Determinants of FDI: Empirical Evidence from India

ABSTRACT

The integration of developing countries with the global economy increased sharply in the 1990s with changing in their
economic policies and lowering of barriers to trade and investment. Foreign Direct Investment (FDI) is assumed to
benefit India, not only by supplementing domestic investment, but also in terms of employment creation, transfer of
technology, increased domestic competition and other positive externalities. The present study tries to empirically
examine the major factors which have determined the inflow of FDI in India in the post reform period. In an attempt to
determine the determinants of FDI, the time series data technique have been employed. This study attempts to
incorporate the potential determinants of FDI such as Natural Resource Intensity, Market Size, Human Capital,
Trade openness, Exchange Rate, Investment and Macroeconomic stability. The study is well adjusted for issues such as
stationarity, cointegration and error-correction. Lastly, a causality test between FDI and its various determinants is
performed.

Geetu Sehra
Kanika Bakshi
2012
Introduction

Capital and human resources are the pivots of development. Short supplies of domestic capital limit the growth of
developing countries. Low GDP keeps savings and investment rates low which, in turn, limit growth. Low
technological base of production is another factor impinging upon growth of developing countries. FDI mitigates
these constraints to growth to some extent. FDI brings capital with foreign technology and modern managerial
techniques and organizational structures (Prakash and Balakrishnan, 2005).

Foreign direct investment (FDI) has been recognized as an important resource for economic development. Many
people argue that the flows of FDI could fill the gap between desired investments and domestically mobilized
saving (Todaro and Smith, 2003, Hayami, 2001). It also may increase tax revenues and improve management,
technology, as well as labor skills in host countries (Todaro and Smith, 2003, Hayami, 2001). It plays an important
role in the long-term development of a country not only as a source of capital but also for enhancing
competitiveness of the domestic economy through transfer of technology, strengthening infrastructure, raising
productivity and generating new employment opportunities (Deutsche Bundesbank, 2003). Additionally, FDI may
help the host country to break out of the vicious cycle of underdevelopment (Hayami, 2001).

Governments in developing countries perceive FDI as a key source of economicdevelopment (UNCTAD 1998)
.Chinese experience of achieving high growth through foreign direct investment has been sited as worth emulating
policy lesson for the Indian economy. Recent industrialization in India , especially after the introduction of New
Economic Policy in 1991, there has been a sharp increase in FDI inflows in India. Along with the virtual abolition
of the industrial licensing system, controls over foreign trade and FDI were considerably relaxed. The reforms did
result in increased inflows of FDI tremendously since 2000.

In India, FDI is considered as a developmental tool, which can help in achieving self-reliance in various sectors of
the economy. With the announcement of Industrial Policy in 1991, huge incentives and concessions were granted
for the flow of foreign capital to India. India is a growing country which has large space for consumer as well as
capital goods. India’s abundant and diversified natural resources, its sound economic policy, good market
conditions and highly skilled human resources, make it a proper destination for foreign direct investments. The
opening up of the Indian economy in the international trade front and more liberal FDI policies has been one of the
factors which led to huge FDI inflows in India

The increasingly significant role of FDI in the growth dynamics of countries has created much research interest
among scholars and much research has been focused on the determinants of FDI and has generally identified the
following factors namely comparative labour costs, country size, economic openness nature of exchange rate
regime return on investment and political factors. Many of the studies include primarily developed countries in their
sample and most of those which include substantial numbers of less developed countries (e.g Schneider and Frey,
1985 and Gastanaga and Nugent, 1998) are estimated with pure cross sections.

This paper is organised as follows: section 2 deals with the theoretical and empirical literature review, section 3
describes the econometric modelling and discusses the empirical approach and the data used, and section 4 presents
the econometric results and analyses the findings and the last section concludes the study.

