FDI, Trade and Growth: Cointegration and Causality evidence from India Introduction Foreign Direct Investment (FDI)

has figured prominently in the recent economic history of most developing countries, especially since the 1980s, when FDI flows to those countries have been directed increasingly at export-oriented projects. Since then, developing countries have been competing aggressively to attract foreign investors. Virtually all countries, through changes in their regulatory environments, have facilitated the expansion of foreign investment. The economic rationale for offering special incentives to attract FDI frequently derives from the belief that foreign investment produces externalities in the form of technology transfers and spillovers. Inflows of World FDI increased steadily and tremendously from US$ 200 billion in 1990 to almost US$ 916 billion in 2005 (UNCTAD, 2006), there is ongoing discussions on the impact of FDI on a host country economy, as can be seen from recent surveys of the literature (Fan, 2002; Lim, 2001; de Mello, 1997, 1999, Borensztein, Gregorio and Lee 1998, Gregorio 1992, Blomstrom et. al. 1992). Most of the studies find positive effects of FDI on transitional and long run economic growth through capital accumulation and technical or knowledge transfers, especially under open trade regime (e.g., Basu, Chakraborty, and Reagle, 2003). Romer (1993) argues that through technology transfer, foreign investment can ease the transfer of technological and business know-how to poorer countries. These transfers may have substantial spillover effects for the entire economy. According to Summers (2000) social benefits can be made by the efficiency gains from the reallocation of capital from industrial to developing countries. The reallocation can improve living standards by mobilizing global savings to finance investments in countries where the marginal productivity of investment is relatively high. The positive relationship between FDI and growth, which holds to varying degree across various regions and over time, also depends crucially on a countrys absorptive capacity

(Borzenstein et al., 1998; Alfaro et al., 2001; Edison et al., 2002; Durham, 2003). These initial conditions that capture the absorptive capacity of host countries include the initial level of development (Blomstrm et al., 1992), existing human capital development (Borensztein et al., 1998), trade policy (Balaubramanyam et al., 1996), financial development (Durham, 2003; Alfaro et al., 2001), legal-based variables (Durham, 2003; Edison et al., 2002), and general government policy (Edison et al., 2002). Recently researchers recognized the fat that quality of FDI is important than quantity alone. FDI is considered as higher quality if it is export oriented, transfers foreign technologies to the host country, and induces economic spillover benefiting local enterprises and workers (Enderwick 2005). Developing countries around the world have been liberalizing their trade regimes and moving away from import-substitution investment regimes to export-promotion development policies. Trade policy reform by countries often involves extensive investment by governments in order to attract FDI, partly because of a perceived link between FDI and the improved export competitiveness of the host country (for example see UNCTAD 2003). The potential importance of the export enhancing role of FDI for host countries has been recognized in a number of country based studies (for example, the United Kingdom (Blake and Pain 1994), Portugal (Cabral, 1995), Europe (Pain and Wakelin, 1998), Ireland (Barry and Bradley, 1997), 52-cross-country study (UNCTAD, 1999), Brazil (Oliveira, 2002), China (Sun 2001, and Zhang, 2005). A cross-country analysis for 52 countries [UNCTAD 1999] suggested a positive relationship between FDI and manufactured exports; the relationship was stronger for developing than developed countries. Similarly, a study by Vuki (2005) for 13 transition countries of Central and Eastern Europe, found that FDI played a big role in export performance. An empirical assessment of the role of foreign direct investment (FDI) on host countrys export performance is important, since exports have been for a long time viewed as an engine of economic growth ((Beckerman 1965). There is a widely shared view that FDI promotes exports of host countries by (a) augmenting domestic capital for exports, (b) helping transfer of technology and new products for exports, (c) facilitating 2

access to new and large foreign markets, and (d) providing training for the local workforce and upgrading technical and management skills (for detail see Caves (1996), and UNCTAD 2003). Since India began economic reform in early 1990s, its economy has gradually opened up to the rest of the world with increasing foreign direct investment inflows and international trade. Its accession to the World Trade Organization (WTO) in 1994-95 made it more closely integrated into the World economy. A high average annual GDP growth rate of 6.6 per cent from 1991 to 2005 and gradual improvement of its market mechanisms attract world-wide attention with emerging investment opportunities and a huge market size. Growth rate of exports has been more than the GDP growth for several years. Many multi-national enterprises have been shifting their production base to India due to the wage advantage along with availability of highly skilled workers. Given the importance of the impact of FDI on a developing country like India, however, there exist few studies, particularly at macroeconomic level. For example, a number of studies have investigated the export performance of foreign owned firms in India for various periods of time (Lall and Kumar 1981, Lall and Mohammad 1984, Kumar 1994). In general the export performance of the foreign owned firms is found to be no better than that of locally owned firms. Both groups appear to have targeted the sheltered profitable domestic markets rather than the highly competitive export markets during the pre-1991 phase. Sharma (2000) examined the contribution of FDI in Indias export performance for the period 1970-98. His empirical result indicates that FDI have not played any significant role in export growth. However, this study does not cover entire reform period. Aggarwal (2001) also reached similar conclusion, using firm level data. Pailwar (2001) argues that India has not been able to attract FDI in export oriented areas. Banga (2003) found that FDI not only led to export diversification but also indirectly improved export via export spillovers in India. According to ADB (2004) FDI accounts for about 3 percent of Indias export compared to 50 percent in various East Asian host countries.

