Determinants of Foreign Direct Investment: Empirical evidence from

ISSN (Print Version) 0975-3931
ISSN (On Line Version) 2278-1277
JGE
Determinants of Foreign Direct Investment:
Empirical evidence from India
Sh. Sofia Devi1
1. Introduction
Every country mobilized investment in order to ensure sustainable development in
the economy. In the recent years, FDI has been considered as an important tool for
accelerating growth and development of developing and transition economies. FDI
plays a growing important role in the globalization process. Over time more and more
countries are linked both for the challenges and competition as well as for the
opportunities. FDI can lead to transfers of technology and know-how, improve the
access to international markets and spur competition. Many counties continued to
liberalize and promote foreign investment in various sectors to stimulate growth of the
economy. New regulatory and restrictive measures were being taken up accordingly.
FDI by multinational corporations has grown rapidly in recent decades and developing
countries have attracted an increasing although developed countries do saw a rise. To
say, FDI flows to developing and transition economies saw a rise mainly through a
continuing increase in Greenfield projects and for the developed countries due largely
to growth of cross border M&As by foreign TNCs. Against a backdrop of continued
economic uncertainty, turmoil in financial markets and slow growth, countries
worldwide continued to liberalize and promote foreign investment as a means to
support economic growth and development (WDR 2011).
In India, reforms did result in increase in flows of FDI during the decades of the
nineties and still continued till now. The importance of FDI and its difference from
other forms of investment is its long term investment involving high risk of political
and economic instability over the period. The inflow of FDI in a country depends
upon political stability, strong macroeconomic fundamentals, good governance and
low level of corruption. Above these, investment in human capital and physical
capital, low cost of local labour, low tax rates are also often cited as the determinants
of FDI in developing countries. Good quality of infrastructure, independent judiciary
system to protect the property and contractual rights of the investors are also
mentioned among the factors that determine the FDI inflows. To say, the inflow of
FDI in an economy is determined by certain economic, political and social
environment of the host country.
1
Research Scholar, The M. S. University of Baroda, Department of Economics,
Faculty of Arts. Gujarat, INDIA. Email id: [email protected]
15
Journal of Global Economy,
Volume 10 No 1, March, 2014
ISSN (Print Version) 0975-3931
ISSN (On Line Version) 2278-1277
The present study seeks to analyse the factors that determine the inflow of FDI in
India during the period 2001-02 to 2011-12. In the second section a brief review of
literature related to the determinants of FDI flows in different countries are discussed.
A brief summary on the trends of FDI inflows during the period under study is given
in section 3. In the next section, hypotheses of the present study are given. Details of
the empirical methodology employed in this study are mentioned in the fifth section.
Section six gives results and conclusions of the empirical analysis. Section seven
concludes with some limitations of the study and policy implications.
2. A Brief Review of Literature
Various empirical studies are carried out by different researchers and
academicians over time to identify the factors that influence the inflow of FDI. The
variables which were found out as the determinants of FDI inflows differ from country
to country. In other words, although there are certain factors that influence FDI, it is
difficult to say which variable is applicable in a particular country or environment. In
general, much of the studies are found to focus on macro economic variables like
market size, inflation, exchange rate, external debt etc. Some studies also incorporated
the institutional variables like political conditions, laws to protect the investors, human
capital, R&D expenses, regional geography, etc. as FDI is a long-term investment with
the risk of uncertainty in some future. A brief review of literature of the present study,
both national as well as at the international level are herewith analysed
Shamsuddin (1994) examined the economic determinants of private FDI by using
a single equation econometric model for 36 less developed countries for the year 1983.
The FDI for the year 1983 was modeled as a function of one year lagged values of
GDP, growth rate of GDP, per capita debt, availability of energy resources in the
recipient country, wage rate, capital debt volatility of prices (computed from the CPI
data). Empirical findings observed that the most important factor in attracting FDI is
the per capita GDP in the host country, followed by other proxies used. Empirical
results are supportive of all hypotheses proposed for testing with the exceptional of the
effect of energy availability.
Janicki et al. (2004) examined bilateral foreign direct investments (FDI) between
the members of the European Union and eight central and east European candidate
economies in transition for the year 1997. Openness to trade, market size, labour cost
and the institutional investor country risks are used as proxies of Foreign Direct
Investment (FDI) inflows. Empirical results reveal that all the variables taken as
determinants of FDI are found significant impact on the FDI inflows.
