on several factors in the host country such as sectors of the economy the economy achieves more growth when FDI inflows to the manufacturing sector is high when compared to that of primary sector Alfaro (2003). Many factors in the host countries such as labour market, capital market, technology, balance of payment etc also are adversely affected through FDI inflow which in turn acts as a fuel for economic growth Lall (2002). The arguments relating to the causality of growth and FDI inflow and vice versa are the focal point for several researchers. The study of Chowdhary and Mavrotas (2003) indicates that when an economy experience high growth it tends to attract more FDI inflows than the countries with weaker growth. All the above mentioned assumptions and findings however brought into light some major effects (both positive and negative) of Foreign Direct Investment. As we have seen earlier in the literature studies, it is clear that Foreign Direct Investment is associated with activities like transfer of technology, capital, managerial skills, promotional skills, organisational reengineering etc. this process in turn generates both costs and benefits for both (investing as well as for host country) the countries which are involved. To measure these costs and benefits is a difficult task, apart from this, the most widespread and common explanation for FDI is that, it has a positive impact. This section covers most significant globally discussed issues that are associated with FDI. These include FDI impact on capital market, labour market, management techniques, balance of payments and technological change or overhauling.

2.6.1. Impacts of Foreign Direct Investment Technological Transfer (Haluk sezer (Piggot and Cook, 2006))
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The recent exploration in the developing countries reveals that FDI is seen as a way to encourage technological change. MNCs while opting for a foreign investment, would more likely to bring along with them their own technologies instead of depending on the local facilities. There are two sided effects for technology when it follows FDI, such as direct when associated with technology spillovers. However both the aspects mentioned above is considered as a positive contribution of FDI to economic growth. Recent empirical analysis based on this context supports the following conclusions: (OECD, 2002) Diffusion of technology in an FDI undertaking occurs through four channels such as vertical and horizontal linkages, switching of skilled labour from MNCs to local firms and also through Research and Development. Empirical evidence shows that more positive impact is seen in vertical linkages, especially in the backward linkages, because the local suppliers get adequate training and technological assistance from MNCs in order to raise the quality of supplier products and services. MNEs even assist them in the purchase of raw materials and intermediary goods and also helps them to establish a most modern production facilities in the host countries. This will ensure better business environment and economic growth. Evidence relating to horizontal spillovers with regard to FDI is less. But some available evidence suggests that horizontal spillovers are more effective when organizational functions in totally different sectors. Apart from the above two channels, labour migration and Research and Development also plays a major role in technological transfer. Employees who are affiliated with a foreign company acquire superior technological know-how and managerial skills. Bende Nabende (2002) suggests in his study that there is a wide scope for the spread of technological knowhow, especially when the employees switch to domestic firm from an MNC. MNEs therefore avoid these spillovers by giving high ransoms to skilled staffs. The other method which they commonly follow is the consideration of expatriate staffs in the host country instead of local ones.

Impact on Human Capital and Labour Market (OECD, 2002, H.Sezer (Piggot and Cook,
2006))

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Some are of the opinion that FDI has got a positive impact on the labour market and that of the host country human capital is considered as one of the element in locational advantage, while MNEs looks for foreign investment in the host country. The developing country in order to attain positive environment for FDI should give utmost importance to general education and human capital. Minimum level of education is necessary for an host country to maximise both FDI inflows and human capital spillovers from MNEs. Another important factor to be considered for FDI is the existence of a well maintained labour-market standard. It is clear from the evidence that MNEs mostly invest in those regions were the standard of labour is similar to that of their home country. In other words, the environments were employees has certain degree of security, freedom from discrimination and abuse etc act as a pull factor for FDI inflows. However the role of MNEs in giving adequate training and up gradation activities with regard to human capital in host country is more significant than that of the domestic enterprises. Effects of FDI on labour market are another debateful matter. Some advocates that FDI have a positive impact on employment in the developing economy. These positive effects can again be direct and indirect in a sense like creating new jobs and new post along the value chain respectively. Spillover effects during MNEs activities in a host country generally increases labour productivity, which inturn induces economic growth. Moreover it is clear that MNEs can influence the level of income distribution by demanding different types of labour and offering higher remuneration for skilled workers. MNCs when they engage in international business requires more educated and skilled staffs to manage and to run their business efficiently. Foreign firms do have the advantage of better Research and Development facilities and latest technologies, so they look for skilled labours by paying huge remuneration, hence compelling them to work for them. This activity of the MNC does quite often create a gap between skilled and unskilled labours within a host country, thereby creating a room for inequality. Effects on Capital Market (H.Sezer (Piggot and Cook, 2006) A significant characteristic of a developing country when compared to that of the developed economy is the existence of weak capital formation. In order to boost capital into the economy, eased restrictions on FDI inflows required. Policies regarding special incentives and reduced tariff rates were executed to increase the FDI inflows in many of the developing economies. MNCs when compared to that of local firms do not suffer from credit constraint

