Rajeev Anantaram: Making FDI work for the host country

India must ensure its FDI policy does not benefit only foreign investors

China and India have struggled to leverage FDI to their own benefit. Both have a lot to offer the foreign investor, but India must ensure that the benefits also flow the other way around.

The discourse on foreign direct investment (FDI) in India has traditionally been oriented towards the sheer volume of inflows. Understandably, the finding of the most recent World Investment Report (WIR 2011) that FDI inflows to India during 2010 declined by a third to $25 billion evoked all-round concern. However, there is very limited discourse on the downstream effects of FDI, which can vary considerably across countries, even for comparable volumes of inflows. A comprehensive analysis of the impact of FDI will have to be more nuanced, to include both volumes and the impact of spillovers on the domestic economy.

First, a few facts. 

• FDI is not a prerequisite for growth. GDP in Japan and South Korea grew at between 8 and 10 per cent a year between 1960 and 1980, with the government adopting an ‘arm’s length’ approach to foreign capital, preferring to rely on domestic savings even in the early stages of growth.
• FDI is not always a barometer of the health of the economy. In countries such as China, where “round tripping” (domestic capital leaves the country and returns as FDI for tax benefits) conservatively accounts for 30 to 40 per cent of annual inflows, the motivations for investment may be varied.
• The government has always had an important role to play in countries such as Taiwan, which have been more welcoming to FDI, by helping steer FDI towards those sectors of the economy that could best use it. In general, a laissez faire approach has not worked in favour of the host country.
• More is not always better. For example, the entry of FDI in an under-supplied real estate market is a sure-fire way to create an asset bubble.

In principle, FDI can bring multiple benefits in addition to capital and, in the presence of well-calibrated policies, can provide noticeable benefits to the host country. These benefits include improving the host country’s access to export markets and potentially providing domestic firms with exposure to global management best practices. The most coveted spillover is technology diffusion from the multinational corporation (MNC) to domestic firms.

However, this process is rarely smooth, for a complex set of reasons that have to do both with MNC strategy and host country conditions. The nature of FDI (whether resource-oriented, market-seeking or export-oriented) is another powerful determinant of the interaction between the foreign firm and the host country.

The contrasting experiences of China and India provide useful insights on the downstream impact of FDI. Neither country is critically dependent on FDI for capital alone: FDI as a share of GDP is approximately 2.2 per cent for China and about 1.6 per cent for India. However, even after accounting for China’s 15-year head start over India in opening up to foreign investment, FDI has impacted China far more profoundly than it has India. Export-oriented (vertical) FDI (particularly from Hong Kong and Taiwan) jump-started China’s manufacturing sector, provided the early export push and by extension helped overcome China’s chronic balance of payments problem.

As recently as 2009, 59 per cent of China’s manufacturing exports and 85 per cent of all high-tech exports were FDI-driven. World-class infrastructure drove export-oriented FDI, which in turn pushed the development of infrastructure. This virtuous cycle explains a significant portion of China’s growth over the past two decades. If managerial best practices were slow to diffuse in China, the sequestering of foreign companies within the Special Economic Zones until the early 1990s, along with issues of language and culture are primarily to blame.

China’s experience with technological diffusion, though, is nowhere as positive. The fundamental obstacle to greater diffusion of technology in China to date has been its National Innovation System, which is simply not primed to foster collaborative work. While a critical mass of human capital to support manufacturing exists, the same cannot be said for innovation-driven research. A weak Intellectual Property Rights (IPR) regime weakened the motivation of MNCs to relocate innovative research in China or even transfer technology to local partners.

To its credit, China is moving rapidly to overcome these weaknesses. The creation of a cadre of well-equipped “research” universities, enhanced R&D budgets for government laboratories, institutional overhaul (shutting down defunct institutions and fostering closer linkages among the rest) and incentives for greater private sector participation in IPR-driven activities — all part of its highly nationalist “indigenous innovation” strategy — are rapidly bringing China closer to the cutting edge in several areas such as nanotechnology, special materials and so on. Ironically, the interactive experience between foreign firms and Chinese institutions has improved as domestic capabilities increase.

On the other hand, FDI in India has been largely market-seeking (horizontal). Thus, forward and backward linkages with the domestic economy are underdeveloped. However, the share of export-oriented FDI has been gradually increasing for a decade. This is particularly true in high value-added sectors such as automobiles and auto components, wireless software and increasingly in pharmaceuticals. Despite this, MNC contribution to India’s export basket is still limited.

India's experience with FDI-driven technology deepening is in its early days, which makes a comparison with China inappropriate. As with China, most MNC-driven R&D work in India is still “adaptive”, in that it modifies standardised technology to local conditions. However, in certain niche industries considerable IP-generating research is being undertaken. Interestingly, significantly more domestic value addition is taking place in MNCs’ India operations than at a comparable point in time in China, as MNCs increasingly seek to leverage India's collective ability in design and innovation.

India still has a long way to go to create the enabling environment to leverage MNC technology as China is just beginning to do. The Science, Technology and Innovation (STI) policy laid out a clear roadmap, which showed a clear understanding of India's strengths. Its recommendations were broadly similar to the steps China has already taken. If it has not been as transformative, absence of leadership is to blame.

Despite being poster countries for foreign investors in recent years, China and India have struggled to leverage FDI to their own benefit. India in particular has a long way to go. Like China, it has a lot to offer the foreign investor. The policy challenge is to ensure that the benefits also flow the other way around.