Tsen (2005) investigated the location-related determinants of FDI in the
manufacturing industry of Malaysia using time series data from 1980 to 2002. The cointegration analysis is used to examine the long-run relationship between FDI and its
determinants. Inflation, infrastructure, education (human capital), exchange rate,
market size, current account balance were the variables used for the determinants of
FDI. The findings concluded that an increase in education, infrastructure, market size
or current account balance lead to an increase in FDI flows. Moreover, an increase in
16
Journal of Global Economy,
Volume 10 No 1, March, 2014
ISSN (Print Version) 0975-3931
ISSN (On Line Version) 2278-1277
inflation or exchange rates lead to a decrease, showing the success story of Malaysia
in attracting FDI for the manufacturing sector in particular.
Tosompark et al. (2010) evaluated the determinants of FDI in Thailand for the
post 1997 crisis, the period from 1998-2008. The variables used for the analysis of
flow of real FDI inflow are - market size, labour cost, exchange rates, exports,
imports, and deposit-lending rates. Empirical results indicated that growing market
size, and increasing average real wage has positive effects on FDI inflow, whereas, the
relationship between FDI inflow and other trade variables are found insignificant
although having correct signs for the estimated coefficients. The study further found
that Thailand was the least affected amongst Asian countries to experience falling
levels of FDI inflow over the recent global financial crisis.
In the Indian context, based on the time series data for the period 1991 to
2010, Goel et al. (2012) analysed the trend, growth and determinants of FDI in India.
The variables used to analyze FDI are GDP, total trade, foreign exchange reserves,
expenditure on R & D, exchange rate, ratio of debt to exports, GDP growth rate. All
the variables except R&D and exchange rate variables exhibited a negative
relationship with FDI inflows. The analysis successful conclusion identifying the main
variables taken in attracting FDI inflows to the country. Further, the study also
revealed that FDI is significant factor influencing the level of economic growth in
India.
Using panel data analysis for the period 1980 to 2008, Kachoo et al. (2012)
identified the factors determining FDI inflows to 32 developing countries. The FDI
inflows are modeled as a function of the market size, total reserves, infrastructure,
labour cost and degree of openness for the host countries. Empirical estimates
suggested that all the variables except openness have strong bearing on the inflows of
overseas capital.
3. Trends of FDI Inflow in India
Table 1 reported the inflows of FDI in India and its percentage in terms of gross
fixed capital formation and GDP over the period 2001-02 to 2011-12. India received
substantial amounts of FDI over the past decades. The annual average inflow of FDI
in the economy over the period 2001-02 to 2004-05 was 251.05 rupees billion, and
further rose to 394.57 rupees billion in the financial year 2005-06. FDI inflows in
India reached the peak level in the financial year 2008-09 to rupees 1906 billion,
before the global recession of 2008-09. Because of the global financial crisis and
economic slowdown, FDI fell sharply to 1181 rupee billion in the financial year 201011. However, the inflow picked up after that to rupees 1555 billion in the financial
year 2011-12 as Indian economy is not very badly affected due to global recession and
providing a good opportunity for growth.
17
Journal of Global Economy,
Volume 10 No 1, March, 2014
ISSN (Print Version) 0975-3931
ISSN (On Line Version) 2278-1277
Table 1: FDI flows in India during the period 2001-02 to 2011-12
Rs.)
FDI inflows
FDI as % of
Gross Fixed
Investment
FDI as % of
GDP
(in billion
2001-04
2005-06
2006-07
2008-09
2010-11
2011-12
251.05
394.57
1026.52
1906.00
1181.00
1555.00
3.4
3.6
8.3
12.9
6.9
8.6
0.9
1.2
2.9
4.6
2.4
3.0
Source: Handbook of Statistics of Indian Economy 2011-12, RBI.
FDI has contributed to gross fixed capital formation and GDP of the Indian
economy. The contribution of FDI on gross fixed capital formation amounted to 3.4
per cent per annum over the period 2001-02 to 2004-05. In the financial year, 200506, it reached 3.6 per cent and further to 12.9 per cent in the financial year 2008-09.
Thereafter with the global financial crisis, the contribution of FDI in gross fixed
capital formation slid down to 8.6 per cent per annum in the financial year 2011-12.
Similar trend is discernible for the contribution of FDI as a per cent of GDP of the
economy.
4. Objectives of the Study
The changing patterns of FDI stock have raised important questions about their
impact on domestic economy. With this backdrop certain variables (macro as well as
institutional variables) are chosen as determinants of the FDI inflow in the economy.
Incorporating these variables with the FDI variable, a model is established, which is
given in details in the next section. So, the hypotheses of the present study is that the
variables chosen as determinants of FDI inflows will bear theoretically expected sign
with the inflows of FDI in the economy. In short,
a. To identify the determinants of FDI inflows in the economy during the period.
b. To see the impact of the variables on the inflows of FDI during the period.
