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AN ECONOMIC ANALYSIS OF FOREIGN DIRECT INVESTMENT IN INDIADOCTORAL THESIS BY

SUMANA CHATTERJEE

DEPARTMENT OF ECONOMICSFACULTY OF ARTSTHE MAHARAJA SAYAJIRAO UNIVERSITY OF BARODA VADODARA, GUJARAT, INDIA

AN ECONOMIC ANALYSIS OF FOREIGN DIRECT INVESTMENT IN INDIAA THESIS SUBMITTED TO THE MAHARAJA SAYAJIRAO UNIVERSITY OF BARODA FOR THE AWARD OF THE DEGREE OF

DOCTOR OF PHILOSOPHY IN ECONOMICSBY

SUMANA CHATTERJEE

RESEARCH GUIDE PROFESSOR P.R. JOSHI

DEPARTMENT OF ECONOMICSFACULTY OF ARTS THE MAHARAJA SAYAJIRAO UNIVERSITY OF BARODA VADODARA, GUJARAT, INDIA

AUGUST 2009

DECLARATION

I hereby declare that this submission is my own work and that, to the best of my knowledge and belief, it contains no material previously published or written by another person nor material which has been accepted for the award of any other degree or diploma of the university or other institute of higher learning, except where due acknowledgment has been made in the text.

Place: Vadodara Date : 27th August 2009

Name Signature

: Sumana Chatterjee :

Registration No : 007487

CERTIFICATE

This is to certify that the thesis entitled An Economic Analysis of Foreign Direct Investment in India, submitted by Ms. Sumana Chatterjee for the award of the degree of Doctor of Philosophy in Economics in the Department of Economics, Faculty of Arts, The Maharaja Sayajirao University of Baroda, Vadodara, Gujarat has been carried out under my guidance.

The matter presented in this thesis incorporates the findings of independent research work carried out by the researcher herself. The matter contained in this thesis has not been submitted elsewhere for the award of any other degree.

Professor P. R. JoshiResearch Guide and Head Department of Economics Faculty of Arts The Maharaja Sayajirao University of Baroda Vadodara, Gujarat

To action alone hast thou a right and never at all to its fruits; Let not the fruits of action be thy motive; Neither let there be in thee any attachment to inaction. - Shri Bhagvatgita (Chapter 2 verse 47)

ACKNOWLEDGMENTS

As I have learned during the past years, writing a dissertation in economics is not only a stimulating but also a very challenging undertaking and I have occasionally asked myself whether I would actually be able to complete this project. Now, when the goal finally has been reached, I would like to take this opportunity to express my gratitude to all the people who helped me make this possible.

First and foremost, I would like to thank my supervisor Prof. P.R. Joshi, who motivated me to start this project and his comments and recommendations have been invaluable for me to successfully finish this dissertation.

I have also benefited significantly from the co-operation and discussions with Prof. A.S. Rao. He has been immensely helpful in providing suggestions for improvements of the empirical work.

I would also like to express my appreciation for all comments and suggestions from my other friends, colleagues and well-wishers at the economics department during the years.

My parents and my son have always supported and encouraged me. I owe them a lot.

Vadodara August 2009

Sumana Chatterjee

LIST OF ABBREVIATIONS

1 2 3 4 5 6 7 8 9

AFTA APEC ASEAN BITs BOP BPO CIS CUFTA DAC

: : : : : : : : : : : : : : : : : : : : : : : :

ASEAN Free Trade Area Asia-Pacific Economic Cooperation Association for South East Asian Nations Bilateral Investment Treaties Balance of Payments Business Process Outsourcing Commonwealth of Independent States Canada United States Free Trade Agreement Development Assistance Committee Department of Industrial Policy and Promotion European Bank for Reconstruction and Development Export Oriented Unit European Union Foreign Direct Investment Gross Domestic Product Gross Fixed Capital Formation International Bank for Reconstruction and Development Inward Foreign Direct Investment International Monetary Fund Indian Oil Corporation Intellectual Property Rights International Organisation for Standardisation Information Technology Mergers and Acquisitions

10 DIPP 11 EBRD 12 EOU 13 EU 14 FDI 15 GDP 16 GFCF 17 IBRD 18 IFDI 19 IMF 20 IOC 21 IPR 22 ISO 23 IT 24 M&As

I

25 MNC 26 NAFTA 27 NRI 28 ODA 29 OECD 30 OFDI 31 ONGC 32 R&D 33 RBI 34 SIA 35 TNC 36 UK 37 UNCTAD : 38 US 39 WIR 40 WTO

: : : : : : : : : : : :

Multi National Corporation North American Free Trade Agreement Non-Resident Indians Official Development Assistance Organisation for Economic Cooperation and Development Outward Foreign Direct Investment Oil and Natural Gas Corporation Research and Development Reserve Bank of India Secretariat of Industrial Assistance Trans National Corporation United Kingdom United Nations Cooperation for Trade and development

: : :

United States World Investments Report World Trade Organisation

II

LIST OF TABLES

TABLE NO. 3.1

CONTENTS Measures of integration of the Indian economy with the world economy

PAGE NO. 66

3.2 3.3 3.4 3.5

Share of India in Global GDP and its growth Inward FDI stock Inward FDI flows Foreign direct investment inflows in selected Asian

67 69 70 71

developing countries 3.6 3.7 FDI Inflows and GDP figures in India Inward FDI flows as a percentage of Gross Fixed Capital Formation by host region and economy 3.8 3.9 3.10 3.11 Inward FDI Performance Index of Some Selected Countries Inward FDI Potential Index of Some Selected Countries Share of top investing countries FDI inflows Statement on RBIs regional office-wise (with state covered) FDI equity inflows 3.12 3.13 3.14 4.1 Sectoral analysis of FDI inflows Major sectors: change in FDI stocks and output growth FDI characteristics Outward foreign direct investment: world and developing countries 4.2 4.3 FDI outflows originating in developing countries Indian OFDI stock 108 111 Continued 85 86 8889 107 75 76 81 83 73 74

III

TABLE NO. 4.4 4.5 4.6 4.7 FDI outward stock FDI outflows

CONTENTS

PAGE NO. 112 113 114 115

FDI flows as a percentage of GFCF Country wise approved Indian direct investments in joint ventures and wholly-owned subsidiaries

4.8 4.9 4.10 4.11 4.12 4.13 4.14 4.15

Distribution of Indian OFDI stock by host regions Changing ownership structure of Indian OFDI Cross-border Mergers & Acquisitions Indian purchases Overseas M&As by Indian enterprises Sector-wise OFDI of India Cumulative OFDI approvals by Indian enterprises Indias direct investment abroad by sectors Some of the biggest acquisitions by Indian companies

117 119 119 120 122 122 123 125126

IV

LIST OF BOXES

BOX NO. 3.1 3.2 3.3 3.4 4.1 4.2 5.1

CONTENTS Matrix of Inward FDI Performance and Potential 2002 Matrix of Inward FDI Performance and Potential 2005 Various incentive schemes for attracting FDI Liberalisation of FDI policy Characteristics of India OFDI Characteristics of OFDI at different stages of the IDP OLI advantages and MNC channels for serving a foreign market

PAGE NO. 78 79 95 95 110 110 144

5.2 5.3 5.4

Locational determinants of foreign direct investment Determinants of FDI Summarised Correlation matrix of IFDI flows and the determinants of IFDI flows

154 161 167

6.1 6.2 6.3

Push Factors determining OFDI Determinants of OFDI Summarised Correlation matrix of OFDI flows and the determinants of OFDI flows

189 189 197

V

TABLE OF CONTENTS

Acknowledgements List of Abbreviations List of Tables List of Boxes I III V

CHAPTER 1: Introduction 1.1 Theoretical exposition of FDI 1.2 Relevance of the present study 1.3 Objectives of the present study 1.4 Methodology and Sources of data 1.5 Thesis Outline

1 2 16 18 27 29

CHAPTER 2: Review of Literature 2.1 Studies from the Global perspective 2.2 Studies from the Indian perspective

33 35 47

CHAPTER 3: Trends and Patterns of Inward FDI 3.1 Indian economic integration with the world economy 3.2 Trends and patterns of inward FDI 3.3 Findings and Conclusions

66 68 71 99

CHAPTER 4: Trends And Patterns of Outward FDI 4.1 Explaining the investment development path 4.2 Trends and patterns of outward FDI 4.3 Findings and Conclusions

103 105 110 139

CHAPTER 5: Determinants of Inward FDI 5.1 Theories of FDI: A chronological overview 5.2 Theoretical Framework 5.3 Literature Review 5.4 Hypothesis and Methodology 5.5 Findings and Conclusions