II Literature Review

The theoretical literature on determinants of FDI presents different strands of thought or views. In general there are
at least nine different approaches to factors that lead to FDI locating to different countries. These theories are: (1)
determinants according to the Neoclassical Trade Theory and the Hecksher-Ohlin model in which capital moves
across countries owing to differences in returns (Markusen, 1995); (2) ownership advantages as determinants of
FDI (including monopolistic advantage and internalization theory) based on imperfect competition models and the
view that MNEs are firms with market power (Hymer, 1960, Caves, 1971 and Buckley and Casson, 1976); (3)
determinants of FDI in Dunnings (1993) OLI framework which brought together traditional trade economics,
ownership advantages and internalization theory; (4) determinants of FDI according to the horizontal FDI model or
Proximity-Concentration Hypothesis (Krugman, 1983, Brainard ,1993); (5) determinants of FDI according to
vertical FDI model, Factor Proportions Hypothesis of the theory of international fragmentation (Helpman 1984,
Dixit and Grossman, 1982), (6) determinants to the Knowledge Capital Model (Markusen, 1997), (7) determinants
of FDI according to the diversified FDI and risk diversification model ( Hanson et al, 2001, Grossman and
Helpman, 2002), (8) determinants of FDI based on competitiveness and agglomeration effects (Gugler and Brunner,
2007) and (9) policy variables as determinants of FDI when FDI is seen as the result of a bargaining process
between Multinationals and Governments (Barrel and Pain,1996).

Hence, there is no one single theory of FDI but a variety of theoretical models attempting to explain FDI location
determinants. The different approaches do no necessarily replace each other but explain different aspects of the
same phenomenon. From each of the theories mentioned, a number of determinants can be extracted these include
market size and characteristics, factors costs, transport costs, risk factors and policy variables. There is no
unanimously accepted single factor determining the flow of investment.

The empirical literature which focuses on the factors that influence the flow of foreign capital in emerging
economies is very vast. Many of these studies have focused on economic, socio-political, and institutional factors of
FDI. Loree and Guisinger (1995) studying the determinants of foreign direct investment by the United States in
1977 and 1982 (both towards developed countries as well as toward developing countries), concluded that
economic variables such as market size, labor cost, trade openness, economic stability related to host country policy
were significant in attracting FDI.

Asiedu (2002) applying Least Square techniques for all estimations in the study and found that openness, return on
investment and GDP as proxy variable for market size, are significant variables for FDI fostering and infrastructure
and political risk found insignificant.

Similarly, Holland (2000) reviewed several studies for Eastern and Central Europe, producing evidence of the
importance of market size and growth potential as determinants of FDI. This view was actually reinforced by the
finding of the study of Tsai (1994) analysed the decades of 1970 and 1980 and addressed the endogeneity problem
between FDI and growth by developing a system of simultaneous equations. Also, FDI was alternately measured as
a flow, and as a stock. Market size turned out to be more important for FDI flows than growth. The trade surplus
presents a negative sign and is significant for FDI, while the flow of FDI decreases as the nominal wage decreases.
On the other hand, the impact of FDI on economic growth is quite limited.

Thus, many of studies that have been conducted regarding to test the FDI determinants and found the size of the
market almost universally as an important determinant of FDI in developing countries

However, Quazi and Mahmud (2004) investigated that which factors, either economic or non-economic, drive the
flow of FDI into South Asia and found that economic freedom, openness, prosperity, human capital, and lagged FDI
significantly increase FDI inflow into South Asia, while political instability depresses it.
This view was further supported by a causality test between FDI and product growth proposed by Nair-Reichert and
Weinhold (2001), based on panel data for 24 developing countries between the years of 1971 and 1985. The main
conclusion here was that the relation between investments, whether foreign or domestic, and product growth was
strongly heterogeneous, and that FDI efficiency was positively influenced by a country’s degree of trade openness.

Campos and Kinoshita (2003) use panel data to analyse 25 transition economies between 1990 and 1998. They
reached the conclusion that FDI is influenced by economy clusters, market size, the low cost of labor, and abundant
natural resources. Besides all these factors, the following variables presented significant results: sound institutions,
trade openness, and lower restrictions to FDI inflows.

Similar conclusions emerge from the subsequent studies by Garibaldi and others (2001), based on a dynamic panel
of 26 transition economies between 1990 and 1999, analysed a large set of variables that were divided into
macroeconomic factors, structural reforms, institutional and legal frameworks, initial conditions, and risk analyses.
The results indicated that macroeconomic variables, such as market size, fiscal deficit, inflation and exchange
regime, risk analysis, economic reforms, trade openness, availability of natural resources, barriers to investment and
bureaucracy all had the expected signs and were significant.

Borensztein et.al (1995) used data for the 1970 – 1989 period involving flows from developed countries to
developing ones. The main conclusions were, in the first place, that FDI had a positive effect on economic growth,
depending on the human capital stock available in the host economy. However, when the level of human capital was
low, the effect was negative. Secondly, FDI had an indirect effect on growth by attracting supplementary activities.