31

and they bring along with the capital for setting up their business in a host country. This capital in turn induces sustained economic growth. It is worth explaining at this juncture the crowding out effect made by FDI. MNCs when they enter host country would prefer local financial market in order to finance their business and therefore domestic firms has to compete with them to avail the existing capital. Because of the advantage of business profitability and possession of huge assets than local firms, financial institutions give loans or capital to MNCs than to domestic firm on the ground of safe return. This might gradually drives the domestic firms out of business and thereby giving MNEs the room to absorb the available capital. This situation is therefore referred to as crowding out effect. Impact on Balance of Payment (H.Sezer (Piggot and Cook, 2006) The effects of FDI on host countries balance of payment is quite important to study at this juncture. The inflow of FDI can bring three direct positive impacts on a host country balance of payment. First, only foreign investment project in a host country by MNC is considered as an additional unit of capital made to the national account and also it brings in foreign exchange. Secondly, a host countries current account can be benefited by FDI replacing imports. Thirdly, FDI undertakings are made by the MNCs to the place were they can get lowest possible cost of production. This in turn increases export oriented affiliation with the host country which will benefit the developing countrys current account. Apart from positive direct effects there are also indirect effects of FDI, especially the spillover effects. The spillover effect, which originates from the MNCs business process encourage the developing host country, especially their local firms to export more. This spillover effects also give the local or domestic firms to understand and to implement the methods to be successful in foreign market, which is also an added advantage. MNCs while dealing business with other countries, generates enormous pressure to lower the trade barriers. This reduced trade barriers benefits the domestic firms to do business between their country and with other developing nations. The other indirect effects often take place in the form of diffusion of skills. Employees who are acquired export knowledge and the contacts from MNCs, might decide to move to domestic firms. This in turn again benefits the local firms through the diffusion of those export management techniques and contacts.

32

Effects of FDI on balance of payment has got two sided effects, apart from positive effects, it can also bring negative effects to the host country such as adverse balance of payment effects. As per Razmi (2005) the economic liberalization policies of less developed countrys to improve FDI inflows, might bring adverse effect to the countries balance of payment. The most important negative effect through FDI will be the trade deficits. The FDI tends to bring more imports than the export to the host country and that situation even get worse when the country is still running in such deficits , which in turn disturbs countrys balance of trade. Studies had proven that there are three factors that contribute to trade deficits. They are as follows: 1. MNCs bring in large amount of machinery and equipment to the host country, were it is scarce. 2. MNCs who are in search of low cost of production and who are interested in moving the facilities to those area bring in raw materials, components and spare parts to run their business. 3. MNCs manipulation of transfer prices, occurring during the process of export and import.