145 145 157 167 170 175

CHAPTER 6: Determinants of Outward FDI 6.1 Theories of outward FDI 6.2 Literature Review 6.3 Hypothesis and Methodology 6.4 Findings and Conclusions

186 186 190 200 204

CHAPTER 7: Summary, Conclusions and Recommendations 7.1 Inward FDI in India 7.2 Outward FDI from India 7.3 Contribution of the Study

218 219 225 234

Bibliography Appendix Tables

i xx

CHAPTER 1 INTRODUCTION

INTRODUCTION

During last twenty to twenty-five years, there has been a tremendous growth in global Foreign Direct Investment (FDI). In 1980 the total stock of FDI equaled only 6.6 percent of world Gross Domestic Product (GDP), while in 2003 the share had increased to close to 23 percent (UNCTAD 2004). This dramatic development has taken place simultaneously with a substantial growth in international trade. The growth in international flows of goods and capital implies that geographically distant parts of the global economy are becoming increasingly interconnected as economic activity is extended across boundaries. FDI is an important factor in the globalisation process as it intensifies the interaction between states, regions and firms. Growing international flows of portfolio and direct investment, international trade, information and migration are all parts of this process. The large increase in the volume of FDI during the past two decades provides a strong incentive for research on this phenomenon.

This dissertation investigates different aspects of FDI at the macro economic level using aggregated data for FDI. The choice of research topics has been made in order to allow for the possibility of finding results that can provide knowledge about the nature of FDI that may help policy makers of both home and host 1 country to take appropriate decisions.

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Henceforth, host country refers to a country that receives an inflow of FDI while home country refers to a country that generates an outflow of FDI.

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SECTION 1.1

THEORETICAL EXPOSITION OF FDI

Financial flows can be put into four categories:

1. Private Debt Flows: They are comprised of bonds, bank loans and other credits issued or acquired by private sector enterprises in a country without any public guarantee.

2. Official Development Finance: It consists of Official Development Assistance (ODA) and other official flows

i. Official Development Assistance: ODA consists of net disbursements of loans and grants made on concessional terms by official agencies of the members of the Development Assistance Committee (DAC) and certain Arab countries to promote economic development and welfare in recipient economies that are listed as developing by the DAC. Loans with a grant element of more than 25 percent are included in ODA. ODA also includes technical co-operation and assistance. ii. Other Official Flows: These are transactions by the official sector whose main objective is other than development or whose grant element is less than 25 percent such as official export credits, official sector equity and portfolio investment and debt re-organisation undertaken by the official sector on non-concessional terms.

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3. Foreign Portfolio Investment: Foreign portfolio investment involves

i. Purchase of existing bonds and stocks with the sole objective of obtaining dividends or capital gains. ii. Investment in new issues of international bonds and debentures by the financial institution or foreign government.

4. Foreign Direct Investment: Direct investment is assumed to have occurred when an investor has acquired 10 percent or more of the voting power of a firm located in a foreign economy. (IMF 2004a) 2

CONCEPTS OF FDI

1. Foreign Direct Investment Entity

There are different ways in which firms and individuals can hold assets in a foreign country. The definition of a foreign direct investment entity decides which of these are considered as direct investment and which firms are considered as multinational enterprises. A foreign direct investment entity has been defined differently for Balance of Payment (BOP) purposes and for the purpose of the study of firm behavior. The definition of foreign direct investment as a capital flow and a capital stock has changed correspondingly.

The dominant current definition of FDI entity prescribed for BOP compilations by the IMF (1993) and endorsed by the OECD avoids the notion of control by

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Lipsey (2003) provides a detailed description of how the definition of FDI has changed over time.

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the investor. Direct investment is the category of international investment that reflects the objective of a resident entity in one economy obtaining a lasting interest in an enterprise resident in another economy (the resident entity is the direct investor and the enterprise is the direct investment enterprise). The lasting interest implies the existence of a long term relationship between the direct investor and the enterprise and a significant degree of influence by the investor on the management of the enterprise. (IMF 1993)

A direct investment enterprise is defined in the IMF BPM5 (Balance of Payments manual 5) as an incorporated or unincorporated enterprise in which a direct investor, who is a resident in another economy, owns 10 percent or more of the ordinary shares or voting power (for an incorporated enterprise) or the equivalent (for an unincorporated enterprise) (IMF, 1993).

The IMF definition is governing for BOP compilations, but there is a different, but related, concept and a different official definition in the United Nations System of National Accounts, the rule book for compiling national income and product accounts, that retains the idea of control and reflects a more micro view. In these accounts, which measure production, consumption, and investment, rather than the details of capital flows, there is a definition of Foreign Controlled Resident Corporation. Foreign controlled enterprises include subsidiaries more than 50 percent owned by a foreign parent. Associates of which foreign ownership of equity is 10-50 percent . May be included or excluded by individual countries according to their qualitative assessment of foreign control (Inter-Secretariat Working Group on National Accounts, 1993, pp. 340-341). Thus from the view point of the host country and for analyzing production, trade, and employment, control remains the preferred concept.

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2. FDI Flows

The definition of FDI flows has changed over time as the definition of FDI enterprises has changed. Direct investment capital flows are made up of equity capital, reinvested earnings, and other capital associated with various inter-company debt transactions. (IMF, 1993) The last category is the most difficult, covering the borrowing and lending of funds including debt securities and suppliers credits between direct investors and subsidiaries, branches and associates. This includes inter-company transactions between affiliated banks (depository institutions) and affiliated financial intermediaries. However, the later are now to be included in direct investment only if they are associated with permanent debt (loan capital representing a permanent interest) and equity (share capital) investment or, in the case of branches, fixed assets. Deposits and other claims and liabilities related to usual banking transactions of depositary institutions and claims and liabilities of other financial intermediaries are classified under portfolio investment or other investment. (IMF, 1993)

DEFINITION OF FDI

There is no specific definition of FDI owing to the presence of many authorities like the OECD, IMF, IBRD, and UNCTAD. All these bodies attempt to illustrate the nature of FDI with certain measuring methodologies. Generally speaking FDI refers to capital flows from abroad that invest in the production capacity of the economy and are usually preferred over other forms of external finance because they are non-debt creating, non-volatile and their returns depend on the performance of the projects

5

financed by the investors. FDI also facilitates international trade and transfer of knowledge, skills and technology. It is also described as a source of economic development, modernisation and employment generation, whereby the overall benefits triggers technology spillovers, assists human capital formation, contributes to international trade integration and particularly exports, helps to create a more competitive business environment, enhances enterprise development, increases total factor productivity and improves efficiency of resource use.

IMFOECD DEFINITION

FDI statistics are a part of the BOP statistics collected and presented according to the guidelines stated in the IMF BPM5 Manual, fifth edition (1993) and OECD Bench mark definition of FDI (2003).

The IMF definition of FDI is adopted by most of the countries and also by UNCTAD for presenting FDI data.

According to IMF BPM5, paragraph 359, FDI is the category of international investment that reflects the objective of a resident entity in one economy (direct investor or parent enterprise) obtaining a lasting interest and control in an enterprise resident in another economy (direct investment enterprise).

The two criteria incorporated in the notion of lasting interest are:

i. The existence of a long term relationship between the direct investor and the enterprise.

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ii. The significant degree of influence that gives the direct investor an effective voice in the management of the enterprise.

The concept of lasting interest is not defined by IMF in terms of a specific time frame, and the more pertinent criterion adopted is that of the degree of ownership in an enterprise. The IMF threshold is 10 percent ownership of the ordinary shares or voting power or the equivalent for unincorporated enterprises. If the criteria are met, then the concept of FDI includes the following organisational bodies:

i. Subsidiaries: (in which the non resident investor owns more than 50 percent) ii. Associates: (in which the non resident investor owns between 10-50 percent) iii. Branches: (unincorporated enterprises, jointly or wholly owned by the nonresident investor)

COMPONENTS OF FDI

The BPM5 and the benchmark recommend that FDI statistics can be compiled as a part of the BOP and international investment position statistics. Consequently countries are expected to collect and disseminate FDI data according to the standard components presented in the BPM5. The concept of FDI includes the capital funds that the direct investor provides to a direct investment enterprise as well as the capital funds received by the direct investment enterprises from the direct investor. It comprises not only the initial transaction establishing the relationship between the investor and the enterprise but also all subsequent transactions between them and among affiliated enterprises, both incorporated and unincorporated (IMF, 1993).

