CHAPTER 1INTRODUCTION

Over the past two decades, many countries around the world have experienced substantial growth in their economies, with even faster growth in international transactions, especially in the form of foreign direct investment (FDI). The share of net FDI in world GDP has grown five-fold through the eighties and the nineties, making the causes and consequences of FDI and economic growth a subject of ever-growing interest. This report attempts to make a contribution in this context, by analyzing the existence and nature of causalities, if any, between FDI and economic growth. It uses as its focal point India, where growth of economic activities and FDI has been one of the most pronounced.

DEFINITION OF FOREIGN DIRECT INVESTMENT :-

Foreign direct investment (FDI) is defined as "investment made to acquire lasting interest in enterprises operating outside of the economy of the investor”. The FDI relationship, consists of a parent enterprise and a foreign affiliate which together form a transnational corporation (TNC). In order to qualify as FDI the investment must afford the parent enterprise control over its foreign affiliate. The UN defines control in this case as owning 10% or more of the ordinary shares or voting power of an incorporated firm or its equivalent for an unincorporated firm.

HISTORY OF FDI IN INDIA.

At the time of independence, the attitude towards foreign capital was one of fear and suspicion. This was natural on account of the previous exploitative role played by it in ‘draining away’ resources from this country.

The suspicion and hostility found expression in the Industrial Policy of 1948 which, though recognizing the role of private foreign investment in the country, emphasized that its regulation was necessary in the national interest. Because of this attitude expressed in the 1948 resolution, foreigncapitalists got dissatisfied and as a result, the flow of imports of capital goods got obstructed. As a result, the prime minister had to give following assurances to the foreign capitalists in 1949:

1. No discrimination between foreign and Indian capital:- The government o India will not differentiate between the foreign and Indian capital. The implication was that the government would not place any restrictions or impose any conditions on foreign enterprise which were not applicable to similar Indian enterprises.

2. Full opportunities to earn profits:-The foreign interests operating in India would be permitted to earn profits without subjecting them to undue controls. Only such restrictions would be imposed which also apply to the Indian enterprises.

3. Gurantee of compensation:-If and when foreign enterprises are compulsorily acquired, compensation will be paid on a fair and equitable basis as already announced in government’s statement of policy.

Though the Prime Minister stated that the major interest in ownership and effective control of an undertaking should be in Indian hands, he gave assurance that there would be “no hard and fast rule in this matter.”

By a declaration issued on June 2, 1950, the government assured the foreign capitalists that they can remit the he foreign investments made by them in the country after January 1, 1950. in addition, they were also allowed to remit whatever investment of profit and taken place.

Despite the above assurances, foreign capital in the requisite quantity did now flow into India during the period of the First plan. The atmosphere of suspicion had not changed substantially. However, the policy statement of the Prime Minister issued in 1949 and continued practically unchanged in the 1956 Industrial Policy Resolution, had opened up immense fields to foreign participation. In addition, the trends towards liberalization grew slowlyand gradually more strong and the role of foreign investment grew more and more important.

The government relaxed its policy concerning majority ownership in several cases and granted several tax concessions for foreign personnel. Substantial liberalization was announced in the New Industrial Policy declared by the government on 24th July 1991 and doors of several industries have been opened up for foreign investment.

Prior to this policy, foreign capital was generally permitted only in the those industries where Indian capital was scarce and was not normally permitted in those industries which had received government protection or which are of basic and/or strategic importance to the country. The declared policy of the government was to discourage foreign capital in certain inessential‘ consumer goods and service industries.

However, this provision was frequently violated as a number of foreign collaborations even in respect of cosmetics, toothpaste, lipstick etc. were allowed by the government. It was also stated that foreign capital should help in promoting experts or substituting imports.

The government also laid down that in al those industries where foreign capital investment is allowed, the major interest in ownership and effective control should always be in Indian hands (this condition was also often relaxed).