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CHAPTER 3 FOREIGN DIRECT INVESTMENT IN CHINA AND INDIA

34

3.1. FDI INFLOWS IN CHINA China being isolated for 30 years, decided to open its economy again in the late 1970s. The period between 1980s 1990s witnessed an increase in the level of FDI inflows, through varied economic reforms. Major types of FDI that are prevailing in China according to Yuan (2005) are: 1) contractual joint ventures 2) Equity joint ventures 3) joint exploration 4) wholly foreign owned enterprises5) share company with foreign investment. All the above mentioned FDIs are considered as the fruits of well implemented economic reforms. The analysis of the Chinese history reveals the actual facts to the readers. The first stage of the reforms kick-started in 1979, with the establishment of joint venture law and the formation of Special Economic Zones. The main aim of the policy was to attract foreign capital or investment through incentives and low tax regimes. During this period, the number of Contractual joint ventures was more in comparison to the Equity Joint Ventures, which accounted 86% to the total number of FDI projects. At the end of this period about 1399 investment projects was approved with an accrued contract capital of 4958 million dollars (Dunning and Narula,1996). In 1984 89 the concept of SEZs was again recalled and upgraded, thereby formulating tax advantaged economic development zone and open coastal economic zones respectievely. The newly improved business environment triggered an increase in FDI by 50% and 120% in 1984 and 85 respectievely(Dunning and Narula,1996). Meanwhile during this period the FDI inflow to manufacturing sector and service sector was worth noticing. The inflow to the manufacturing sector rose by 33% from 14%, but the considerable flow to the service sector got decreased. The magnificent growth of FDI inflow that was visible during 1984 85 came to an in 1986, because of the changes involved in both general business scenario and market situation. In order to improve investment environment, the state council executed another reform called 22 regulations or the so called provisions for the encouragement of foreign investment. The new economic policy had given the investors more confidence, and resulted in a increase inward FDI more than 36% during 1987 1988. The FDI inflow to manufacturing sector again rose to 56% from 33% (in 1984- 88) during this period. The service sector again experienced a 5% decline in FDI, because of Chinese selective FDI policies. These reforms and the growth were again hindered during the period between 1988 91, because of a political crisis that took place between student activists and the government military officials in Tianameen Square (Margaret M.price, 1994)). In order to accelerate investment activities, overall economic restructuring was made. The 1979 joint venture was renewed and rules regarding the
35

elimination of contract duration in some Joint Ventures were made. The period of 1990s and 2000s can be considered as the golden era of Chinese economic growth, several reformation such as opening of inland cities, liberalization of service sector and infrastructural development was made. The early 1990s recorded a negligible ratio of increase in the flow of FDI to the total domestic investment, which was 7% in 1992. The FDI inflow steadily increased after this period, thus projecting a figure of 17% in 1996(Zhang, 2006).The overall FDI projects during 1996 also rose to 70%, 90% and 134% respectively, which was more when compared to that of 1992 (Dunning and Narula,1996). After a long 15 years of negotiation, China on 11th of November 2001, became an official member of WTO. This had given china the opportunity again to restructure the economic reforms. This in turn had improved business environment a lot. According to Yuan (2006), china during the post WTO period had made significant changes in the economic policies, one among such policies was the reduction of tariff rate and establishment of direct trading rights for foreign firms. This along with Chinese membership in WTO had given more confidence for the investors which as a consequence lead to better FDI inflows (Xiaobao Dang, 2008). On the whole from the above analysis, Chinese FDI history can be divided into 5 stages. 1) 1979- 1983 experiment stage 2) 1984 1991 growth stage 3) 1992 1993 peak stage 4) 1994- 200 adjustment stage 5) 2001 present post WTO stage. The reform undergone during these stages was the critical factors that led to such a huge productivity boom in China (Xiaobao Dang, 2008). 3.1.1. The impact of FDI in Chinese economy Chinas run to the second most desirable investment places in the world was begun in from the year 1978, through various economic reforms, since then the economy had attained a steady growth. One of the main agenda behind these economic reforms was the attraction of FDI. This case study of china explicitly projects the significant role of FDI in economic growth. Foreign capital has played a largely positive role in chinas economic development during the reform (Machanna, August 15 2010). According to Zuliu and Mohsins Khan (IMF report, 1997) capital investment plays a vital role in economic growth and it becomes more potant when accompanied by economic reforms or market oriented reforms.

36

The most prominent advantage of FDI in china was the sudden increase in export and import trade. The Chinese market share in the international trade increased to 6.1% from 1.6% during the period 1985 to 2000. The other prominent impact of FDI on Chinese economy was the creation of job opportunities, technological spillovers and capital contribution. The FDI also facilitated the transition towards a market system from a centrally controlled system. This in turn had given few valuable benefits to china, which includes the formation of a market mechanism, production restructuring, up-gradation in the domestic enterprises competitiveness and Chinese economic integration with the global economy (Zhang, 2006).