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The components of Direct Investment constitute direct investment income, direct investment transactions and direct investment position. FDI flows are the sum of three basic components; viz. equity capital, reinvested earnings and other capital associated with inter-company debt transactions:

i. Equity Capital: It consists of the value of the MNCs investment in shares of an enterprise in a foreign country. It consists of non cash which can be in the form of tangible and intangible components such as technology fee, brand name etc. It comprises equity in branches, all shares in subsidiaries and associates and other capital contributions. ii. Reinvested Earnings: It consists of the sum of the direct investors share (in proportion to the direct equity participation) of earnings not distributed as dividends by subsidiaries or associates and earnings of branches not remitted to the direct investor. iii. Other Direct Investment Capital: They are also known as inter-company debt transactions. They cover the short and long term borrowing and lending of funds including debt securities and suppliers credit-between direct investors and subsidiaries, branches and associates (BPM5). In sum direct investment capital transactions include those operations that create or liquidate investments as well as those that serve to maintain, expand or reduce investments.

The IMF definition thus includes as many as twelve different elements, namely: equity capital, reinvested earnings of foreign companies, inter-company debt transactions including short term and long term loans, overseas commercial borrowing (financial leasing, trade credits, grants, bonds), non cash acquisition of equity, investment made by foreign venture capital investors, earnings data of indirectly held FDI enterprises, control premium, non competition fee and so on.

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FDI defined in accordance with IMF guidelines can take the form of Greenfield investment in a new establishment or merger and acquisition of an existing local enterprise known as Brownfield investment.

FDI ACCOUNTING IN INDIA

FDI statistics in India are monitored and published by two official sources: Reserve Bank of India (RBI) and Secretariat of Industrial Assistance (SIA) in the Ministry of Commerce and Industry.

REVISED FDI DEFINITION

In the Indian context till the end of March 1991, FDI was defined to include investment in:

i. Indian companies which were subsidiaries of foreign companies ii. Indian companies in which 40 percent or more of the equity capital was held outside India in one country iii. Indian companies in which 25 percent or more of the equity capital was held by a single investor abroad.

As a part of its efforts to bring about uniformity in the reporting of international transactions by various member countries, the IMF has provided certain guidelines which enable inter-country comparisons. Reflecting this with effect from March 31, 1992 the objective criterion for identifying direct investment has been modified and is fixed at 10 percent ownership of ordinary share capital or voting rights. Direct

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investment also includes preference shares, debentures and deposits, if any, of those individual investors who hold 10 percent or more of equity capital. In addition to this, direct investment also includes net foreign liabilities of the branches of the foreign companies operating in India.

A committee was constituted by the Department of Industrial Policy and Promotion (DIPP) in May 2002 to bring the reporting system of FDI data in India into alignment with international best practices. Accordingly, the RBI has recently revised data on FDI flows from the year 2001 onwards by adopting a new definition of FDI. The revised definition includes three categories of capital flows under FDI; equity capital, reinvested earnings and other direct capital. Previously the data on FDI reported in the BOP statistics used only equity capital.

TYPES OF FDI

i. Inward Foreign Direct Investment: This refers to long term capital inflows into a country other than aid, portfolio investment or a repayable debt. It is done by an entity outside the host country in the home country. ii. Outward Foreign Direct Investment: This refers to a long term capital outflow from a country other than aid, portfolio investment or a repayable debt. It is done by an entity outside the host country in the home country. iii. Horizontal Foreign Direct Investment: This refers to a multi-plant firm producing the same line of goods from plants located in different countries iv. Vertical Foreign Direct Investment: If the production process is divided into upstream (parts and components) and downstream (assembly) stages, and only the latter stage is transferred abroad, then the newly established assembly plants demand for parts and components can be met by exports

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from home-country suppliers. This is what Lipsey and Weiss (1981, 1984) and other researchers describe as Vertical FDI, whose aim is to exploit scale economies at different stages of production arising from vertically integrated production relationships. v. Greenfield Foreign Direct Investment: Greenfield FDI is a form of investment where the MNC constructs new facilities in the host country. vi. Brownfield Foreign Direct Investment: Brownfield FDI implies that the MNC or an affiliate of the MNC merges with or acquires an already existing firm in the host country resulting in a new MNC affiliate.

MULTINATIONAL CORPORATIONS

Multinational Corporations (MNC) or Transnational Corporations (TNCs) are the most important carriers of FDI. According to the World Investment Directory, MNCs are incorporated or unincorporated enterprises comprising parent enterprises and their foreign affiliates. A parent enterprise is defined as an enterprise that controls assets of other entities in countries other than its home country, usually by owning a certain equity capital stake.

An equity capital stake of 10 percent or more of the ordinary shares or voting power for an incorporated enterprise or its equivalent for an unincorporated enterprise is normally considered as a threshold for the control of assets.

A foreign affiliate is an incorporated or unincorporated enterprise in which an investor who is a resident in another economy owns a stake that permits a lasting interest in the management of that enterprise.

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An MNC can be defined as an entity which has one or more of the following criterion:

i. Sole proprietorship held abroad ii. Foreign branches of the company iii. Subsidiaries of the company iv. Associates

TYPES OF MNCs

i. National Firms: This refers to single plant firms with headquarters and plant in the same country. ii. Horizontal Multinationals: This refers to two plant multinationals which engage in producing the same line of goods across plants in different countries. iii. Vertical Multinationals: This refers to two plant multinationals which engage in dividing the production process in parts and components across different plants across the nations to take advantage of the scale economies arising from vertically integrated production relationships.

COMPILATION OF FDI DATA

Generally, there are two main alternatives for compiling FDI data:

i. To use Balance Of Payments statistics or ii. To perform firm surveys

The Balance of Payments data measures FDI as the financial stake of a parent in a foreign affiliate. The advantage of Balance of Payments data is that they can be

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collected relatively easy for virtually all existing countries. Unlike Balance of Payments data, firm surveys focus on the actual operations of MNCs.

FDI data is reported as a stock or a flow value. As described in IMF (2004a), flows of FDI consist of equity capital, reinvested earnings and what is usually referred to as other capital. Data on FDI flows are on a net basis i.e. (capital transactions credits less debits between direct investors and their foreign affiliates). Net decreases in assets (outward FDI) or net increases in liabilities (inward FDI) are recorded as credits (recorded with a positive sign in the balance of payments), while net increases in assets or net decreases in liabilities are recorded as debits (recorded with a negative sign in the balance of payments). The negative signs are reversed for practical purposes in the case of FDI outflows. Hence, FDI flows with a negative sign indicate that at least one of the three components of FDI (equity capital, reinvested earnings or intra-company loans) is negative and is not offset by positive amounts of the other components. These are instances of reverse investment or disinvestment. Stocks of FDI are similarly composed of equity capital, reinvested earnings and other capital. However, data on FDI stocks is presented at book value or historical cost, reflecting prices at the time when the investment was made

Inflows of FDI and the inward stock of FDI is a result of investment performed in the host country by foreign MNCs. Correspondingly, outflows of FDI and the outward stock of FDI represents investment in foreign countries performed by MNCs based in the source country.

FDI data is collected and reported by several international organisations:

i. IMF compiles and reports FDI data for the majority of the countries in the world. The data is based on balance of payments statistics and according to

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IMF (2004a) compiled from international transactions reporting systems and data from exchange control or investment control authorities. ii. UNCTAD prepares the annual publication of the World Investment Report. The report presents data for both flows and stocks of FDI as well as additional data such as the share of FDI in GDP. The report presents data for most countries. UNCTAD primarily tries to collect data directly from national official sources such as the central banks and statistical offices of individual economies. If this is not possible, data is complemented or obtained from the IMF or the OECD. iii. OECD reports FDI data for its member countries. The data is primarily based on Balance of Payments statistics as reported from the central banks and is presented in the International Direct Investment Statistics Yearbook. Data for bilateral flows of FDI is reported and there is some data for the distribution of FDI among industrial sectors in the OECD economies. iv. The World Bank includes FDI data among the so-called World Development Indicators. The data is primarily based on Balance of Payments data from the IMF and cover most countries. v. There are also a number of regional organisations such as ASEAN and EBRD reporting data for particular geographical regions. The EBRD presents FDI data for the European transition economies in the annual publication Transition Report (e.g. EBRD 2004). The FDI data is compiled on the basis of data from the IMF, data from central banks and EBRDs own estimates and survey.

LIKELY BENEFITS OF FDI

i. FDI is less volatile than other private flows and provides a stable source of financing to meet capital needs.

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ii. FDI is an important and probably dominant channel of international transfer of technology. MNCs, the main drivers of FDI are powerful and effective vehicles for disseminating technology from developed to developing countries and are often the only source of new and innovative technology which is not available in the arms length market. iii. The technology disseminated through FDI generally comes as a package including the capital, skills and managerial knowhow needed to appropriate technology properly.

