Spillover effects of FDI on financial services: Does FDI

promote local financial development in India?

by
ThuHang Tran

An Honors Thesis to be submitted to Department of Economics

Wellesley College
April, 2007

(Ruhlman) Abstract:

The Government of India decisively liberalized its economy in 1991 following a severe
balance of payments crisis. The major changes included a reform of the Industrial
Licensing Policy, reductions in tariffs and the opening of the economy to foreign direct
investment (FDI). How did these reforms affect the Indian economy? In particular, how
did this new inflow of capital contribute to India's current growth track? There has been
much research on the spillover effects of FDI on growth (intra-industry externalities,
technological transfer, etc.) but not much on the effects on the financial sector. Does FDI
have an impact in promoting financial services locally? I will look at variation in FDI
across districts in India, given different pre-existing local industrial structures, to find out
how FDI liberalization might have aided local financial development following India's
1991 reforms.
 3. Proper acknowledgement of the previous work on which you are building. Sufficient
references such that a reader could, by going to the library, achieve a sophisticated
understanding of the context and significance of the question.
4. Explain the scope of your work, what will and will not be included.
6. Is it obvious where introductory material ("old stuff") ends and your contribution
("new stuff") begins?

Introduction:
India crisis, liberalized, xong point to FDI one of the biggest reforms, mac du so voi china
thi $4bn va $40bn ko dang’ gi. Regardless of the accounting debate between China and
India on how to define FDI. Despite this debate, development now (one of the world’s
biggest gi day’… thanh tuu results nhat la ve financial services
http://meaindia.nic.in/indiapublication/Financialsector.htm)
Ministry of External Affairs

 did FDI play any role in econ growth, development, tech transfer? What role has FDI
played in India, specifically in India’s financial sector successes? Been much research
on tech transfer… thi moi’ nghi~ la maybe role of FDI? Its effects?
Even though there is much debate on accounting principles and the definition of FDI
between India and China,

Despite the widely cited/compared? much lower amount of FDI compared to China (on
which there is much debate pointing to the accounting differences and divergence in
defining FDI1 in India and China that widened the gap in numbers), India has obviously
achieved much success, most notably in the financial sector. One can point to the
development in Indian capital markets: the national presence of the infotech-driven
National Stock Exchange (NSE), the effective independent regulator Securities and
Exchange Board of India (SEBI), the Mumbai Stock Exchange with an increased market
capitalization from $40bn in 90-91 to $203 in early 2000. Indian banking sector has also
reformed and evolved remarkably well, reaching a total asset size of $270bn, total
deposits amounting to $220bn covering a branch network of over 66000 branches
country-wide. Financial institutions in India in 2001 disbursed a total of $14bn across all
districts.2

Much research on FDI has focused on its role with regards to income growth, income
distribution and other economic factors such as trade, technological transfer and
productivity, considering the financial sector and financial markets as a channel through
which FDI affect dependent factors. Nevertheless, is it plausible that FDI also directly
promote financial development directly? Does FDI have direct positive effect on the
financial industry over and above the investments that comes in when the sector was

1
For definition of FDI please see: http://www.econ.jhu.edu/people/Contessi/fdi_files/definitions.htm
And IMF’s Balance of Payment Manual 1993 document:
http://www.imf.org/external/np/sta/bop/BOPman.pdf
For the debate on re-defining FDI please see:
http://www.oecd.org/document/33/0,2340,en_2649_33763_33742497_1_1_1_1,00.html
2
Ministry of External Affairs, India: http://meaindia.nic.in/
liberalized? There has been little research examining the effect of FDI on financial
development separately/independently. The most relevant literature looked at FDI in
perspective with economic growth and financial market development.