3.2. FDI INFLOWS IN INDIA The importance of FDI Indias economic growth is indispensable. The economic survey of 2001-2002 by the Indian government had pinpointed several benefits of FDI on Indian economy, which are as follows: it encourages domestic investment for achieving higher economic growth; FDI is beneficial for both consumers and domestic industries in many ways; FDI brings along with it the benefits of technological up-gradation; fuller utilization of resources; and access to better managerial skills, which in turn helps the Indian industries to become highly competitive in the global market. FDI also helps in opening export markets, which enables access towards better goods and services (Swapna s. Sinha, 2007). To study the impact of FDI in Indian economy, it is necessary to analyse the period before liberalization and period after liberalization of 1991. The governmental policies towards FDI have been changing from the post independence period. To study these variations, we can divide the period into four distinct faces. The period of gradual liberalization of attitude which was from independence to 1960s; the period of most selective stance from 1960s to 1970s; the period of less or limited liberalization of policies, which was from 1980s to 1990s. The period after 1991, the economy was opened and the concept LPG (Liberalization, Privatization and Globalization) was introduced (Dunning and Narula, 1996). After independence, India adopted several developmental plans of them the strategy of import substituting industrialization was the first. The aim of the strategy was to improve the productivity and capability of the heavy industries (Shujiro and Fukunari, 2006). During this

37

period the FDI inflow was increasingly receptive. The Foreign Investment policy issued by the Prime Minister in 1949 considered FDI is necessary to accumulate capital and also needed to secure more technical, scientific and industrial knowledge. To do this, foreign investors were given the assurance of fair reimbursement in the event of acquisition and no restriction on the payment of profits and dividends (Shujiro and Fukunari, 2006). The FDI policies in India was again liberalised during 1957 58 followed by the foreign exchange crisis, the policy included more incentives and concessions. In the late 1960s government focussed on several industries, which include drugs, aluminium, heavy electrical equipments textiles etc and opened the economy for them in order to increase FDI inflows. In order to promote FDI in India, the government even started Indian investor centres with offices in various investor countries. The result for these amendments as a measure to attract FDI was overwhelming. A large number of foreign enterprises including foreign drug companies showed interest in establishing branches in the country. The inflow of FDI during this period was better when compared to that of early 1950s. The FDI accumulation in the country during 1948 1964 was multiplied from Rs2560 million to Rs5655million (Dunning and Narula, 1996). The attitude towards FDI during the late 1960s by the government was more of a restrictive one. FDI proposals which accompanied technological transfer and investment, which is more 40% foreign ownership was only accepted. Different items were specified by the government to the foreign collaborators for the royalty payments and for the duration of technology transfer agreements. The government also had putforth to the foreign investors, to use Indian consultancy services wherever it is available. The year 1973 was characterised by with the establishment of new FERA and limitations in the activities of foreign companies was made which concentrated only on selected high priority industries. According to new FERA, the foreign companies having 40% had to register with Indian corporate legislation, exceptions from the 40% limit was given only for high- priority sectors, which was concentrating on exports (Shujiro and Fukunari, 2006). This restrictive environment had stagnated the FDI inflows. The FDI inflow recorded during 1974- 1980 was only Rs163 million. Liquidation of FDI stock in non-manufacturing sector due to government takeover of several companies and fresh inflows to the manufacturing sector were worth noticing during this period. The share of manufacturing sector in the FDI stock increased to 86.9% in 1980 from 40.5% in 1964 (Dunning and Narula, 1996).