LIKELY COSTS OF FDI

Recent years have seen increased public concern that the benefits of FDI have yet to be demonstrated and that, where benefits exist, they may not be shared equitably in the society. The adjustment costs associated with FDI include:

i. Higher short term unemployment due to corporate restructuring ii. Increased market concentration iii. Incomplete utilisation of FDI benefits due to incoherent institutional policies and regulatory conditions, unavailability of skilled labor and infrastructure.

The debate on the likely costs and benefits has reached new heights. Under these circumstances it is important to inform the discussion by drawing lessons from the country experience and to assist the Government in identifying the conditions and policy requirements for maximising the benefits of FDI and minimising the risks and potential costs.

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SECTION 1.2

RELEVANCE OF THE PRESENT STUDY

It is widely known that capital flows into developing economies like India have risen sharply in nineties and has, therefore, become a self propelling and dynamic actor in the accelerated growth of the economies. This study focuses on FDI as a vector of Indian globalisation. Recently not only did India become a more frequent destination for FDI, but also many Indian firms have started investing abroad in a big way. Thus we find a surge in both inward and outward FDI flows. The impassioned advocacy of increased FDI flows (inward and outward) is based on the well worn arguments that FDI is a rich source of technology and knowhow; it can invigorate the labour oriented export industries of India, promote technological change in the industries and put India on a higher growth path. This exuberance of FDI needs to be based on analytical review of Indias needs and requirements and her potential to participate in huge investment flows. Thus there is a definite need to incorporate the various dimensions of FDI into a theory of open economy development so as to explain in one integrated theoretical paradigm, the undercurrents of both inward and outward FDI flows.

The empirical literature on the relationship between FDI and development is mixed. Despite a number of studies and seeming contradictions, two consistent issues that repeatedly arise are:

i. What are the motivations / reasons for FDI flows? ii. What are the economic implications of FDI flows?

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Hence a detailed analysis of FDI into India requires an examination of the determinants and impact of FDI in the Indian economy. Studying both inward and outward FDI flows together will help to assess the nature and the true extent to which the Indian economy has globalised.

This study takes a closer look at the structure of Foreign Direct Investments into and from India. It traces the development of Indias economic policy regarding FDI and the resulting changes in both inflows and outflows. The expansion of FDI into and from India has been accompanied by a rapid economic growth and an increasing openness to the rest of the world. It is equally important to understand why India has become one of the important beneficiaries of FDI in the world and what drives the more recent progress of Indias outward FDI.

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SECTION 1.3

OBJECTIVES OF THE STUDY

In order to appreciate the importance of FDI flows for the Indian economy, it would be pertinent to examine the changes in the global FDI flows and the place of India within. In this respect the following issues shall be studied with respect to inward flows to and outward flows from India:

The nature and extent of Indian economys integration with the world economy

The nature of the regional distribution of FDI flows from the global FDI flows The comparative standing of FDI among developing countries The pattern of originating and destination countries of Indian FDI flows The nature of change in the sectoral composition of FDI in India The regional distribution of inward FDI in India The structure of cross border mergers and acquisitions from India The FDI flows as a percentage of GDP and GFCF FDI performance v/s potential in India Major policy initiatives taken to boost FDI flows

Why do firms go abroad? Why do they choose to invest in a specific location? These are some of the questions that have plagued scholars since the advent of interest in FDI. The origins of the theoretical literature on the determinants of FDI are to be found in Stephen Hymers (1960) doctoral dissertation. His thesis, briefly put, is that firms go abroad to exploit the rents inherent in the monopoly over advantages they possess and FDI is their mode of operations. The advantages firms possess include

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patented technology, team specific managerial skills, marketing skills, and brand names. All other methods of exploiting these advantages in external markets, such as licensing agreements and exports are inferior to FDI because the market for knowledge or advantages possessed by firms tends to be imperfect. In other words they do not permit firms to exercise control over operations essential for retaining and fully exploiting the advantages they own. Hymers insights form the basis of other explanations such as transactions costs and internationalisation theories, most of which in essence , argue that firms internalise operations, forge backward and forward linkages in order to bypass the market with all its operations.

John Dunning (1977, 1981) neatly synthesises these and other explanations in his well known eclectic paradigm or the OLI explanation of FDI. For a firm to successfully invest abroad, it must possess advantages which no other firm possess (Ownership), the country it wishes to invest should offer locational advantages (Location), and it must be capable of internalising operations (Internalisation) i.e. the OLI theory. Internalisation is synonymous with the ability of the firms to exercise control over such operations. And such control is essential for the exploitation of the advantages which the firm possesses and the location advantage which the host country offers. It is the location advantages emphasised by Dunning which forms much of the discussion on the determinants of FDI in developing countries. The two other attributes necessary for FDI are taken as given from the perspective of the developing countries. Dunning set the ball rolling on econometric studies with a statistical analysis of survey evidence on the determinants of FDI. His study identified three main determinants of FDI in a particular location: market forces (including market size and growth as determined by the national income of the recipient country), cost factors (such as labour cost and availability and the domestic inflation situation) and the investment climate (as determined by such considerations as the extent of foreign indebtedness and the state of BOP).

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Foreign investors are attracted to economically dynamic countries. They look for factors like high and growing per capita incomes, large domestic markets, well educated work force, well developed physical and technological infrastructure, proximity to export markets, social and political stability and the presence of other foreign investors called as agglomeration effect. What is crucial in attracting FDI is the countrys absorptive capacity or those factors that promote domestic economic growth through investment, infrastructure and human capital development. Accordingly it can be said that, growth and development leads to FDI rather than FDI leading to growth and development. Labour costs might be a more significant determinant of inward FDI in developing countries when these inflows reflect an intention to minimise production costs. This type of FDI is commonly referred as efficiency seeking and market seeking FDI. Resource seeking investors come into countries in order to exploit natural resources and factors like physical infrastructure and the pool of labour jointly determine the profitability of such investments. Market seeking investors make investments in order to sell their products in the host countrys domestic markets so they are more concerned with factors like domestic market size and per capita income.

Although the empirical literature continues to grow unabated, its overall message can be summarised in the following propositions, some of which shall be put to an examination in this study:

i. Host countries with a sizeable domestic market, measured by GDP per capita and sustained growth of these markets measured by growth rates of GDP, attract relatively large volumes of FDI.

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ii. Resource endowments of a host country including natural and human resources are a factor of importance in the investment decision process of the foreign firms. iii. Infrastructure facilities including transportation and communication are important determinants of FDI. An unexplored issue has been the role of information decisions. FDI requires substantial fixed costs of identifying an efficient location, acquiring knowledge of the local regulatory environment and coordination for supplies. Thus access to better information may make FDI to that location more likely. iv. Macro economic stability signified by stable exchange rates and low rates of inflation is a significant factor in attracting foreign investors. v. Political stability in the host countries is an important factor in the investment decision process of foreign firms. vi. A stable and transparent policy framework towards FDI is an attractive factor to potential investors. vii. Foreign firms place a premium on a distortion free economic and business environment. An allied proposition here is that a distortion free foreign trade regime which is neutral in terms of the incentives it provides for Import Substitution (IS) and Export Promoting (EP) industries attracts relatively large volumes of FDI than either an IS or EP regime. viii. Fiscal and monetary incentives in the form of tax concessions do play a role in attracting FDI. MNCs are potentially subject to taxation in both the host and home countries. It is found that the way in which parent country reduces double taxation on their MNCs can have implications for FDI. ix. Trade protection is also found to encourage FDI. It is found that FDI response to these trade actions (tariff jumping FDI) occurs only for firms with previous experience as MNCs.

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x. Wages are an important factor determining inward FDI. It is possible that lower wages are associated with higher levels of inward FDI. However, where there is a control for productivity, there could be a positive association found between FDI and the types of labour standards that may raise wages but that ultimately contributes to workers productivity. It is found that FDI is positively correlated to the right to establish unions, to strike, to collective bargaining and to the protection of the union members.

The aim of this study is to investigate the determinants of FDI in India from the perspective of country characteristics, identifying the most significant factors in India that influence foreign investors decision to invest in the country. Several location advantages as determinants of FDI in India, drawn from previous studies, will be tested.