The sudden liberalization of FDI in various industries created a wonderful natural

experiment. I want to examine and empirically measure the efficacy of FDI on the
development of local financial services in the case of India by utilizing the variations in
FDI inflows (created by the above-mentioned abrupt “reform by storm” of foreign
investment in 1991) and local financial development (represented by bank branches,
total amount of credits and deposits) across districts in India. I hope to find a positive
spillover effect of FDI on local financial services evidenced by empirical data in the
periods immediately before and after FDI liberalization.

The paper is organized as follow. The next section reviews main research directions
done on relevant subjects and findings of representative works (research on
determinants and impacts of FDI – theoretically and empirically in developing countries
in general and in India in particular; research on banking reforms and its effect in India).
Section III covers empirical strategy, data sources and econometric model employed.
Results and their robustness are discussed in the following section before conclusions
are offered with policy implications.
Literature Review:
Haddad, Mona & Ann Harrison: Are there positive Spillovers from FDI?
Journal of Development Economics, 42: 51-74
Are there positive spillovers from direct foreign investment? : Evidence from
panel data for Morocco
Journal of Development Economics, Volume 42, Issue 1, October 1993, Pages 51-74
Mona Haddad and Ann Harrison

Since I am looking to estimate the impact of FDI on local financial development in

districts of India, I will review relevant literature on three main research directions: the
determinants of FDI, the effects of FDI and literature on financial reforms in India.

Literature on the Determinants of FDI:

 providing targeted fiscal incentives, such as tax concessions, cash grants, and
specific subsidies;
 improving domestic infrastructure;
 promoting local skills development to meet investor needs and expectations;
 establishing broad-reaching FDI promotion agencies;
 improving the regulatory environment and decreasing red tape; and
 engaging in international governing arrangements.

Root, F. and Ahmed, A. (1979) ‘Empirical Determinants of Manufacturing Direct Foreign

Investment in Developing Countries’, Economic Development and Cultural Change 27,
751-68.

Literature on the Impact of FDI:

The resources in this list focus on the impact of FDI on:

 economic growth

FDI in Developing Countries and Growth: A Selective Survey. Luiz R. de Mello Jr.
Journal of Development Studies v34.n1 (Oct 1997): pp1-34.

How Does Foreign Direct Investment Promote Economic Growth? Exploring the
Effects of Financial Markets on Linkages Author Chanda, Areendam; Alfaro, Laura;
Kalemli-Ozcan, Sebnem; Sayek, Selin Affiliation Unlisted; Unlisted; Unlisted; Unlisted
Source Department of Economics, Louisiana State University, Departmental Working
Papers, No Date
Abstract The empirical literature finds mixed evidence on the existence of positive
productivity externalities in the host country generated by foreign multinational
companies. We propose a mechanism that emphasizes the role of local financial
markets in enabling foreign direct investment (FDI) to promote growth through backward
linkages, shedding light on this empirical ambiguity. In a small open economy, final
goods production is carried out by foreign and domestic firms, which compete for skilled
labor, unskilled labor, and intermediate products. To operate a firm in the intermediate
goods sector, entrepreneurs must develop a new variety of intermediate good, a task
that requires upfront capital investments. The more developed the local financial
markets, the easier it is for credit constrained entrepreneurs to start their own firms. The
increase in the number of varieties of intermediate goods leads to positive spillovers to
the final goods sector. As a result financial markets allow the backward linkages between
foreign and domestic firms to turn into FDI spillovers. Our calibration exercises indicate
that a) holding the extent of foreign presence constant, financially well-developed
economies experience growth rates that are almost twice those of economies with poor
financial markets, b) increases in the share of FDI or the relative productivity of the
foreign firm leads to higher additional growth in financially developed economies
compared to those observed in financially under-developed ones, and c) other local
conditions such as market structure and human capital are also important for the effect
of FDI on economic growth. Availability
http://www.bus.lsu.edu/economics/papers/pap06_13.p df URL