38

As a part of modernisation, Indias FDI perspectives began to change in the1990s. There was overall freedom in the import of capital goods and technological transfer, this in turn exposed Indian industry to have competition with foreign investors or companies. The other changes adopted during this period include; numerous incentives, exemption from foreign equity restrictions under FERA to 100% export oriented units for the purpose new export processing Zones were established and also brought the liberalization rules for the approval of industrial licensing. The rules regarding lump sum technical fees and royalties were released and taxes were also decreased. Indias growth rate during 1980s was far better than that of previous decade, which projected an average growth of nearly 6% (Shujiro and Fukunari, 2006). The stock of FDI also got tripled during this period to 27 billion. The share of services, plantations and manufacturing sectors to the total FDI stock increased, while the share of chemicals and metal products got declined. Besides UK, US and Germany, Japan also started their investment in India during this period (Dunning and Narula, 1996). Indian scholars pointed out that the economic policies of 1970s 1980s in some way or the other was responsible for the crisis of 1990- 91. The economic environment of preliberalisation period was more or less closed in nature. Policies during this period were mainly for the protection of the domestic firms. Inward orientation and import substitution was the main backbone of development strategy during this period. Because of the above said unfavourable economic reforms, FDI inflow was less and dint had much role to play with upliftment of Indian Economy. The share of FDI during 1970- 80 to Indias GDP was on . 033% (K R Gupta, 2000). 1991 till date is considered as Indias post liberalization period. It started of with the liberalization of investment and trade policies under the short form LPG (Liberalization, Privatization and Globalization). The government reduced most of the products tariff rates. The recorded average tariff rate on import during 1990-91, 1994-95 and 1997-98 was 87, 25 and 20% respectively. They also had made reforms in old policies like discontinuation in technological requirements for FDI in India. A wide variety of sectors mostly consumer goods sectors were opened for the foreign investment. Previous FDI requirements (except for 24 consumer goods industries), like export earnings balance the dividend payment for over the first 7 years from the date of commercial production was dropped and profit repatriation by the foreign- managed firms were eased. In the mid 1990s India became the member of Multilateral Investment Guarantee Agencies, as a consequence, all the government approvements were insured against nationalization. The government also allowed 100%
39

equity in high technology and export oriented industries. In order to deal with large investment proposals, a Foreign Investment Promotion Board was set up. It deals with foreign investments which exceeds foreign equity of 51%. During this period Reserve Bank of India was also authorized to give approvals to projects in the high priority areas, where foreign equity did not exceed 50% in mining sector and 51% in other sectors. This open attitude by the government enabled FDI inflow to get tripled and it recorded US$ 10 billion per year (A Mattoo and R M Stern, 2003).

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CHAPTER 4 EMPERICAL ANALYSIS

41

4. METHODOLOGY AND DATA COLLECTION In the previous section, we discovered that what fraction of FDI flows to India and China. The strategies and policies they have adopted also played an immense role in attracting such an inflow. The current section examines the contribution of FDI on Chinese and Indian economy. The data for FDI inflows and other variables are from the data base of UNSTAD. The data undertaken for the study covers a period of 39 years starting from 1970 to 2009. The section for the purpose is divided into two. The first section deals with graphical representation. This method is adopted to explain the relationship between the growth rates of the primary variable of concern, FDI and GDP for India and China as a whole. The second section presents the regression analysis for the aggregate for India and China as a whole. 4.1. Graphical analyses The purpose of the analysis is to show the affiliation between the growth rate of GDP and FDI. If the GDP growth rate is related to that of FDI, then it might be due to FDI determining of GDP, the growth rate of FDI at any time t is calculated as (FDIt FDIt-i) / FDIt-1. Similar method is employed to calculate GDP growth rate. The analysis also shows the recent trends in FDI inflows in INDIA and CHINA. Figure: 4.1.1. FDI and GDP growth rate in CHINA

relatio
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The figure 4.1.1for china shows that the FDI inflow during the time period from 1970 to 1982 was some what zero and it might be due to the closed nature of economic activity during those days (Zhang 2006). The trend started to change since 1980 onwards and this might largely due to the liberalization policies which they adopted during those days. An important point to be noted during the period 1982 to 1990 was that both FDI and GDP was going at the same rate and was almost parallel. After 1990 there witnessed a sudden increase in the rates of FDI but the GDP growth rate during those period was less, but positive. The period from 1998 to 2000 is also worth noticing because FDI growth rate plunged to almost 4% from 5% and it was almost constant till the year 2001. This sudden slow down in the FDI inflow during this time was largely due to the Asian crisis of 1997. However the directions of both the lines were moving in the same direction from the period 1980 onwards. After 2000 the FDI inflow again started to rise, but experienced little fall back during 2002 and 2005 respectively. The GDP line shows that the economic growth rate was enormous from 2000 to 2009 respectively, but FDI experienced a steep fall during the period 2007 to 2008 and this is, might be as a consequence of global financial crisis. On the whole the relationship between FDI flow and GDP growth rate was positive and the graph shows both the lines were, somewhat moving in the same direction.