Traditionally rich developed economies started FDI into other developed / developing economies to maximise the economic rent earned on capital. The developing and underdeveloped economies were viciously gripped by low levels of productivity leading to a low wage level and hence low level of savings and investment. Low levels of investment again perpetuate low levels of productivity. This inward spiral needs an external stimulus in the form of FDI. This could raise efficiency and expand output leading to economic growth in the country. The inward spiral then could turn outward signaling growth and prosperity. The direction of FDI by countries Inward Direct Investment (IDI) and Outward Direct Investment (ODI) was developed by John Dunning in a theory named Investment Development Path or IDP. He said that outward and inward direct investment position of a country is systematically related to its economic development relative to the rest of the world. The IDP suggests that countries tend to go through five main stages of development and these stages can

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be classified according to the propensity of those countries to be outward or inward direct investors. In sequence these stages are:

i. Non-existence of both inward and outward FDI ii. Emergence and expansion of inward FDI and bare existence of outward FDI iii. Expansion of outward FDI and slowing growth of inward FDI iv. Outward FDI stock exceeding inward FDI stock v. Net outward FDI stock (Gross outward FDI stock Gross of FDI stock) fluctuating to zero level

This suggests that a countrys outward FDI will not be large until the inward FDI increases. As indicated by the IDP path, India has already started its move as an outward investor and is in the second stage of the IDP.

Initiating from nineties, Indias successful industrialisation contributed to the growth of its FDI abroad. This increase in outward FDI (OFDI) suggests that the country is moving rapidly towards becoming a developed and mature economy.

As regards the outward foreign direct investment from India, the hypothesis examined is as follows:

Outward FDI from India has undergone a fundamental shift, which can be successfully explained as stage two, within the framework of the Investment Development Path

There are several factors that explain the emergence of India as a heavy OFDI investor. First the surge of OFDI has coincided with that of all FDI. Since the mid 1980s, worldwide flows of FDI have grown at unprecedented rates. Indian MNCs

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were influenced by this trend and began to participate actively by organising their own corporate network around the world. Rapid economic growth in the Asia-Pacific region has been the second factor contributing to Indian international investment. Many countries in the Asia-Pacific region adopted policies towards international trade and investment which helped to accelerate domestic economic growth. Third, Indias emergence as an outward investor was the direct result of the countrys rapid industrialisation strategy and outward looking policies. Finally shifts in Indias comparative advantage have played an important role in increasing the countrys foreign presence.

Following are the push factors explaining OFDI, some of which shall be put to examination in this study:

i. Economic Growth: The most important factors that may affect the FDI flows, as recognised in the literature, are the domestic market-related variables. Both current market size and potential market size can have a significant influence on outward FDI. Small market size and potential risk of losing market share may act as push factors for outward FDI. One of the main factors contributing to the outward FDI can be linked to the income of a country. Increase in the income of a country eventually will lead to structural changes to the economy of the country. The mounting of income enables firms to gain competitive advantage by enlarging the production scale as well as adoption of new technology. Ultimately, firms are able to acquire ownership advantages which become the driving force for establishing foreign production ii. Exports: Increased exports may assure the producers of existing markets and therefore lower the uncertainties and risks attached to investments, thereby encouraging outward FDI. This effect is stronger if exports are targeted towards a region with trade and investment agreements, which ensures access

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to larger integrated markets and the possibility of cross-border vertical integration and smooth operations of affiliates. Such outward FDI are undertaken mainly with the motive of expansion. iii. Imports: Increased imports into the country may have a displacement effect on investments, which may then be channeled outward into economies with lower manufacturing costs and greater access to larger markets. Such investments are undertaken mainly with the motive of relocation. iv. Inflow of FDI: Inward FDI flows may be a potential factor that may influence the capability of domestic investors to undertake outward FDI. FDI is expected to improve the technological standards, efficiency and competitiveness of domestic industry. FDI is also associated with bringing in "relatively" more upto-date technology into the industry since markets for technology are imperfect. The higher the inflow of FDI, the higher will be the capability of domestic investors to undertake investments abroad. Though existing FDI stock as a determinant of inward FDI flows has been used in many studies, none of the studies have as yet estimated the impact of inward FDI on outward FDI. v. Infrastructural Availability: It is expected that the lower the availability of infrastructure, higher will be the infrastructure costs and higher will be the outward FDI. vi. Cost Factors: Other domestic drivers of outward FDI are those that cause investment cost differentials across countries. These include costs of labour, capital and infrastructure. Cost factors may significantly influence the choice of an investment location for the resource-seeking and efficiency-seeking FDI. It is expected that higher real wages and efficiency wages in the home country increases outward FDI. vii. Regional Trade Agreements: With regard to the regional trade agreements, it is found that an increasing number of trade agreements of the home country will likely shift the production units into the site with the lower costs of production

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since access to home as well as host-country markets becomes available. Further, many regional trade agreements not only improve market access but also improve the investment environment to make it more conducive to a free flow of FDI. viii. Tax Policies: Domestic policies with respect to taxes can also influence the cost of investments across economies. The higher the tax, the higher will be outward FDI. ix. Domestic Labour Environment: A favourable labour environment, which is influenced by flexible labour laws, also influences the decisions to invest. The more rigid the labour laws, the higher will be the incentive to invest abroad. x. Exchange Rates: Exchange rate is an influential factor in affecting the outward FDI. Appreciation of the currencies enables firms from those countries to gain benefits in financial terms to support their abroad investment relative to countries with weaker currencies.

The literature on outward FDI from the developing economies is limited. Although studies have examined the trends in outward FDI from the developing countries and analyzed the drivers, few studies have empirically estimated the impact of these drivers on outward FDI, especially from the developing countries.

The purpose of this study is to empirically investigate the dynamic relationship between changes in macro economic factors and changes in FDI made by the Indian firms. The impact of inward FDI coming to India on the outward FDI from India is also examined. The study focuses on the period from 1980-2005. 1980 is chosen as the starting point as OFDI began in a small way from that period onwards.

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SECTION 1.4

METHODOLOGY AND SOURCES OF DATA

The data used in this study is aggregate annual time series at current prices, covering the period 1980-2005. A process of gradual relaxation of controls and regulations with a view to attract large inflows of foreign investments was discernable from the year 1981. In a limited and phased manner market forces were allowed to govern the foreign investment flows during this period. Hence this period was selected. The inward and outward FDI data have been considered as flow measures rather than stocks because inward and outward FDI behavior is more

comprehensively measured for flows than for stocks.

This study builds on existing research studies and methodologies, to test the determinants of inward and outward investment from India. Relevant studies, done so far, have been both qualitative and quantitative in nature. The qualitative methods used include surveys and questionnaires and oral interviews. However, there are a number of challenges and issues that crop up when qualitative methods are used specially in econometric studies. These include subjectivity and bias of responses and the inability to incorporate such biases in the econometric studies. As such this study uses the method of Multiple Linear Regression model. In order to estimate the regression model, a statistical software, Statistical Package for Social Sciences (SPSS), has been used.

The data was extracted from the following sources:

i. Hand Book of Statistics on the Indian economy, RBI, various issues

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ii. UNCTAD, WIR series, various issues iii. Economic Survey, Government of India, various issues iv. World Development Indicators, World Bank

The following two hypotheses are studied using this methodology.

i. Pull (Locational) factors determine the flow of Inward Foreign Direct Investment to India. ii. The Push factors determine the flow of Outward Foreign Direct Investment from India.

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SECTION 1.5

THESIS OUTLINE

Chapter 1: Introduction

The areas covered in this chapter are as follows:

Theoretical exposition of Foreign Direct Investment Definition and concepts of FDI Relevance of the present study Objectives of the present study Methodology and sources of data

Chapter 2: Review of Literature

This chapter comprises a review of the major works done in the area of Foreign Direct Investment in India and internationally.

Chapter 3: Inward Foreign Direct Investment in India: Trends And Patterns

The issues that have been studied in this chapter are:

The nature and extent of Indian economys integration with the world economy.

The nature of the regional distribution of FDI flows from the global FDI flows. The comparative standing of FDI among developing countries.

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The pattern of originating countries of Indian FDI flows. The nature of change in the sectoral composition of FDI in India. The regional distribution of inward FDI in India. The structure of cross border mergers and acquisitions from India. The FDI flows as a percentage of GDP and GFCF. FDI performance v/s potential in India. Major policy initiatives taken to boost FDI flows.

Chapter 4: Outward Foreign Direct Investment in India: Trends And Patterns

The issues that have been studied in this chapter are:

The comparative standing of India among developing countries The pattern of destination countries of Indian FDI flows The nature of change in the sectoral composition of FDI flows from India The structure of cross border mergers and acquisitions from India The FDI flows as a percentage of GDP and GFCF FDI performance v/s potential in India Major policy initiatives taken to boost FDI out flows

Two major questions are addressed here:

Whether the OFDI from India has undergone a fundamental shift that might be considered as a distinct second wave of OFDI, which differs substantially from the first wave?

