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Relationship between FDI and Economic Growth in India and China: A Comparative Study

Updated on August 8, 2018

Introduction

Theoretically, it is believed that Foreign Direct Investment (FDI) enhances growth by attracting production intelligence, technology, and managerial skills. The arguments posit that FDI constitutes the largest component of net resource inflows in developing countries. Most economists consider FDI as an important element for economic growth in developing nations (Rehman 2016). In particular, the assertions provide that knowledge spillover, which is the most important advantage of FDI, occurs through activities such as learning by watching, training of labor, and business between local suppliers and foreign firms. Additionally, policy makers from different countries embrace the view that FDI can offer incentives for attracting foreign investment by imposing favorable effects on development. Concerned by this paper is to examine different empirical methods in a bid to establish the relationship between FDI and economic growth in India and China. The impact of FDI in an economy varies depending on the type of FDI a country adopts (Kaur, Yadav and Gautam 2013). As such, this article also focuses on determining the type of FDI utilized in China and India, and how that affects economic growth in each country. In practice, the nature of FDI flows exists in the form of: Resource-seeking FDI, Market-seeking FDI, Production-oriented FDI, Trade-facilitated FDI, Export-oriented FDI, and Efficiency seeking FDI.

Comparison Of The Relationship Between FDI And Economic Growth In China And India

Human capital, technology, and educational attainment are the key aspects that result in the different competitive advantages and consequently, technological growth in India and China. Besides, the different political regimes adapted by the two countries also explain their different state capacities. India has a democratic government, which is criticized for lack of capacity needed to improve the nation’s outdated infrastructure (Bari 2013). China’s authoritarian regime on the flipside, receives credit for a great state capacity evidenced in the county’s determination in building a world-class infrastructure.

China and India experienced a more than two decades of rapid growth, which are arguably the most significant development history since the 1980s. The two countries learned from the struggle during the state-directed autarkic industrialization, which motivated them to liberalize domestic markets and reduce trade barriers as measures of initiating economic reforms. Drawing from a systematic evaluation of export patterns, both China and India portray similar comparative advantage in resource and labor-intensive manufacturing (Sahoo and Sethi 2015). However, India and China exhibit different development patterns in spite of having similar policies and objectives for economic reforms. Despite the similar growth trajectories and natural factor endowments evident for the case of China and India, the two nations do not attract similar types of FDI.

Even though India and China integrate well into the global market, they portray distinctively varying roles because China serves as a global workshop and India its office. Gupta and Singh (2016) find that India’s manufacturing sector attracted 30 percent FDI inflows whereas the service sector received 68 percent between the year 2000 and 2010. In contrast, China’s service sector and manufacturing sector attracted 38 percent and 59 percent respectively in the same year (Gupta and Singh 2016). When compared to the global norms, India’s manufacturing share of GDP is lower whereas it has a noticeably higher service share of GDP. In contrast, China has a service share markedly lower than the global standards, and it has a substantially higher manufacturing share of GDP.

Relationship Between Foreign Direct Investment and Economic Growth In India and China

Pre and post-1991 phases are the two phases of liberalization and deregulation identified with India. The pre-1991 phase was restrictive in terms of limit specifications for foreign and sectoral investments (Kurul and Yalta 2017). In 1991, however, India allowed foreign investments in major sectors. The year 1991 marked the beginning of economic reforms in the country with critical reforms adopted in the field of trade, investment, and finance. Examples of reforms that India enacted that rendered its market attractive for foreign investments include: Foreign Exchange Management Act (FEMA), competition Act, and amendments in Intellectual Property Rights (IPR). Furthermore, with the highly skilled manpower that India currently boasts of alongside consistent performance in economic growth makes it an economy attraction to foreign investments.

Exploiting the role of FDI flows in export-led urbanization and industrialization plus the efficiency of growth and structured upgrading in China is becoming increasingly necessary. China enacted open-door policies in the year 1978, and this in turn led to the inflows of foreign direct investment into the country.

Labor mobility determines FDI, and hence, impacts on economic development. Economic structure patterns are consistent with the distribution of FDI (Jun 2015). Whereas the service sector in India accounts for the most concentration of FDI in the country, China’s FDI is mainly absorbed by the manufacturing sector. The service sector, particularly financial services and information technology serves a crucial role in the Indian economy. Conversely, the primary driver for the Chinese economy is labor-intensive manufacturing. Micro level institutions in India and China such as those that impose policies governing land and labor markets shape the nations’ labor mobility. Consequently, this affects their development paths and FDI patterns. India’s labor mobility compels investment in the modern service sector that has a relatively high demand for skilled labor (Jun 2015). By so doing, foreign firms choose to invest less in unskilled-labor-intensive manufacturing sector. On the other hand, foreign firms in China enjoy the rewards of scale economies by focusing their investments in labor-intensive manufacturing due to the high labor mobility in the nation.