The foreign capital investments and technical collaborations were required to be so regulated as to fit into the overall framework of the plans. In those industries where foreign technicians and managers were allowed to operate as Indians with requisite skills and experience were not available, vital importance was to be accorded to the training and employment of Indians in the quickest possible manner.

One of the remarkable features of globalization in the 1990s was the flow of private capital in the form of foreign direct investment. FDI is animportant source of development financing, and contributes to productivity gains by providing new investment, better technology, management expertise and export

markets. Given resource constraints and lack of investment in developing countries, there has been increasing reliance on the market forces and private sector as the engine of economic growth

TYPES OF FDI :BY DIRECTION:-•InwardInward foreign direct investment is when foreign capital is invested in local resources. •OutwardOutward foreign direct investment, sometimes called "direct investment abroad", is when local capital is invested in foreign resources.

BY TARGET :-•Greenfield investmentDirect investment in new facilities or the expansion of existing facilities. Greenfield investments are the primary target of a host nation’s promotional efforts because they create new production capacity and jobs, transfer technology and know-how, and can lead to linkages to the global marketplace. The Organization for International Investment cites the benefits of greenfield investment (or insourcing) for regional and national economies to include increased employment (often at higher wages than domestic firms); investments in research and development; and additional capital investments. Criticism of the efficiencies obtained from greenfield investments include the loss of market share for competing domestic firms. Another criticism of greenfield investment is that profits are perceived to bypass local economies, and instead flow back entirely to the multinational's home economy. Critics contrast this to local industries whose profits are seen to flow back entirely into the domestic economy.

•Mergers and AcquisitionsTransfers of existing assets from local firms to foreign firms takes place; the primary type of FDI. Cross-border mergers occur when the assets and operation of firms from different countries are combined to establish a newlegal entity. Cross-border acquisitions occur when the control of assets and operations is transferred from a local to a foreign company, with the local company becoming an affiliate of the foreign company. Unlike greenfield investment, acquisitions provide no long term benefits to the local economy-- even in most deals the owners of the local firm are paid in stock from the acquiring firm, meaning that the money from the sale could never reach the local economy. Nevertheless, mergers and acquisitions are a significant form of FDI and until around 1997, accounted for nearly 90% of the FDI flow into the United States. Mergers are the most common way for multinationals to do FDI. •Horizontal FDI

Investment in the same industry abroad as a firm operates in at home.

•Vertical FDI Backward Vertical FDIWhere an industry abroad provides inputs for a firm's domestic production process.

Forward Vertical FDIWhere an industry abroad sells the outputs of a firm's domestic production.

BY MOTIVE :-

FDI can also be categorized based on the motive behind the investment from the perspective of the investing firm:

•Resource-SeekingInvestments which seek to acquire factors of production that are more efficient than those obtainable in the home economy of the firm. In some cases, these resources may not be available in the home economy at all (e.g. cheap labor and natural resources). This typifies FDI into developing countries, for example seeking natural resources in the Middle East and Africa, or cheap labor in Southeast Asia and Eastern Europe.

•Market-SeekingInvestments which aim at either penetrating new markets or maintaining existing ones. FDI of this kind may also be employed as defensive strategy; it is argued that businesses are more likely to be pushed towards this type of investment out of fear of losing a market rather than discovering a new one. This type of FDI can be characterized by the foreign Mergers and Acquisitions in the 1980’s y Accounting, Advertising and Law firms.

•Efficiency-SeekingInvestments which firms hope will increase their efficiency by exploiting the benefits of economies of scale and scope, and also those of common ownership. It is suggested that this type of FDI comes after either resource or market seeking investments have been realized, with the expectation that it further increases the profitability of the firm.. Typically, this type of FDI is mostly widely practiced between developed economies; especially those within closely integrated markets (e.g. the EU).

•Strategic asset seeking A tactical investment to prevent the loss of resource to a competitor. Easily compared to that of the oil producers, whom may not need the oil at present, but look to prevent their competitors from having it.