Whether this new wave can be successfully explained within the framework of the IDP (Investment Development Path)?

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As regards the outward foreign direct investment from India, the hypothesis examined is as follows:

Outward FDI from India has undergone a fundamental shift, which can be successfully explained as stage two, within the framework of the Investment Development Path

Chapter 5: Determinants of Inward FDI to India

The issues studied in this chapter are as follows:

Theories of inward FDI Literature review and theoretical framework Empirical determination of the Locational determinants (Pull factors) of FDI to India

Chapter 6: Determinants of Outward FDI from India

The issues studied in this chapter are as follows:

Theories of outward FDI Literature review and theoretical framework Empirical determination of the Push factors of FDI from India

Chapter 7: Summary, Conclusions and Recommendations

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REFERENCES

1.

Dunning, J.H. (1977). Trade, location of economic activity and the MNE: a search for an eclectic approach in The International Allocation of Economic Activity ed. by Ohlin, B. and P.O. Hesselborn: 395-418, London, Macmillan.

2.

Dunning, J.H. (1981). Explaining the International Direct Investment Position of Countries: Towards a Dynamic or Developmental Approach,

Weltwirtschaftliches Archiv 117: 30-64. 3. Hymer, S.H. (1960). The International Operations of National Firms, PhD thesis, MIT (published by the MIT Press 1976). 4. IMF, (2004a). Foreign Direct Investments, Trends, Data Availability, Concepts, and Recording Practices, IMF, February 9, Online. 5. IMF (2004b). Direction of Trade Statistics Yearbook, Washington, International Monetary Fund. 6. IMF and OECD (2003). Foreign Direct Investment Statistics: How Countries Measure FDI, Washington, International Monetary Fund. 7. IMF, (1993). Balance of Payments Manual, 5th edition, International Monetary Fund, Washington, International Monetary Fund. 8. Lipsey, R.E. and M.Y. Weiss (1981). Foreign Production and Exports in Manufacturing Industries, Review of Economics and Statistics 63(4): 488-494. 9. Lipsey, R.E. and M.Y. Weiss (1984). Foreign production and exports of individual firms, The Review of Economics and Statistics 66: 304-308. 10. Reserve Bank of India, (RBI), www.rbi.org.in 11. Secretariat of Industrial Assistance, Department of Industrial Policy and Promotion, Ministry of Industry, Government of India. www.dipp.nic.in 12. WIR (2004). The Shift Towards Services, World Investment Report, UNCTAD, United Nations, Geneva.

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CHAPTER 2 REVIEW OF LITERATURE

A lot of research has already been done across the globe analyzing the various aspects of FDI. These studies can be broadly classified into two categories:

MACRO VIEW

The studies done in this group focus on FDI as a particular form of capital across national borders from home to the host countries as measured in the BOP. The variables of interest in these studies are the flows of financial capital, the value of stock capital that is accumulated by the investing firms and the flows of incomes from these investments.

MICRO VIEW

Studies under this group try to explain the motivation for investment in controlled foreign operations from the view point of the investor. The emphasis here is on examining the consequences of the operations of the MNCs to the home and the host countries. These consequences arise from their trade employment, production, and their flows of stocks of intellectual capital unmeasured by the capital flows and the stocks in the BOP.

Most of the currently held perceptions of foreign investments role take a macro view. Such a positive view gained currency mainly after the Latin American crisis in the early eighties and the South-East Asian crisis in the late nineties and accordingly the structural importance of FDI has been restored back in comparison to foreign financial flows. The crux of the policy, therefore, is how the benefits of such investments are distributed over the foreign firms and the host country. However, in a

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micro perspective, a different question is asked what does FDI do to the working of the domestic markets and their effect on productivity and output.

In the development literature, well reflected in the International as well as the Indian discourse, there has been a lot of debate generated along various aspects of FDI. Some of the major works are reviewed here. For simplification purpose the studies have been divided in two categories.

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SECTION 2.1

STUDIES FROM THE GLOBAL PERSPECTIVE

Mihir Desai, Foley and Antras (2007) in their study try to provide an integrated explanation for MNC activity and the means by which it is financed. They are of the view that the ways in which the firms try to obtain external finance can create many frictions for the firm, which leads, further to multinational activity. However, the desire to exploit technology is not affected by the financing decisions. They try to relate the level of financial development of an economy to MNC activity and they find that the propensity to do FDI, the share of affiliate assets financed by the parent firm and the share of affiliate equity owned by the parent are higher in countries with weak financial developments, but the scale of MNC activity is lower in such settings. They conclude that in India MNC activity is likely to be limited by concerns over managerial opportunism and weak investor protection and the ability of the Indian MNCs to employ their internal capital markets opportunistically will help dictate their overseas and domestic success.

Foley et. al. (2005) in their study try to evaluate the evidence of the impact of outbound FDI on the domestic investment rates. They find that OECD countries with high rates of outbound FDI in the eighties and nineties exhibited lower domestic investment than other countries, which suggests that FDI and domestic investment are substitutes for each other. However, in the US, in the years in which US MNCs had greater foreign capital expenditures, coincided with greater domestic capital spending by the same firms, implying that foreign and domestic capital are complements in production by the MNCs. This effect is consistent with cross sectional evidence that firms whose foreign operations expand simultaneously

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expand their domestic operations and suggest that interpretation of the OECD crosssectional evidence may be confounded by omitted variables.

In another study James Markusen (2003) and others have tried to explain the phenomenon of export platform (a situation where the affiliates output is largely sold in the third markets rather than in the parent or the host markets). They find that pure export platform production arises when a firm in each of the high cost economies has a plant at home and a plant in the low cost country to serve the high cost country. Another case of export platform arises when there is trade liberalization between one of the high cost countries and small low cost countries. The outside high cost country may wish to build a branch plant inside the free trade area due to the market size but chooses the low cost country on the basis of the cost.

Lee Bransteeter et. al. (2007) in their study try to theoretically and empirically analyse the effect of strengthening IPRs on the level and composition of industrial development in the developing countries. They develop a North-South product cycle model in which northern innovation, southern imitation and FDI are all endogenous variables. The model predicts that IPR reform in the south leads to increased FDI from the north as the northern firms shift production to the southern affiliates. This FDI accelerates southern industrial development. Also as the production shifts to the South, the northern resources will be reallocated to R&D, driving an increase in the global rate of innovation. Testing the models predictions the study finds that MNCs expand the scale of activities in reforming countries after the IPR reforms.

In a different study Mihir Desai et. al. (2005) focus on the impact of rising foreign investment on domestic activity. It is observed that firms whose foreign operations grow rapidly exhibit coincident rapid growth of domestic operations but this pattern is inconclusive as foreign and domestic business activities are jointly determined. Their

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study uses foreign GDP growth rates interacted with lagged firm specific geographic distributions of foreign investments to predict changes in foreign investment by a large number of American firms. Estimates indicate that 10 percent greater foreign capital invested is associated with 2.2 percent greater domestic investment and 10 percent greater foreign employee compensation is associated with 4 percent greater domestic employee compensation. They find that the changes in foreign and domestic sales, assets, and no. of employees are positively associated and also greater foreign investment is associated with additional domestic exports and R&D spending.

Jonathan Haskel (2004) and others in their study try to find out whether there are any productivity spillovers from FDI to the domestic firms and if so how much should the host countries be willing to pay to attract FDI to their countries. Using plant level panel covering U.K. manufacturing from 1973 through 1992 they estimate a positive correlation between domestic plants TFP (Total Factor Productivity) and the foreign affiliates share of activity in that plants industry. Typical estimates suggest that a 10 percent point increase in foreign presence in the U.K. industry raises the TFP of that industrys domestic plants by about 0.5 percent. These estimates are used to calculate the job value of these spillovers. These calculated values appear to be less than per job incentives that the Government has granted in some cases.

In an interesting study Volcker Nocke and Stephen Yeaple (2004) develop an assignment theory to analyse the volume and composition of FDI. Firms conduct FDI by either engaging in Greenfield investment or in cross border acquisitions. They find that in equilibrium, Greenfield FDI and cross-border acquisitions coexist, but the composition of FDI between these modes varies with firm and country characteristics. They observe that firms engaging in Greenfield investment are systematically more efficient than those engaging in cross border acquisitions. They

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find that most FDI takes the form of cross border when factor price differences between countries are small, while Greenfield investment plays a more important role for FDI from high wage to low wage countries.