Most of the studies on the Growth Impact of FDI in India are in striking contrast to the current euphoria. Pradhan (2002) who estimates a Cobb-Douglas production function using aggregate data for 1969-97 with FDI stocks as additional input variable found that FDI have no significant impact on growth. Chakraborty and Basu (2002) using aggregate data for 1974-1996, report a one-way causality runs from GDP to FDI. In the long run, FDI is positively related to GDP and Openness to trade. Dua and Rashid (1998) report similar results. Kumar and Pradhan (2002) consider the FDI-growth relationship to be Granger neutral for India as the direction of causation was not pronounced. Bhat et al. (2004) report similar conclusions by applying Granger causality. Agrawal (2005) found the growth impact of FDI is negligible by applying panel estimates for five South Asian countries including India for the period 1965-1996. It is clear from the above mentioned fact that most of the studies confined to mid 1990s and may fail to capture the effects of the changing policy environment in the post reform period. So one can question the findings of these studies in the present condition. On this background, the present study investigates the causal nexus between FDI, Trade and Industrial production. Our study differs from existing study in three ways- First, we mainly focus on the reform period only; given the fact that before liberalization there was negligible level FDI flows to India. Second, we use quarterly data for our purpose. Third, we utilise Johansens cointegration approach and Toda and Yamamoto (1995) methodology of modified granger causality which provides us better results than previous studies. More precisely, existing empirical work on the causality between FDI and growth uses standard Granger-causality-type tests to detect the direction of causality in the above important relationship. The remainder of the paper is organized as follows. Section 2 deals with theoretical back ground of the paper. Section 3 presents a brief discussion on FDI flows, data source and methodology. In section 4 we discuss empirical results and conclusions. Section 2 Theoretical back ground FDI and Growth

In the Solow-type standard neoclassical growth models, FDI is traditionally conceived as an addition to the capital stock of the host economy (e.g., Brems, 1970). In this view, there are no substantial differences between domestic and foreign capital. More importantly, the impact of FDI on growth is similar to that of domestic capital. With diminishing returns to capital, FDI has no permanent impact on the growth rate. FDI will have, however, a shortrun impact on growth, which depends on the transitional dynamics to the steady-state growth path. However, new growth theories incorporate the role of knowledge or technology endogenously as a factor of production in its own right and provide for the possibility of non-diminishing returns to capital (Grossman and Helpman 1991, Romer 1994.) There are a number of conceivable channels through which FDI permanently affects the growth rate. A convenient way to think about these effects is by separating out how FDI affects each argument in the production function. FDI can affect output by increasing the stock of capital. However this impact is likely to be small under the assumption of perfect substitutability. Although the empirical evidence on this matter is ambiguous (Hanson, 2001), if foreign and domestic capital are complements the final impact of FDI on aggregate output will be larger as a result of these externalities. One can also think about the impact of FDI on labour. Once again, the expected impact is small and in this case it will be in terms of job creation. Yet, the role of FDI as knowledge and technology transfer becomes even more apparent as FDI has clearly a more import role in the augmentation of human capital than on the numbers employed. Consider the case in which foreign investment is carried out in activities in which the host economy has limited previous experience. In this case FDI will entail important knowledge transfers in terms of training of the labour force, skills acquisition, new management practices and organisational arrangements. The last and arguably the most important venue through which FDI affect economic growth is through technology. FDI inflows directly raise the levels of technology in the host economy. That can be for a variety of mechanisms. One plausible mechanism is that FDI inflows increase the variety of intermediate products and types of capital equipment in

the host economy (Borensztein et al., 1998). In so doing, FDI inflows lead to an increase of the productivity in the host economy. Another important mechanism through which FDI affects growth is learning. FDI inflows diffuse knowledge about production methods, product design and new organisational and managerial techniques. In this light, imitation becomes a crucial element. Another important mechanism is that FDI raises the productivity of domestic Research and Development activities. FDI and Trade There has been, traditionally, a divergence in terms of the development of the theories on FDI and international trade. Trade theory, attempts to explain why countries trade with each other and FDI theory tries to account for why firms produce abroad and invest in particular countries. In the neoclassical approach of trade theory, the paper of Mundell (1957) was the first to focus on the relationship between, capital movements and trade of commodities. In the HOS framework, in taking account of the assumptions of perfect competition and constant economies of scale, Mundell argued that a tariff protection would generate a perfect substitution between capital movements and trade of commodities. Moreover, the question of complementarity / substitution was raised again with the new international theory developed at the end of the 1970's and dealing with imperfect competition and increasing economics of scale.