Labor Mobility In India and China

Domestic labor mobility is a proximate trigger of economic development paths and FDI patterns. High labor mobility strengthens the comparative advantage in labor-intensive production as well as increases the supply of labor; low labor mobility market does the complete opposite (Zheng 2016). Due to the low labor mobility in India, foreign firms tend to focus more on investing in modern services where the demand for skilled human resource is relatively high. In contrast, MNEs in China concentrate more on investing in labor intensive manufacturing as they target small scale economies because China has high labor mobility. India’s labor regulations constrain the flexibility of firms in hiring and firing while strengthening the collective bargaining power of formal employees (Zheng 2016). Consequently, this prevents the movement of labor between informal and formal sectors. Chinese labor policies undermine collective bargaining of workers as well as their job security by raising the rigidity of hiring and firing by firms. The other consequence of this is the enhancement of occupational labor mobility in the nation. China’s land regulations increase spatial labor mobility and raises rural-urban inequality through the facilitation of urban expansion; the contrary is true for India.

Relationship between FDI and Economic Growth in Developing Countries

Fundamentally, literature on economic growth theory falls into any of these categories: Solow model or neo-classical model, Harrold-Domar model or post-Keynesian growth model, and new growth model. Each of these models is ideal in supporting the existence of positive effect of FDI on economic growth. Technical progress is the main source of growth in the neo-classical model (Sahoo and Sethi 2015). The common dominant understanding is that developing countries, as opposed to developed nations, are endowed with low capacity of innovation by their human capital. Hence, it is ideal to welcome the idea that technologically innovation accounts for a relatively small proportion of economic growth experienced in developing economies is true. However, FDI can bridge a technological gap between two categories of nations only if the domestic firms can access superior technology and skills from the MNEs. Stressed by the Harrold-Domar growth model is the role of capital accumulation and savings in promoting growth. The model best explains growth effect by FDI in a host country, as it postulates that FDI boosts total investment. According to the new model setting, knowledge itself is a function of total capital stock; it is a productive factor. Embraced by the model is the idea that factor accumulation is a growth promoter because it focuses on the endogeneity of technical progress (Sahoo and Sethi 2015). Supporting the new model is the assumption that the capital goods proportion that foreign companies produce relative to the production by domestic firms is indirectly related to the fixed set-up cost. The argument in support of this is that it is expected that FDI lowers the set-up cost through the inception of more advance know-how, which in turn aids in producing better standards of capital goods in developing countries.

Literature Review

A common perception is that FDI propels economic development in developing countries especially when governments in those nations seek to restructure or develop industry towards skilled internationally-oriented activities. The same perception contends that in the contemporary world, FDI is a dominant mode through which economies become integrated. Both micro firm-level and macro-level analysis studies, argues Varghese (2016), find mixed evidence regarding the notion that there is a significantly positive role of FDI on economic growth. In a bid to attract more FDI, these governments provide incentives such as tax holidays, tax breaks, and fiscal documents to foreign investors (Kurul and Yalta 2017). Empirical evidence indicates that the process-innovative strengths or the specialized products determine the success of MNEs based in developing countries. A study by Gupta and Singh (2016) avers that FDI is among the primary ways through which domestic enterprises acquire managerial competence and technology owned by MNEs.

There seems to be no agreement among empirical studies regarding the effect of FDI on the economic growth of developing countries regardless of there being a rosy perspective of FDI externalities driving economic performance. Kaur, Yadav and Gautam (2013) instead find that over 70 percent of global FDI goes to developed countries, and not the developing ones. Further explained by the same research is that the imperfection in financial markets evident in developing economies serves a vital role in hindering capital flows in such countries. Bari (2013), states that when critically viewed, FDI can lead to a deterioration of payment account balance in developing nations such as India. The study maintains that there is need to assess the possibility of bidirectional causality or lack or of causality link that exists between economic growth and FDI. An inflow of FDI possibly leads to the “crowding out” effect (Jun 2015). In this regard, FDI leads to a drastic upshot in unemployment and imports in the host country by occupying the domestic investment market, which in turn leads to the substitution for investments.

References

Bari, M.A. 2013, "Foreign Direct Investment and Economic Growth In Bangladesh and India: A Comparative Study", South Asian Journal of Management, vol. 20, no. 1, pp. 7-37.

Gupta, P. & Singh, A. 2016, "Causal nexus between foreign direct investment and economic growth", Journal of Advances in Management Research, vol. 13, no. 2, pp. 179-202.

Jun, S. 2015, "The Nexus between FDI and Growth in the SAARC Member Countries", Journal of East Asian Economic Integration, vol. 19, no. 1, pp. 39-70.

Kaur, M., Yadav, S.S. & Gautam, V. 2013, "A bivariate causality link between foreign direct investment and economic growth", Journal of International Trade Law & Policy, vol. 12, no. 1, pp. 68-79.

Kurul, Z. & Yalta, A.Y. 2017, "Relationship between Institutional Factors and FDI Flows in Developing Countries: New Evidence from Dynamic Panel Estimation", Economies, vol. 5, no. 2, pp. 17.

Rehman, N.U. 2016, "FDI and economic growth: empirical evidence from Pakistan", Journal of Economic and Administrative Sciences, vol. 32, no. 1, pp. 63-76.

Sahoo, K. & Sethi, N. 2015, "Linkages between Foreign Capital, Domestic Capital and Economic Growth in India", Journal of International Economics, vol. 6, no. 2, pp. 71-82.

Varghese, T. (2016). Analysis of foreign direct investment in India. International Journal of Information, Business and Management, 8(4), 250-269.

Zheng, Y. (2016). “Institutions, labor mobility, and foreign direct investment in china and India.”Studies in Comparative International Development, 51(2), 147-168. doi:http://dx.doi.org/10.1007/s12116-015-9201-7

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