In an edited volume Dilip Das (2001) studies the world of private capital flows and concludes that FDI has positively contributed to growth and development, especially in the case of China. Analyzing the flows of FDI and its composition world wide, he posits that earlier the flows were composed largely of commercial bank debt flowing to the public sector where as the recent years have witnessed an increase in the level of private sector portfolio and direct flows. One reflection of the importance of the investment climate is that the levels, location, motive for FDI into transition economies are strongly associated with the progress in transition.

Magnus Blomstrom and Ari Kokko (2005) suggest that the use of investment incentives to attract more FDI is generally not an efficient way to raise national welfare. The strongest theoretical motives for financial subsidies to attract investment are spillovers of foreign technology and skills to local industry and the authors argue that these benefits may not be an automatic consequence of foreign investment. The potential spill over benefits is realized only if the local firms have the ability and motivation to invest in absorbing foreign technology and skills. To motivate subsidization of foreign investment, it is, therefore, necessary at the same time to support learning and investment in local firms as well.

In his study on human capital formation and FDI in developing countries, Koji Iyamoto (2003) takes a view of the complex linkages between the activities of the MNCs and the policies of host developing countries. The literature indicates that a high level of human capital is one of the key ingredients for attracting FDI as well as for the host countries to get maximum benefits from these activities. He finds that one

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way to improve human capital formation and attract more FDI is to provide a strong incentive for MNCs and Investment Promotion agencies to participate in formal education and vocational training for workers employed with domestic firms .In addition FDI promotion activities can target high value added MNCs that are more likely to bring new skills and knowledge to the economy that can be tapped by the domestic enterprises.

Analyzing foreign investment trends, Vincent Palmade and Andre Anayiotas (2004) find no reason to be skeptical about the fall in FDI since 1999 and the growing share of China in FDI, which worries most of the developing countries. They say that the decline is largely a one time adjustment following the investment boom of the nineties. They assure that FDI is now more varied as it is coming from more countries and going to more sectors. The conditions for attracting FDI varies by sectors: in labour intensive manufacturing, efficient customers and flexible labour markets are the key while in the retail sector, access to land and equal enforcement of the tax rules matter the most. In the interests of the domestic investors and also to attract more investment they advise to sort out the various micro issues by different sectors.

Studying the trends of FDI in the OECD countries, Hans Christiansen and Ayse Bertrand (2004) conclude that though the FDI in the OECD countries continued to fall in 2003, because of sluggish macro economic performance which depresses outward and inward FDI, it does not imply that FDI activity is low by any longer term historic standard. The reasons they give for low FDI activity is that companies operating in the economies with poor macro economic performances are less attractive to the outside investors and scale back their outward investment also. Another reason is that several sectors that saw rampant cross-border investment in the late 1990s and 2000 have entered into a phase of consolidation during which enterprises tend to be

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disinclined to embark on new purchases while still in the process of integrating foreign acquisitions of recent years in their corporate strategies.

Nagesh Kumar (2001) analyses the role of infrastructure availability in determining the attractiveness of countries for FDI inflows for export orientation of MNC production. He posits that the investment by the governments in providing efficient physical infrastructure facilities improve the investment climate for FDI. He first constructs a single composite index of infrastructure availability of transport, telecommunication, and information and energy for 66 countries over 1982-94 periods using principal component analysis. The role of infrastructure index in explaining the attractiveness of foreign production by MNCs is evaluated in the framework of an extended model of foreign production. The estimates corroborate the fact that infrastructure availability does contribute to the relative attractiveness of a country towards FDI by MNCs, holding other factors constant. These findings suggest that infrastructure development should be an integral part of the strategy to attract FDI inflows in general and export oriented production from MNCs in particular.

Douglas Brooks and Sumulong (2003) in their study analyse the policy context in which FDI flow occurs. They find that a favorable policy framework for FDI is the one that generally provides economic stability, transparent rules on entry and operations, equitable standards of treatment between domestic and foreign firms and secures the proper functioning and structure of the markets. In general empirical evidence suggests that policies encouraging domestic investment help to attract domestic investment. They find that FDI contributes to the development process by providing capital, foreign exchange, technology, competition and export market access, while also stimulating domestic innovation and investment.

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In her paper on FDI and gender equity, Elissa Braun (2006) presents a review of research and policy on the links between foreign investment and development. This work provides broad and consistent evidence for the contention that growth leads to FDI rather than FDI leading to growth. The work also underscores the importance of economic policy context for gaining development benefits from FDI. Besides keeping the production costs low to attract more FDI, countries must also have adequate domestic capacities to benefit from FDI. These capacities are related to economic growth including high level of investment, infrastructure and human capital. Looked from a gender perspective, foreign investment in female intensive industries has had a significant impact on womens work and development. She finds that there is likely to be some short term improvement in womens income as FDI expands but the trajectory of womens wages is less promising .These findings are consistent with those that indicate trade and FDI have done little to narrow the gender wage gap.

In a study done by the Japan Bank for International Cooperation (2002) on key development issues related to FDI, following were the findings. The outflows of global FDI have increased with cross border mergers and acquisitions among OECD countries triggered by policy initiatives like implementation of EUs single market program and the creation of NAFTA. ASEAN and South Asia began cross border mergers and acquisitions after their financial crisis. Also in the 1990s the US emerged as the worlds largest recipient of FDI while China led the race of attracting FDI inflows. The study also finds that FDI tends to crowd in domestic investment as the creation of complementary activities outweighs the displacement of the domestic competitors and that spillover effects of FDI on the productivity growth of the local firms do not occur automatically. The magnitude of these spillovers depends on various home country and firm level characteristics like relative and absolute absorption capacities of individual host countries and firms. The study concludes by stating that host countries government policies should attach greater importance to

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the stability and predictability of the local business environment in which foreign trade occurs.

Maria Carkovich and Ross Levine (2002) conclude that an economic rationale for treating foreign capital favorably is that FDI and portfolio flows encourage technology transfers that accelerates overall economic growth in the recipient countries. While micro economic studies give a pessimistic view of the growth effects of the foreign capital, macro economic studies find a positive link between FDI and growth. However, the authors say that the previous macro economic studies do not fully control for endogenity, country specific effects and inclusion of lagged dependent variables in the growth regression. After reducing many statistical problems plaguing past macro-economic studies and using two new data bases, they find that FDI inflows do not exert an independent influence on economic growth. Thus while sound economic policies may spur both growth and FDI, the results are inconsistent with the view that FDI exerts a positive impact on growth that is independent of the other growth determinants.

Analyzing the influence of IPRs in encouraging FDI, Keith Maskus (1998) finds that while there is evidence, that strengthening IPRs can be an effective means of inducing additional inward FDI, it is only one component among a broad set of factors. Emerging economies must recognize the strong complementary relationships among IPRs, market liberalization and deregulation, technological development policies and competition regimes. He suggests that given the complexity and trade offs for market participants, governments and emerging economies should devote considerable attention and analysis to the strategies to achieve net gains from stronger IPRs.

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The Global Business Policy Council (2005) prepared a FDI confidence Index, in which the following findings were made. In 2005 China, India and Eastern Europe reached new heights of attractiveness as destinations for FDI as they competed for higher value added investments including R&D. The U.S dropped to the third place, Western Europe was likely to remain a low priority and Eastern Europe would enjoy better prospects despite rising costs. Though FDI appears to be on rise, corporate savings overhang and investor pessimism about the global economy could dull the prospects of cross border corporate investment. However, the globalization of R&D would not be a zero sum game. Rather it would be a balancing act, as companies leverage opportunities in knowledge centers in the developing world in conjunction with traditional R&D hubs in the industrial world.

Studying production, distribution and investment model for an MNC, Zubair Mohammed et. al. (2004) develop an integrated production, planning, distribution and investment model for a multinational firm that produces products in different countries and distributes them to geographically diverse markets. They argue that since MNCs operate in different countries under varying exchange and inflation rates, varying opportunities for investing and differing regulations, these factors should be included in the decision process. In the modeling, the paper incorporates these factors and elicits the performance of the model through an example and discusses the results. The results indicate that the exchange rates and the initial capacity levels of the firms have significant effects on the production, distribution and investment decisions and consequently on the profits.

Galian et. al. (2001) build an empirical study based on the eclectic paradigm, aiming to find out the main ownership, internationalization and location factors which affect such internationalization process. The results confirm the importance of

factors such as the existence of specific assets of an intangible nature .They also

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show that the transaction costs and other questions related to knowledge transfer and accumulation are relevant in the choice of FDI over alternative forms of internationalization. Current and future markets and their expected growth are the key factors for selecting a destination.