On the contrary, Onyeiwu and Shrestha (2004) argues that despite economic and institutional reform in Africa
during the past decade, the flow of Foreign Direct Investment (FDI) to the region continues to be disappointing and
uneven. In their study they use the fixed and random effects models to explore whether the stylized determinants of
FDI affect FDI flows to Africa in conventional ways. Based on a panel dataset for 29 African countries over the
period 1975 to 1999, their paper identifies the following factors as significant for FDI flows to Africa: economic
growth, inflation, openness of the economy, international reserves, and natural resource availability. Contrary to
conventional wisdom, political rights and infrastructures were found to be unimportant for FDI flows to Africa. The
significance of a variable for FDI flows to Africa was found to be dependent on whether country- and time-specific
effects are fixed or stochastic.

Lastly, Buckley et.al (2002) used panel data for several regions in China for the 1989-98 period. In the first place,
the author points out that if the rate of growth of FDI has positive effect upon GDP4 growth, the reverse does not
hold true. Secondly, no evidence was found to support the hypothesis according to which the efficiency of FDI
depends on a minimum level of human capital. Contrastingly, human capital is more significant in less developed
provinces, while FDI stimulates growth notably in the more developed provinces.

Despite the plethora of theoretical and empirical research on the determinants of FDI, there is still considerable
disagreement regarding the significance of the determinants. Also, the empirical studies show that the results varies
due to economy, time period and extent being concerned, methodology applied etc. All these require a fresh insight
so as to study the determinant of FDI in India for the period 1990: 2010.

III Model Specification

The theoretical work on the determinants of FDI and a discussion of various factors affecting FDI has already been
presented in the preceding section. We adopt the previous work model in writing a reduced form specification of a
demand for inward direct investment function with some amendments. The dependent variables in our study is the
FDI inflow in million US dollar and the independent variables that are expected to determine FDI flows are
carefully chosen, based on previous literature and availability of dataset for the selected period. The independent
variables in our estimation include Trade Openness, Human Capital, Natural Resources, Investment, Gross
Domestic Product for market size and Inflation rate for Macroeconomic stability. In connection with discussions of
the previous section, we propose an estimation model as follows, where the selected variables are expected to
determine the FDI inflows:
FDIt = α + β1 opennesst + β2Human Capitalt + β3Natural Resourcet + β4Market Sizet + β5Macroeconomic Stabilityt
+εt

Where, ε t = Random disturbance term (assumed to satisfy the usual regression model conditions)

We will be expressing all variables in natural logarithm terms because log helps to smoothen the series and gives
the elasticities.The above equation provides quantitative estimates of how FDI will change as a result of change in
the above mentioned explanatory variables.
Our choice of India and the time period of post reform period was mainly guided by the fact that as per the recent
survey done by the United National Conference on Trade and Development (UNCTAD), India will emerge as the
third largest recipient of foreign direct investment (FDI) for the three-year period ending 2015 (World Investment
Report 2010).

Description of variables and Data Sources

The dependent variable, FDI, is measured as the net foreign direct investment inflow as a percentage of GDP and is
a widely used measure (see Adeisu, 2002; Quazi, 2005; Goodspeed et al, 2006). The main sources of data series are
from the International Monetary Fund’s International Financial Statistics (IFS) (various issues), World
Development Indicators (various issues) and from African Development Bank, Selected Statistics on African
Countries (2000).

Openness: It is a standard hypothesis that openness promotes FDI (Hufbauer et al. 1994). In the literature, the ratio
of trade to GDP is often used as a measure of openness of a country and is also often interpreted as a measure of
trade restrictions. This proxy is also important for foreign direct investors who are motivated by the export market.
Empirical evidences (Jun and Singh, 1996) exist to back up the hypothesis that higher levels of exports lead to
higher FDI inflows. We therefore include Trade/GDP in the regression to examine the impact of openness on FDI.

Human Capital: Foreign direct investors are also concerned with the quality of the labour force in addition to its
cost. In fact the cost advantages accrued by lower wages in developing nations can well be mitigated by lowly
skilled workers. A more educated labor force can learn and adopt new technology faster and is generally more
productive. Higher level of human capital is a good indicator of the availability of skilled workers, which can
significantly boost the locational advantage of a country. Root and Ahmed (1979), Schneider and Frey (1985),
Borensztein et al, (1998), Noorbakhsh et al. (2001) and Aseidu (2002) found that the level of human capital is a
significant determinant of the locational advantage of a host country and plays a key role in attracting FDI. We
control and test for the impact of labor quality, using the general secondary education enrollment rate (SER)
available from the country’s Central Statistical Office, Labour division.