Important study:
Title Foreign Direct Investment, Economic Growth, and Financial Sector
Development: A Comparative Analysis Author Choong, Chee-Keong; Yusop,
Zulkornain; Soo, Siew-Choo Affiliation U Tunku Abdul Rahman; U Putra Malaysia;
Monash U Malaysia Source ASEAN Economic Bulletin, vol. 21, no. 3, December
2004, pp. 278-89 ISSN 0217-4472

Abstract In this study, patterns of foreign direct investment (FDI) and economic
growth are investigated among select developed and East Asian countries. In
particular, it aims to investigate the development of the domestic financial sector in
transferring the technological diffusion embodied in FDI inflows to the chosen
countries. It is evident in all the countries under study that both FDI and economic
growth are not cointegrated by themselves directly, but rather through their dynamic
interaction with the development of the domestic financial sector. Our results prove
that the presence of FDI inflows creates a positive technological diffusion in the long
run only if the evolution of the domestic financial system has achieved a certain
minimum level. From the short-run causality models, the striking similarity in the
behaviour of FDI on economic growth across countries suggests the possibility of
common financial sector development in different countries, despite differences in
their fiscal policy, industrial development, and other domestic determinants.

 Trade

Sharma, K. (2000) “Export Growth in India: Has FDI played a Role? “ Economic Growth
Center Discussion Paper No. 816, Yale University.

 employment and skill levels;

Employment and skill levels;

Kathuria, V. (2000) Productivity Spillovers from Technology Transfer to Indian
Manufacturing Firms, Journal of International Development, 12, 343-369.

 technology diffusion and knowledge transfer; and

Emma Xiaoqin Fan, Technological Spillovers from Foreign Direct Investment – A survey,
ADB 2003, Asian Development Review, vol.20, no.1, pp. 34-56.
  Linkages and spillover to domestic firms.

Smarzynska B.K., 2002, Does Foreign Investment Increase the Productivity of Domestic
Firm? In search of spillovers through backward linkages” WB policy WP 2923 Oct.

Aitken, B., and A. Harrison, 1999. “Do Domestic Firms Benefit from Direct Foreign
Investment? Evidence from Venezuela.” American Economic Review 89(3):605-18.

Gorg, H., and Greenaway, D. (2001) Foreign Direct Investment and Intra-Industry
Spillovers: A Review of the Literature, 137, Research Paper Series, Centre for Research
on Globalisation and Labour Markets Programme, School of Economics, Nottingham
University.

Most of the literature treats the finance sector and financial markets as a channel
through which FDI affect other factors. Nevertheless, is it plausible that FDI promote
financial development directly as well?

Literature on Financial Reforms in India:

Abhijit V. Banerjee and Rohini Pande

Data - Methodology:
data/methodology section that is as detailed as you can be without having to go to a lot
of trouble (i.e. it should accurately reflect where you are currently with respect to data)

What belongs in the "methods" section of a scientific paper?

1. Information to allow the reader to assess the believability of your results.
2. Information needed by another researcher to replicate your experiment.
3. Description of your materials, procedure, theory.
4. Calculations, technique, procedure, equipment, and calibration plots.
5. Limitations, assumptions, and range of validity.
The methods section should answering the following questions and caveats:
1. Could one accurately replicate the study (for example, all of the optional and
adjustable parameters on any sensors or instruments that were used to acquire
the data)?
2. Could another researcher accurately find and reoccupy the sampling stations or
track lines?
3. Is there enough information provided about any instruments used so that a
functionally equivalent instrument could be used to repeat the experiment?
4. If the data is in the public domain, could another researcher lay his or her hands
on the identical data set?
5. Could one replicate any laboratory analyses that were used?
6. Could one replicate any statistical analyses?
7. Could another researcher approximately replicate the key algorithms of any
computer software?
Citations in this section should be limited to data sources and references of where to find
more complete descriptions of procedures.
Do not include descriptions of results.

