THE DETERMINANTS OF FOREIGN DIRECT INVESTMENT: AN ECONOMETRIC STUDY WITH SPECIAL REFERENCE TO INDIA

The following paper was presented in the 51st conference of the Indian Econometrics Society at Punjabi University ,Patiala during 12-14 December,2014

THE DETERMINANTS OF FOREIGN DIRECT INVESTMENT: AN ECONOMETRIC STUDY WITH SPECIAL REFERENCE TO INDIA

Dr. Debesh Bhowmik

JEL-F21,F23,O4,C12,C32

Key words – Foreign direct investment, determinants of foreign direct investment, co-integration,

Foreign direct investment (FDI) has assumed increasing importance over time, becoming a prime concern for policy makers and a trendy debatable topic for economists. The debate on FDI has several facets, but the particular aspect that policy makers in capital-starved countries are concerned with is the determinants of FDI inflows. Many countries have policies aimed at creating stronger incentives for foreign investors who are potentially capable of providing FDI flows. Understanding the determining factors of FDI inflows and unveiling the reasons why some countries are more successful than others in attracting FDI may provide policy makers with useful guidance for future policy prescription. The provision of incentives and the adoption of FDI-stimulating policies are motivated by the realisation that FDI is a more reliable source of capital than portfolio investment. Large number of (time series and cross section) studies have been conducted to identify the determinants of FDI (inflows) but no consensus view has emerged, in the sense that there is no widely accepted set of explanatory variables that can be regarded as the “true” determinants of FDI.

Taking GDP growth rate, degree of opennesss, total external debt, interest rate and exchange rate as the important determinants of FDI in India during 1990-2013, the paper verified that the Engle-Granger methodology showed that there is co-integrating relationship where degree of openness and interest rate are significant where as Johansen test proved that there are 5cointegrating vectors  in the level series, 5 cointegrating vectors in the first difference series and 5 cointegrating vectors in the log series respectively. The VECM verified  that there are serial correlation and ARCH error with non-normal distribution where all roots lie inside the unit circle including 5 unit roots but impulse response functions do not approach to zero and error correction terms and residual systems are explosive. Similarly, the same conclusions were drawn in case of log series.

As concluding remarks we like to mention that a country which has a stable macroeconomic condition with high and sustained growth rates will receive more FDI inflows than a more volatile economy. Therefore, it is expected that GDP growth rate, industrial production, and interest rates would influence FDI flows positively and the inflation rate would influence positively or negatively. Market size plays an important role in attracting foreign direct investment from abroad. Market size is measured by GDP. Market size tend to influence the inflows, as an increased customer base signifies more opportunities of being successful and also the fact that with the rampant development the purchasing power of the people has also been greatly influenced moving to many levels higher in comparison to what it was before the economic growth.

Among the major reasons which discourage the international investors from investing in India

despite of its consistent economic growth includes: 1) Politics and corruption 2) Lack of

infrastructure 3) Inadequate Legal system 4) Instability of Indian Social and Political

environment 5) Absence of Corporate governance practices 6) Maturity of the financial markets

All in all a more open policy frame is required which can be integrated with developing

economies’ policy frame so that India becomes the most attractive destination and actually receive Foreign Direct Investment in the sectors which has potential to grow from foreign capital. Further, more the integration at National level is required as sectors which are covered under automatic route are subject to other caveats imposed by State and respective Ministry.