Figure: 4.1.2 FDI and GDP growth rate in INDIA

relationship between GDP growth and FDI change in INDIA

percentage of change 30 25 20 15 10 5 0
19 19 19 19 19 19 19 19 19 19 20 20 20 20

FDI GDP

-5

70

73

76

79

82

85

88

91

94

97

00

03

06

Year

43

09

The figure 4.1.2 for India shows that, the variable FDI and GDP growth is not moving at the same proportion, which might indicate that FDI does not play a relevant role in economic growth. The period ranging from 1970 to 1993 suggest that the inflow of FDI was minute and during the period 1978 to 79 it went to negative, but the GDP growth was less but was positive. The FDI growth during 1994 to 1999 was positive and went to a maximum of 3%. It again declined during 1999 to 2002, this might be as consequences of Asian financial crisis. The important point to be noted that at any point till 2006 both FDI and GDP growth rate was not more than 5%. There witnessed sharp rise in FDI inflows during 2006 to 07 and it rose almost to 12% which was actually double the growth of the previous periods, but the relationship of FDI and GDP during that period shows, that FDI has got only less importance in the economic growth of India. After experiencing a small fall back during 2007 it again went upward to a maximum of 24% in 2008, which was enormous when compared to that of 2007, but at the same time GDP also increased but not at significant level compared to that of FDI. The graph shows that in the beginning of 2009 the FDI inflows went down very sharp to 21% from 24% while the GDP growth decreased and became constant. However the period from 2006 to 2008 can be considered as a golden period for FDI inflows in India. Both the graph gives us an insight into the flow of FDI in these countries and the relevance of FDI on economic growth. Most significant thing to be noted is that the graphs do not explain the impact of FDI on economic growth of these countries but only shows the relationship between these variables. Another important fact is that, these investment inflows became more strong and positive after the adoption of liberalization policies in these countries. Therefore the graph supports the findings of Agarwal (2000), Zhang (2006) and Dang (2008), that growth in these countries were periodical and it largely occurred as a result of more liberalized policies. It is astonishing to see how the growth rate went upward after opening up their economy (especially the early1990 period and the post 1990 period is worth noticeable in both the countries China and India respectively). 4.2. REGRESSION ANALYSIS The method used for the empirical analysis on this dissertation involves linear regression analysis. The variables concern for the study involves GDP, which is considered as the dependent variable, while FDI inflow is taken as the independent variable of interest. The study also covers the relevance of other variables that contribute to the total GDP. The analysis is done in two different parts, one part predominantly for China and the other for

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India. For the purpose two equations are formulated by including independent variables like FDI, exports and labour force for China along with the dependent variable GDP. Meanwhile in the equation for India independent variable like FDI, Labour force and workers remittance receipts from abroad are also included. This is done with an intention to study the impact of these variables along with FDI on economic growth of these countries respectively. Labour and employment plays major role in the economy. Often large entrepreneurs are largely directed towards to those countries where they avail skilled labour at a cheap rate for their business. Besides labour also contribute a major portion in the total GDP. The study, therefore analysis their contribution in accordance with FDI. Workers remittance level is another important factor that contributes to GDP growth rate. The importance of the same is increasing day by day in India and China. The number of people who are working in another country remits a part of their wages or business activities to their country of origin in a way of savings. The exchange rate and the conversion procedure also plays a major role which again add to the total GDP. The study therefore analysis their contribution as well, to the total GDP in India. Net export is another most important variable considered for the thesis. Net export is the difference between total import and export. It is also referred to as balance of trade of a country. It is also considered as a major part of national account (current) in the balance of payment of a country. The correlation of net exports and national asset position is immense, that an increase or decrease in net exports will have a direct impact on the later, causing it to change. As mentioned earlier, for the purpose of the thesis, a linear regression model is used. The results are so obtained with the use of SPSS (statistics package for the social sciences), a software similar to E-views. This is commonly used by the management students and corporate official all around the world to determine a precise analysis of the problem. The study done by S.Adewumi (2006) and Xiaohong Ma (2009) had used similar analysis to find the impact of FDI on economic growth in Africa and China respectively. S.Adewumi (2006) had used three methods such as graphical, regression and granger causality, while Xiaohong Ma (2009) employed only regression model to do the analysis. The finding so obtained from both studies was some what positive in nature. The correct precision and the compatibility of regression method used in both the studies can be taken as a base to formulate a multiple regression model to analyse the problem concerned for the thesis.
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Multiple linear regression model is used to determine the impact of one or more independent variable on a dependent one. It allows analysts to examine the effect of more than one independent variables on dependent variable (xinyan, xinogang su, 2009). The equation for the model for China is formulated as follows: GDP= + 1 FDI + 2 LBR + 3 Nx+ t . (1) Were GDP = Average annual growth rate of real per capita FDI = Measured as a percentage of GDP, in US dollar millions, LBR = Annual average of the labour force, given in percentage, Nx = Measured as a percentage of GDP, in US dollar Millions Here the variable GDP is the gross domestic product, while FDI is the foreign direct inflows, while Nx and LBR represent net exports and labour force of China respectively. The equation for the model for India is formulated below: GDP = + 1FDI + 2LBR + 3WR (2) Were GDP = Average annual growth rate of real per capita. FDI = Measured as a percentage of GDP, in US dollar millions, LBR = Annual average of the labour force, given in percentage, WR = Measured as a percentage of GDP, in US dollar millions. Here the variable GDP is the gross domestic product, while FDI is the foreign direct inflows, while LBR and WR represents labour force and workers remittance receipts of India respectively. The hypothesis for the empirical analysis is that the impact of FDI on economic growth of India and China is positive. The confirmation of the above hypothesis can be made according to the estimated value of 1 in the regression models. The hypothesis for the model is: Ho: 1 = 0 (FDI inflow do not have any impact on economic growth), while H1: 2 0