 Petia B. Topalova’s “Trade liberalization, Poverty and Inequality: Evidence from

Indian Districts”. (2005)
 Adaptation from trade tariffs to FDI inflows.
 Externally imposed reforms  exploit variation in the “initial” industrial
composition across districts and the timing of FDI liberalization – Period
immediately before and the five-year plan immediately following reforms.
 Constructed measure of district trade exposure.

 Ydt = α + β.Tariffdt + γt + δd + εdt

Petia’s data:
 Indian National Sample Survey NSS: Household survey data 83-84, 87-88, 93-
94, 99-00  District level measures of poverty and inequality.
 Indian Census 1991: industrial share data, district level in 1991 at 3-digit National
Industrial Classification (NIC) code.
 Constructed database of annual tariff data for 1987-2001 for measure of changes
in Indian trade policy.
My adapted version:
 Ydt = α + β.FDIdt + γt + δd + εdt
  Ydt = Local financial development outcomes (bank branches, credit/deposits)
 FDIdt = FDI flowsdt * ISdt
 ISdt = Pre-existing Industrial Structure 1991
Data update:
 Bank Branches/Credit-Deposit at district level 1991-2004.
 FDI (at worst national inflows over the years, at best states/sector breakups)
 Pre-existing industrial shares: Indian Census 1991.
 Other variables: Indian Census 1991 - 2001.

Hypothesis:
References:
1. Aitken, B., and A. Harrison, 1999. “Do Domestic Firms Benefit from Direct Foreign
Investment? Evidence from Venezuela.” American Economic Review 89(3):605-18.

Emma Xiaoqin Fan, Technological Spillovers from Foreign Direct Investment – A survey,
Asian Development Review, vol. 20, no. 1, pp. 34-56. (2003 ADB).

Gorg, H., and Greenaway, D. (2001) Foreign Direct Investment and Intra-Industry
Spillovers: A Review of the Literature, 137, Research Paper Series, Centre for Research
on Globalisation and Labour Markets Programme, School of Economics, Nottingham
University.

Kathuria, V. (2000) Productivity Spillovers from Technology Transfer to Indian

Manufacturing Firms, Journal of International Development, 12, 343-369.

Title Foreign Direct Investment, Economic Growth, and Financial Sector

Development: A Comparative Analysis Author Choong, Chee-Keong; Yusop,
Zulkornain; Soo, Siew-Choo Affiliation U Tunku Abdul Rahman; U Putra Malaysia;
Monash U Malaysia Source ASEAN Economic Bulletin, vol. 21, no. 3, December
2004, pp. 278-89 ISSN 0217-4472

Sharma, K. (2000) “Export Growth in India: Has FDI played a Role? “ Economic Growth
Center Discussion Paper No. 816, Yale University.

FDI in Developing Countries and Growth: A Selective Survey. Luiz R. de Mello Jr.
Journal of Development Studies v34.n1 (Oct 1997): pp1(34).

How Does Foreign Direct Investment Promote Economic Growth? Exploring the
Effects of Financial Markets on Linkages Author Chanda, Areendam; Alfaro, Laura;
Kalemli-Ozcan, Sebnem; Sayek, Selin Affiliation Unlisted; Unlisted; Unlisted; Unlisted
Source Department of Economics, Louisiana State University, Departmental Working
Papers, No Date

Root, F. and Ahmed, A. (1979) ‘Empirical Determinants of Manufacturing Direct Foreign

Investment in Developing Countries’, Economic Development and Cultural Change 27,
751-68.

Petia Topalova, “Trade Liberalization, Poverty and Income Inequality”, …

Jalilian Weiss, FDI and Poverty in the ASEAN region

Javornik Smarzynska, To share or not to share: Does local participation matter for
Spillovers from FDI?
Klein, Aaron, FDI and Poverty Reduction WB WP

Smarzynska B.K., 2002, Does Foreign Investment Increase the Productivity of Domestic
Firm? In search of spillovers through backward linkages” WB policy WP 2923 Oct.