Natural Resource Intensity (RES): As posited by the eclectic theory, all else equal, countries that are endowed with
natural resources would receive more FDI. Very few studies on the determinants of FDI control for natural resource
availability (except Gastanaga et al., 1998; Morisset, 2000 and Noorbakhsh et al., 2001). The omission of a measure
of natural resources from the estimation, especially for African counties case, may cause the estimates to be biased
(Asiedu, 2002). We therefore include the share of minerals and oil in total exports to capture the availability of
natural resource endowments. This measure of natural resources has been employed in several studies, including
Warner and Sachs (1995), Asiedu and Esfahani (2001) and Aseidu (2002) among others and was available from
World Development Indicators 2003.

Market Size: The size of the host market, which also represents the host country’s economic conditions and the
potential demand for their output as well, is an important element in FDI decision-makings. Moreover Scaperlanda
and Mauer (1969) argued that FDI responds positively to the market size ‘once it reaches a threshold level that is
large enough to allow economies of scale and efficient utilization of resources’. The importance of the market size
has been confirmed in many previous empirical studies (Kravis and Lipsey, 1982; Schneider and Frey, 1985;
Wheeler and Mody, 1992; Tsai, 1994; Loree and Guisinger, 1995; Lipsey, 1999; Wei, 2000. To proxy for market
size (SIZE), we follow the literature and use real GDP per capita. The figures are drawn from RBI Bulletin, various
issues. Since this variable is used as an indicator of the market potential for the products of foreign investors, the
expected sign is positive.

Macroeconomic Stability : The rate of inflation acts as a proxy for the level of economic stability, considering that
one of the classic symptoms of loss of fiscal or monetary control is unbridled inflation. Considering that investors
prefer to invest in more stable economies, that reflect a lesser degree of uncertainty, it is reasonable to expect that
inflation would have a negative effect on direct investment.

In an attempt to determine the determinants of FDI, in this study the time series techniques has been employed.

IV Research Methodology

This section explains the research methodology of estimating the significance of the various determinants of FDI as
mentioned above. In time series analysis, the estimations usually start of with unit root (stationarity) test. This is to
avoid spurious results because most variables may not be stationary at levels (Engle and Granger, 1987). Thus, we
will be using Augmented Dickey-Fuller (ADF) to check stationarity.
The presence of long run relationship among the variables is checked through different methods of Cointegration.
The co integrating relations of non stationary series are used as a tool for discussing the existence of long-run
economic relations. The model has been estimated by using the Engle Granger (EG) two step cointegration
procedures.
According to Granger, if there is evidence of Cointegration between two or more variables, then a valid Error
Correction Model should also exist between the two variables. Following the cointegration tests, we therefore we
have estimated the ECM. Error Correction Model is also used to estimate the acceleration speed of the short-run
deviation to the long-run equilibrium (Singh et al., 2005). In other words, ECM is a mechanism for the dependent
variable to adjust, and return, to its existing long-term trend. ECM is all about how the long-term error will explain
the movement in the short-run.
Finally, a Granger-causality analysis has been carried out in order to assess whether there is any potential
predictability power of one indicator for the other. The causal relationships between FDI and other explanatory
variables were analyzed using the basic principle of Granger causality test.

V Results

This section analyzes the results based on the research methodology explained in the preceding section. Test result
confirms existence of unit root at levels and stationary at its first difference for FDI , investment (Invt), GDP,
openness( Trade to GDP), natural resources (natural res), human capital (human k) and inflation (Table 2). Thus,
all the variables are integrated of the order 1, I (1). The Engle Granger cointegration results reveal a long-run
relationship between FDI and the explanatory variables.

Once the co-integration was established, Error Correction Model was used to estimate the parameters. The error
correction term is estimated at -0.0319 (p = 0.002) is statistically highly significant indicating short run relationship
between the variables, has negative sign and suggests a moderate speed of convergence to equilibrium. The model
is well specified with an R2 and adjusted R2 value of 0.7409 and 0.7226 respectively. The result shows that
openness had a positive impact on FDI as well and is in line with the fact that an efficient environment that comes
with more openness to trade is likely to attract foreign firms and is highly significant (at 1% level of significance).

However inflation has been found insignificant, but it does not mean that these variables have no role to
affect FDI inflow. It is correct in sign. Natural resource (naturalres.) is positive but not significant.GDP
which is used as a proxy for size of the market is significant at 5% level of significance and thus, supported
the fact that most of the FDI in India are motivated by the market-seeking purpose. Human capital
played a positive role in attracting FDI and is significant at 10% level of significance.