5. Data Source & Methodology
5.1 Data and variables
The present study is based on the secondary data source. Data are compiled from
the annual publication of RBI, Handbook of Statistics of Indian Economy 2011-12.
All the variables are given in terms of rupee billions at the base year 2004-05. The
variables taken are the inflows of FDI in the economy, market size variable, foreign
exchange reserves variable, exchange rates, economic as well as social well being
expenditure of the central government and lastly, openness of trade in the economy.
Openness of trade is measured by the ratio of sum of exports and imports to GDP in
percent. The exchange rate is measured in terms of U.S. dollar, as dollar is the
18
Journal of Global Economy,
Volume 10 No 1, March, 2014
ISSN (Print Version) 0975-3931
ISSN (On Line Version) 2278-1277
standard and main currency in the international capital inflows. GDP at constant price
is taken as a proxy for the market size. Lastly, a variable of central government
expenditures on economic and social activities together is also taken as one of the
determinants of FDI.
Definition of Variables:
1. Market Size:
The larger the market size of the host country, the more attractive it is to FDI
inflows. An economy with a large market size is supposed to attract more
amount of FDI as it provides more opportunities of sales and hence more profits
to the foreign firms and thereby making more inflow of FDI in the host country.
Moreover, large market size is associated with larger demand for products and
services, and this will allow to reap the benefits of economies of scale. So, the
impact of market size on FDI is likely to be positive.
2. Availability of Foreign Exchange Reserves:
This is considered as another determinant of FDI. The more the reserves, the
higher will be the amount of FDI contracts that can be taken up by the host
country. A positive relationship between FDI inflows and the availability of
Foreign exchange reserves is expected.
3. Central Government expenditure on economic and social activity:
The availability of quality infrastructure, particularly electricity, water,
transportation and telecommunications, is an important determinant of FDI. The
inflow of FDI in a particular country is therefore, determined by the level of
infrastructure facilities of the entity. Further, the inflow of FDI in the host
country is also determined by the expenditure of the government on human
capital, education, R &D, public goods and other social development activities.
Higher the government expenditure on these productive economic and social
activities, higher will be the amount of inflow of FDI. Therefore, a positive
relationship between FDI inflow and the expenditure of the government on
economic and social activities is expected.
4. Trade Openness :
One of the important determinants of FDI is the trade policy reforms in the host
country. The inflow of FDI in the host country is constrained when there is
protectionist policy followed. So, a proxy of openness is taken as one of the
determinants of FDI inflows. The openness is likely to have positive impact on
the inflow of FDI in the host country.
5. Exchange rate:
The appreciation and depreciation of the exchange rates between the entities
will have an impact on the inflow and outflow of foreign investment. A link
between the exchange rate and the inflow of FDI is expected to have a negative
sign and positive for outflows. The exchange rate in the current study is defined
19
Journal of Global Economy,
Volume 10 No 1, March, 2014
ISSN (Print Version) 0975-3931
ISSN (On Line Version) 2278-1277
as the ratio of the domestic currency to US $ at time t. Since dollar is considered
as the standard exchange value, exchange rate is taken in terms of U.S. dollars
in spite of the real effective exchange rate index.
5.2 Methodology
To identify the factors that influence the FDI inflows, the above mentioned
variables are incorporated in the following equation:
ln(FDI)t = β0 + β1 ln(Market Size)t + β2 ln (Openess)t + β3 ln (Exchange)t
+ β4 ln (Reserves)t + β5 ln (Expenses)t + εt
(1)
Where,
FDI = Foreign Direct Investment inflows
ln is the natural logarithm
And the variables are the same as explained in the above section and ε is the white
noise error term which satisfies the usual OLS properties. And βs are the coefficients
of the independent variables. Expressing all the variables in natural logarithmic form,
the above regression model (1) is estimated by using the method of OLS.
6. Findings and Discussions
The estimated results of equation (1) are reported in Table 2.The value of Rsquare shows that the model explains 93 per cent of the variation in FDI in the Indian
economy during the period 2001-02 to 2011-12. Further the D-W statistic (1.95),
which is almost approaching 2, so there is no autocorrelation in the sample.
The estimated model is given as:
ln(FDI)t = (-133.958) + (11.922) lnMarket Sizet + (-5.284) lnOpennest
+ (7.886) lnExchanget + (3.103) lnReservest + (-3.024)
lnExpensest
(F=12.524, prob. = 0.007) (D-W statistics = 1.946)
Table 2: Regression results of FDI model for the period 2001-02 to 2011-12
Independent Variables
Estimated Coefficients
t-values
R-square
Constant
- 133.958
- 2.722*
0.926
ln(Market Size)
11.922
2.406*
ln(Openess)
- 5.284
- 1.995
ln(Exchange)
7.886
2.473*
ln(Reserves)
3.103
2.270*
ln(Expenses)
-3.024
-2.220
Source: Author’s own calculation. * significant at the 5 per cent level.