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The result of the model for India and China is represented in the tables 4.2.1.2 and 4.2.2.2. Durbin Watson test is also included in the analysis to find the autocorrelation in the error term. If the DW value is near to zero, the autocorrelation will be positive, and if it is near to 2, then no autocorrelation. Thet value is shown in the model to test the significance level of the co-efficient estimates. There are 39 observations in each analysis for China and India. The FDI inflow datas for China for the years between 1970 to 1980 is not available because China has opened its economy after a long period of the late 1970s encouraged more FDI inflows during 1980 onwards (Dunning and Narula, 1996). The labour force data for India and China and workers remittance receipts data for India is only available from 1980 .onwards. These limitations might have an impact on the regression results 4.2.1. REGRESSION ANALYSIS OF CHINA GDP = -253.901 + .564FDI + 3.747LBR + .086Nx (-.998) R square = .140, (1.353) (1.023) (1.350)

DW = 1.023

1) From the analysis for the sample (see table 4.2.1.1 in appendix), 1 = .564 > 0, in other words FDI has an independent variable has got a positive effect on the economic growth of China. In other words a unit increase in FDI causes the GDP to increase by .564 percent in China. The coefficient value for 2 is 3.744, it indicates that labour contribution to economic growth is worth noticing and positive in China. Besides, 3 = .086 > 0 means net exports in China also has got a positive impact, thereby indicating that a unit increase in exports causes the GDP to increase by .49 percent in China. By comparing all the variables, we find that FDI, LBR and Nx has got positive impact on Chinas economic growth. 2) From the equation the t-value for FDI, LBR and Nx are 1.353, 1.025 and 1.350 which are all positive and significant- but not that significant when compared to that 5% significance level. Of all the variable again FDI has got more positive effect, indicating that FDIs contribution is more significant than the other variable.

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4.2.2 REGRESSION ANALYSIS OF INDIA GDP = -7.562 + .536FDI + .165LBR + .212WR (-.084) R square = .086 (.581) (.144) (.267)

DW = 1.836

1) The analysis (see tables 4.2.2.1 and 4.2.2.2 in appendix) shows that 1 = .536> 0, indicating that co-efficient estimates of FDI is positive with the GDP growth rate of India. The equation suggests that a unit increase in the FDI cause GDP to grow by .581 percent for India. Besides the value of 2 and 3 are .144 and .267 respectively, showing that the nature of contribution made by labour force and workers remittance are almost positive in nature. Of all the variables the coefficient estimates of FDI is more positive, whereby indicating that role of FDI in economic growth is quite significant. 2) The t-value for FDI, LBR and WR are .581. .144 and .267 respectively, which are all positive but not significant at 5% significance level. Of the entire variables computed, FDI has got highest effect on the GDP, even though its not significant. The study thus reveals FDI has got relevance in the GDP growth of India, hence supporting our theory of concern for the study.