To further achieve the objective of the study, Pair wise granger causality test was carried out. The result
shows that there is a bi-directional relationship between FDI and GDP as well as between FDI and human
capital. No causality was found between FDI and inflation. Results also show that there is a unidirectional
causality runs from investment to FDI whereas in case of openness and natural resources it moves in opposite
direction. This means that the past values of FDI can help in predicting the future value of investment but in
case of openness and natural resources their past values help predicting future level of FDI in India.

V Conclusions

Foreign capital is treated as a resource gap-filling factor in the context of capital scarcity in developing
countries. This research investigated the factors enhancing the attractiveness of FDI in India in the post
reform era. The abundance of natural resources is reported to be positive and significant (supporting the
presence of resource-seeking FDI) and is line with Aseidu (2002) and Kinoshita and Campos (2004) works.
The size of the domestic market, stock of human capital, though to a large extent as witnessed by the size of
their respective coefficients, played a positive role while inflation a negative role in attracting FDI in the
markets and the results are consistent with empirical works in the field.

To enhance more FDI into India bureaucratic delays and various governmental approvals and clearances
involving different ministries need to be fastened so as to increase the absorption rate of FDI into the country.
Also, the management authorities of country needs to ensure stable economic and political environment,
provision of physical quality infrastructure, maintaining inflation rate, encourage domestic investment,
curtail external debt, financial incentives, reduce duties, peace and security, law & order situation and
consistency in the government policy because these all are the key factors for potential investors in making
investment choices.

Table 1: Inflow of FDI in India

 (Mil US$)

Year FDI Inflow

1991 144
1992 264
1993 607
1994 992
1995 2065
1996 2545
1997 3621
1998 3359
1999 2205
2000 2428
2001 3571
2002 3361
2003 2079
2004 3213
2005 4355
2006 11119
2007 15921
2008 33029
2009 27044
2010 21007
Source: UNCTAD

Table 2: ADF Unit Root Test for Stationarity

Variable Levels First Difference

(log Values)
FDI 0.3071* 0.0000**

Investment (Invt.) 0.23* 0.003**

GDP (proxy for market size) 0.5114* 0.0012**
Openness 0.34* 0.0000**
Natural Resource (naturalres.) 0.328* 0.0025**
Human Capital (humank) 0.573* 0.0000**
Inflation 0.289* 0.001**
 *Non Stationary ** Stationary

Table 3: Result of the error correction model

Independent Variables (in log) Coefficient t statstic

Lagged FDI .7888995 5.05*

Investment (Invt.) .5669812 1.47
GDP (proxy for market size) 0.063 3.62**
Openness 5.789 4.67*
Natural Resource (naturalres.) 1.407693 1.59
Human Capital (humank) 0.19 2.02***
Inflation -0.12 -0.09
ect-1 -0.0319 -7.63*
Constant 35.93954 4.10*
R2 0.7409
Number of observations 18
Time variable 1990-2010

Note:* indicates significance at 1%, ** indicates significance at 5%, *** indicates significance at 10%.
i) Dependent variable: log value of FDI.
ii) The ADF test confirms that the residuals are stationary
iii) Durbin’s h statistic indicated no serial correlation

Table 4: Pair wise Granger Causality Tests

 Null Hypothesis (H0) F- Statistic Probability Conclusion

FDI does not granger causes 0.82 0.05** H0 cannot be rejected

Investment
Investment does not granger 0.25 0.6195 H0 rejected
causes FDI
FDI does not granger causes 0.33 0.5674 H0 rejected
GDP
GDP does not granger causes 0.72 0.4001 H0 rejected
FDI
FDI does not granger causes 0.05 0.8158 H0 rejected
openness
Openness does not granger 8.44 0.0048** H0 cannot be rejected
causes FDI
FDI does not granger causes 0.00 0.9794 H0 rejected
Natural resource (naturalres.)
Natural resource (naturalres.) 4.07 0.0473** H0 cannot be rejected
does not granger causes FDI
FDI does not granger causes 0.05 0.8293 H0 rejected
human Capital (humank)
Human Capital (humank) 0.23 0.6326 H0 rejected
does not granger causes FDI
FDI does not granger causes 1.15 0.0593*** H0 cannot be rejected
inflation
Inflation does not granger 7.5 0.0025** H0 cannot be rejected
causes FDI

Note:* indicates significance at 1%, ** indicates significance at 5%, *** indicates significance at 10%.
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