The coefficients that bear the theoretically expected signs are market size as
measured by the GDP and foreign exchange reserves variable. Both the coefficients of
market size and the foreign exchange reserves are significant at the 5 per cent level of
significance. Whereas, variables like Openness, government expenses on economic
and social goods and exchange rate variables gave theoretically opposite signs. Out of
the variables that give theoretically opposite expected signs, only the coefficient of
20
Journal of Global Economy,
Volume 10 No 1, March, 2014
ISSN (Print Version) 0975-3931
ISSN (On Line Version) 2278-1277
exchange rate variable is found significant at the 5 per cent level. This indicated that
the inflow of FDI in the economy during the period is positively related to the
exchange rates value of the host country. The rest of the variables are dropped from
the analysis as they are insignificant.
7. Concluding Remarks
With the reforms in the early part of the 90s, changes in the structure of the inflow
of FDI are visible. Gains from the FDI inflows in the economy are substantial. The
foreign investors have taken a keen interest in investing into India. It is pertinent to
identify the determinants of FDI with the belief that FDI can be one of the important
tools for accelerating growth and development for the economy. The study has
examined the economic determinants of FDI inflows in India and observed that the
most important factors in attracting FDI are the market size, i.e. measured by the GDP
and the availability of foreign exchange reserves. This means that the increasing
inflow of FDI in India during the period 2001-02 to 2011-12 is supported by the
market size variable and the amount of foreign exchange reserves available in the
economy. And the exchange rates variable is found to have empirically negative
impact on the inflow of FDI.
Although the present study model of single-equation econometric model
performing well in explaining the variation in the inflow of FDI, there are other macro
economic variables that are not taken as explanatory variables. Further, the proxy for
foreign exchange variable, i.e. ratio of Indian rupee per U.S. dollar in each period may
have likely some sort of bias. Even though U.S. dollar is a standard barometer in the
international trade, FDI comes from different nations with different forms of currency
with different values.
A healthy economic and political climate is essential for receiving continuous
gains from the foreign investors. Macro economic problems such as budget deficits,
large external debts and drastic inflation rates will be the possible factors that can
prevent the developed economies from investing their resources in this region.
Further, a healthy economic and political climate is essential to attract for foreign
investors and so political stability in the economy should be maintained.
8. Limitations of the Study and Scope for Further Research
Although the present study explains the determinants of the inflow of FDI in a
developing country like India, one should consider this result with caution because of
the choice of the explanatory variables in the model. Above the variables used as the
determinants of FDI, there are certain macro economic variables that are not taken in
the analysis, like - institutional and legal variables, strategic and knowledge resources,
infrastructures, etc.
Further, the study is an aggregate macroeconomic view of the country during
the given time period for the specific variables. A study from the perspectives of
regional as well as from various sectoral points of view by incorporating variables like
corporate risk and governance will be more meaningful and suggestive. In other
words, the study needs to investigate further on specific contents and ideal mix of
21
Journal of Global Economy,
Volume 10 No 1, March, 2014
ISSN (Print Version) 0975-3931
ISSN (On Line Version) 2278-1277
various economic and political variables in order to explain the changing trends of
foreign direct investment inflows. Therefore, further research can be directed to
overcome this limitation of the study.
REFERENCES
Goel, S., Kumar, P. & Rao, K. S. (2012). “Trends and Patterns of FDI in India and its
economic growth.” Asian Journal of Research in Business Economics and
Management, Vol. 2, No. 4, pp. 130-144.
Janicki, H. P. & Wunnava, P. V. (2004). “Determinants of foreign direct investment: empirical
evidence from EU accession candidates.” Applied Economics. Vol. 36, No. 5, pp.505509.
Khachoo, Ab. Q. & Khan, M. I.(2012). “Determinants of FDI inflows to developing countries:
a panel data analysis.” MPRA, Paper No. 37278.
Shamsuddin, A.F. M. (1994). “Economic Determinants of FDI in Less Developed Countries.”
The Pakistan Development Review. Vol. 33, No. 1, pp. 41-51.
Tosompark, C.T. & Daly, K. (2010). “The Determinants of FDI inflows – Recent evidence
from Thailand.” Working Paper, University of Western Sydney.
Tsen, W. H. (2005). “The Determinants of Foreign Direct Investment in the manufacturing
industry of Malayasia.” Journal of Economic Cooperation. Vol. 26, No. 2, pp. 91-110.
World Investment Report 2012, UNCTAD.
22
Journal of Global Economy,
Volume 10 No 1, March, 2014

Download Report