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CHAPTER - 5 FINDINGS AND CONCLUSION

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5.1. FINDINGS AND CONCLUSION FDI inflows in India and China was periodical, and the relevance of the same is increasing year by year. China being isolated for more than 30 years opened its economy on the late 1970s, since then the flow was astonishing. China at present is the main FDI attracting zone in entire Asia and India is in second place according to the recent studies. India on the other hand opened its economy in 1991 with the introduction of Liberalization, Privatization and globalization policies, since then the inflow was quite good. The pre- liberalization period of both the countries were of a closed nature, giving due importance to domestic firms. After realising opportunities and possible benefits the policy makers in both the countries decided to open the economy. The main aim of this research is to examine the role of FDI in economic growth in CHINA and INDIA. The study is so aligned that, it gives due importance to both empirical and theoretical aspects to give the readers an insight into the strategies, intervention, role of FDI and partially the role of other factors of growth that are prevailing in INDIA and CHINA, which enabled them to achieve such a rapid economic growth. The graphical analysis of China as a whole shows that the relationship between FDI and GDP growth rate was remarkable and both the variables are going at the same upward direction, indicating that FDI might have a significant effect on GDP growth rate in China. The graphical analysis of India shows that there is only very minute relationship between FDI and GDP growth rate. The direction of flow of both the variable are not equal and vary at certain periods, FDI as a variable might not have a significant role in the in the economic growth of India. The main point to be noted is that the graphs do not explain the impact of FDI on economic growth of these countries but only shows the recent trend in FDI inflow and the affiliation between these variables. Regression equation is formulated after doing the graphical analysis. For the purpose linear regression method is used to calculate the impact and the role of FDI on GDP growth of China and India. There are 39 observations in each analysis for China and India. The FDI inflow datas for China for the years between 1970 to 1980 is not available because China has opened its economy after a long period of the late 1970s encouraged more FDI inflows during 1980 onwards (Dunning and Narula, 1996). The labour force data for India and China

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and workers remittance receipts data for India is only available from 1980 onwards. These limitations might have an impact on the regression results. Empirical results for China suggests that FDI as an independent variable has a favourable impact on the GDP growth rate of China. The other variable such as labour force and exports also has got positive relation with GDP, thereby indicating that all the variables contributes positive to economic growth in CHINA. Empirical results for India suggests that FDI as a primary variable has got a positive relation between GDP growth rate, indicating that FDI is relevant in contributing to the growth of GDP growth rate in India. Of all the variables computed FDI is more positive but not that significant at 5% significance level. Recent statistical figures shows that FDI inflows are increasing yearly and it might have a major role in the contribution of GDP growth rate of both the countries in the nearing future.

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APPENDIX A1.1. Regression analysis for China

Table : 4.2.1.1 Model Summary(b)

Model 1

R .374(a)

R Square .140

Adjusted R Square .040

Std. Error of the Estimate 2.83087

DurbinWatson 1.023

a Predictors: (Constant), nx, fdi, lbr b Dependent Variable: gdp

Table : 4.2.1.2

Coefficients(a)

Unstandardized Coefficients Model 1 (Constant ) fdi lbr nx a Dependent Variable: gdp B -253.901 .564 3.747 .086 Std. Error 254.464 .417 3.657 .064

Standardized Coefficients Beta t -.998 .335 .289 .308 1.353 1.025 1.350 Sig. .328 .188 .315 .189

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A1.2 Rgression analyis for India

Table : 4.2.21

Model Summary(b) Adjusted R Square -.020 Std. Error of the Estimate 2.15592 DurbinWatson 1.836

R R Square .293(a) .086 a Predictors: (Constant), wr, lbr, fdi b Dependent Variable: gdp Table : 4.2.2.2

Model 1

Coefficients(a) Unstandardized Coefficients Model 1 B (Constant ) fdi lbr wr a Dependent Variable: gdp -7.562 .536 .165 .212 Std. Error 90.431 .923 1.145 .795 .218 .031 .099 Standardized Coefficients Beta t -.084 .581 .144 .267 Sig. .934 .566 .886 .792

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