Web exclusive: The role of FDI in economic growth

In the immediate aftermath of the global financial crisis in late 2008 and early 2009, a flight of foreign capital particularly portfolio investment was witnessed from India.

However, despite the huge FII outflows during FY09, India’s total foreign investment remained in surplus primarily due to substantial FDI inflows.

During the crisis period, when other capital flows such as banking capital or foreign portfolio investment witnessed high volatility, FDI exhibited a low volatility. Net FDI inflows during FY09 (the year of global financial turmoil) amounted to $35 bn as compared with the net FDI inflows of $34.73 bn in FY08 - before the crisis period. On the other hand, foreign portfolio investment witnessed a net outflow of $13.85 bn during FY09 as against a net inflow of $27.27 bn. With the improvement in the investor confidence, the net FDI inflows amounted to $26.6 bn during Apr-Dec 09.

The stability attribute of FDI has led it to be viewed as a ‘safe’ form of external financing which is often used to fill the gap between domestic savings and investment.

Apart from being a relatively ‘safe’ mode of external financing to supplement the domestic savings, FDI generates other benefits as well. The analysis of effects of FDI at macro as well as micro level (sectoral level) reveals that FDI has played a multi-dimensional role in the overall development of the Indian economy.

The key benefits of FDI primarily include increase in overall output through capacity additions, employment generation, the acquisition of new technology and knowledge, contribution to exports growth, creation of competitive business environment in the country and increased tax revenue from corporate profits generated by FDI-enabled companies.

The spill-over effects of FDI on various industries show that it has not only led to the overall capacity expansion but has also contributed in the improvement of output-capital ratio in sectors, particularly electricity distribution & control apparatus, petroleum product, mining of iron ore and transport equipment.

As per the DIPP classification, these sectors are among the top ten FDI receiving sectors and have strong backward and/ or forward linkages with the economy, in turn providing further impetus to the economic growth.

FDI in India has significant impact on the competitive environment, technology upgradation, research & development and industrial management skill of the domestic industry. This can explicitly be observed in the case of Indian pharmaceutical industry. The foreign pharmaceutical companies have contributed significantly in terms of latest manufacturing techniques & marketing practices, technology advancement, imitation and human capital development, thereby leading to substantial enhancement in productivity & competitiveness of domestic companies.

Given that FDI has played a role in the development of the domestic manufacturing & services sectors, the Government’s stance on FDI policy front is extremely crucial as it will provide the necessary impetus to increase FDI inflows in future. The government’s recent move to publish a comprehensive document on FDI policy decisions is commendable as it provides clarity on the FDI policy provisions.

Besides, the government intends to review certain policy provisions, which mainly include exclusion of portfolio investments by FIIs while calculating the overall FDI limit, restrictions on sales by wholesale trading companies with foreign equity and raising the 26 per cent cap on FDI in defence.

The author is Head – Economic Analysis, Dun & Bradstreet India