Examining location aspects of foreign investment in developing countries, Jalilian (1996) attempts to incorporate new forms of foreign investment in a unified model .He uses the model to show how differences in production environment in particular are likely to affect both the timing and modes that any foreign investment is likely to take. The explanatory variables in this model are the relative efficiency gap and the variable cost differential between producing at home or in less developed country; which includes those related to the differences in the production environment.

Studies included in an edited volume by Rajesh Narula and S. Lall (2006) aim at understanding the factors that led to an optimization of the benefits from FDI for the host country. Despite the diversity of the countries covered and the methodology used, the chapters in this volume point to a basic paradox. With weak local capabilities, industrialization has to be more dependent on FDI. However, FDI cannot drive industrial growth without local capabilities. The studies here do not support the view that FDI is a sine qua non for economic development. They unmistakably show that market forces cannot substitute for the role of the government and argue in favour of a proactive industrial policy. Thus FDI per se does not provide growth opportunities unless the domestic industrial sector exists which has the necessary technological capacity to profit from the externalities from MNC activity.

In his study of FDI and trade patterns in Malaysia, Bernard Tai Khiun Mien (1999) explores the relationship between incoming FDI and trade orientation in the Malaysian manufacturing sector. It is found that by pursuing an open proactive trade

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and industrial strategy, Malaysia has been able to realize the benefits of FDI. This study shows that Malaysias manufacturing sector which is driven strongly by foreign investment has become increasingly outward looking since the past two decades. Increased export-orientation has been accompanied by a favorable shift in the comparative advantage of non traditional manufacturing sub sectors in Malaysia.

A paper by Bishwanath Goldar (1999) analyses the trends of FDI in Asia, with a special focus on FDI flows from Japan. He relates the FDI flows to changing industrial structure and to trade flows. An econometric analysis is also done to identify key determinants of FDI flows to Asian countries. It is found that Japan has been the main source of FDI flows to Asia. Japanese FDI has helped cost reduction and export promotion in the host countries but in the process Japan has created a large trade surplus with these countries.

Explaining FDI flows to India, China and the Caribbean, Arindam Banik et. al. (2004) look at FDI inflows in an alternative approach based on the concepts of neighborhood and extended neighborhood, rather than on the basis of conventional economic indicators as market size, export intensity, institutions etc. The study shows that the neighborhood concepts are widely applicable in different contexts. There are significant common factors in explaining FDI inflows to select regions. While a substantial fraction of FDI inflows may be explained by select economic variables, country specific factors and idiosyncratic component account for more of the investment inflows in Europe, China and India.

Jongsoo Park (2004) has tried to build a Korean perspective on FDI in India based on the case study of Hyundai Motors. He contends that since the launch of reforms, Korean companies have invested in joint ventures or Greenfield projects in automobiles, consumer goods and others. This case study of Hyundai Motor

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Industries set against an exploration of Indias FDI experience from a Korean perspective indicates that industrial clusters are playing an important role in economic activity. The key to promoting FDI inflows into India may lie in industries and products that are technology intensive and have the economies of scale and significant domestic content.

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SECTION 2.2

STUDIES FROM THE INDIAN PERSPECTIVE

Chandra Mohan (2005) in his study on FDI in India is of the view that India has not been able to attract a good level of FDI and he argues that the current level of FDI appears respectful due to a more liberal definition of FDI which was actually adopted to make our comparison with the Chinese FDI more comfortable. He says that the Government must not consider foreign investments sacrosanct. Instead he advises the Government to indulge in more proactive strategies to seek more FDI for which it must help in removing the procedural hassles at the state level. Also the government should make the investment climate more conducive along with a proper regulatory approach for the flagship investors which would encourage the risk-averse small manufacturing enterprises to turn out in larger numbers.

Bary Rose Worth, Anand Virmani and Susan Collins (2007) study empirically Indias economic growth experience during 1960-2004 focusing on the post 1973 acceleration. The analysis focuses on the unusual dimensions of Indias experience: the concentration of growth in the service production and the modest level of human and physical capital accumulation. They find that India will need to broaden its current expansion to provide manufactured goods to the world market and jobs for its large pool of low skilled workers. Increased public saving as well as rise in foreign saving, particularly FDI could augment the rising household saving and support the increased investment necessary to sustain rapid growth.

Examining Indias experience with capital flows, Ajay shah and Ila Patnaik (2004) discuss Indias policies towards capital flows in the last two decades. They point out

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that since the early nineties India has implemented policies aimed at liberalizing trade and deregulating investment decisions. Throughout most of this period India has maintained strong controls on debt flows and has encouraged FDI and portfolio flows. At the same time the Indian authorities have adopted a pegged nominal exchange rate. According to them, domestic institutional factors have resulted in relatively small FDI and large portfolio flows. They also point out that one of Indias most severe policy dilemmas during this period has been related to the tension between capital flows and currency regime. They agree that in spite of the progress achieved since the reforms were adopted the goal of finding a consistent way to augment investment using current account deficits has remained elusive.

Commenting on FDI in India, P.L Beena et. al. (2004) agree to the fact that India has come a long way since 1991 as regards the quantum of FDI inflows is concerned, though there is a view that the MNCs are discouraged from investing in India by bureaucratic hurdles and uncertainty of the economic reforms. However, they feel that very little discussion has taken on the experience of the MNCs and the relationship between their performance and experience with the operating environment and the extent of spillovers in the form of technology transfers. The importance of the former is that the satisfaction of the expectations of the MNCs that are already operational within India is an important precondition for growth in FDI inflow. Transfer of technology and know how on the other hand is at least likely to have an impact on Indias future growth and the quantum of FDI inflow. They argue that to the extent that Indias future growth will depend on the global competitiveness of its firms, the importance of such spillovers can be paramount.

In order to provide foreign investors a latest picture of investment environment in India, Peng Hu (2006) in his study analyses various determinants that influence FDI inflows to India including economic growth, domestic demand, currency stability,

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government policy and labour force availability against other countries that are attracting FDI inflows. Analyzing the new findings it is interesting to note that India has some competitive advantage in attracting FDI inflows, like a large pool of high quality labour force which is an absolute advantage of India against other developing countries like China and Mexico, to attract FDI inflows. In consequence this study argues that India is an ideal investment destination for foreign investors.

Kulwinder Singh (2005) has analysed FDI flows from 1991-2005. A sectoral analysis in his study reveals that while FDI shows a gradual increase and has become a staple of success in India, the progress is hollow. The telecommunications and power sector are the reasons for the success of infrastructure. He comments that FDI has become a game of numbers where the justification for the growth and progress is the money that flows in and not the specific problems plaguing the individual sub sectors. He finds that in the comparative studies the notion of infrastructure has gone a definitional change. FDI in sectors is held up primarily by telecommunications and power and is not evenly distributed.

Mohan Guruswamy, Kamal Sharma et. al. (2005) discuss the retail industry in India in their study on FDI in the retail sector. They focus on the labour displacing effect on employment due to FDI in the retail sector. They say that though most of the strong arguments in favour of FDI in the retail sector are not without some merit, it is not fully applicable to the retailing sector and the primary task of the Government in India is still to provide livelihood and not create so called efficiencies of scale by creating redundancies.

In their study on FDI and its economic effects in India, Chandana Chakraborty and Peter Nunnenkamp (2006) assess the growth implications of FDI in India by subjecting industry specific FDI and output to causality tests. Their study is based on

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the premise that the composition and type of FDI has changed in India since 1991 which has led to high expectations that FDI may serve as a catalyst to higher economic growth. They find that the growth effects of FDI vary widely across sectors. FDI stocks and output are mutually reinforcing in the manufacturing sector. They also find only transitory effects of FDI on output in the services sector which attracted the bulk of FDI in the post-reform period. These differences in the FDI growth relationship suggest that FDI is unlikely to work wonders in India if only remaining regulations were relaxed and more industries opened up to FDI.

V.N. Balasubramanyam and Vidya Mahambre (2003) in their study of FDI in India conclude that FDI is a very good means for the transfer of technology and know how to the developing countries. They do not find any reasons to regard China as a role model for India. They agree with the advocacy of the policies designed to remove various sorts of distortions in the product and factor markets. These are policies which should be adopted in the interests of both the domestic and foreign investment. A level playing field for one and all may be a much better bet than specific policies geared to the promotion of FDI. The study suggests that India may be better placed than in the past to effectively utilize licensing and technical collaboration agreements as opposed to FDI.

Studying export growth in India, Kishore Sharma (2000) finds that export growth in India has been much faster than GDP growth over the past few decades. Several factors have contributed to this phenomenon including FDI. However, despite increasing inflo