CLASSIFICATION OF FOREIGN DIRECT INVESTORS :-A foreign direct investor may be classified in any sector of the economy and could be any one of the following •an individual;•a group of related individuals;•an incorporated or unincorporated entity;•a public company or private company;•a group of related enterprises;•a government body;•an estate (law), trust or other social institution; or•any combination of the above.DIFFERENT FDI INCENTIVES :-•low corporate tax and income tax rates•tax holidays•other types of tax concessions•preferential tariffs

•special economic zones•EPZ - Export Processing Zones•Bonded Warehouses•Maquiladoras•investment financial subsidies•soft loan or loan guarantees•free land or land subsidies•relocation & expatriation subsidies•job training & employment subsidies•infrastructure subsidies•R&D support•derogation from regulations (usually for very large projects) BENEFITS OF FDI :-

Attracting foreign direct investment has become an integral part of the economic development strategies for India. FDI ensures a huge amount of domestic capital, production level, and employment opportunities in the developing countries, which is a major step towards the economic growth of the country. FDI has been a booming factor that has bolstered the economic life of India, but on the other hand it is also being blamed for ousting domestic inflows. FDI is also claimed to have lowered few regulatory standards in terms of investment patterns. The effects of FDI are by and large transformative. The incorporation of a range of well-composed and relevant policies will boost up the profit ratio from Foreign Direct Investment higher. Some of the biggest advantages of FDI enjoyed by India have been listed as under:

Economic growth- This is one of the major sectors, which is enormously benefited from foreign direct investment. A remarkable inflow of FDI in various industrial units in India has boosted the economic life of country.

Trade- Foreign Direct Investments have opened a wide spectrum of opportunities in the trading of goods and services in India both in terms of import and export production. Products of superior quality are manufacturedby various industries in India due to greater amount of FDI inflows in the country.

Employment and skill levels- FDI has also ensured a number of employment opportunities by aiding the setting up of industrial units in various corners of India.

Technology diffusion and knowledge transfer- FDI apparently helps in the outsourcing of knowledge from India especially in the Information Technology sector. It helps in developing the know-how process in India in terms of enhancing the technological advancement in India.

Linkages and spillover to domestic firms- Various foreign firms are now occupying a position in the Indian market through Joint Ventures and collaboration concerns. The maximum amount of the profits gained by the foreign firms through these joint ventures is spent on the Indian market.

DETERMINANTS OF FDI :-

Nowadays, virtually all countries are actively seeking to attract FDI, because of the expected favourable effect on income generation from capital inflows, advanced technology management skills and market know-how.

The key determinants and factors associated with the extent and pattern of FDI in developing host countries: attractiveness of the economic conditions in host countries; the policy framework towards the private sector, trade and industry, and FDI and its implementation by host governments; and the investment strategies of MNE’s.

As a consequence of globalization and economic integration, one of the most important traditional FDI determinants, the size of national markets, has decreased in importance. At the same time, cost differences between locations, the quality of infrastructure, the ease of doing business and the availability of skills have become more important (UNCTAD 1996). Traditional economic determinants, such as natural resources and national market sizefor manufacturing products sheltered from international competition by high tariffs or quotas, still play an important role in attracting FDI by a number of developing and developed countries as well as economies in transition.

For foreign investors, the host country policies on the repatriation of profits and capital and access to foreign exchange for the import of intermediaries, raw materials and technology are particularly important. The pattern of recent FDI flows supports the conclusion that liberal policies on technology, which tend to go hand in hand with more liberal policies in general, serve to attract more and better foreign investments.

KEY DETERMINANTS OF FDI

Economic conditions• MarketsSize; income levels; urbanization; stability and growth prospects; access to regional markets; distribution and demand patterns.

• ResourcesNatural resources; location.

• CompetitivenessLabour availability, cost, skills, trainability; managerial technical skills; access to inputs; physical infrastructure; supplier base; technology support

Country’s policies• Private sectorPromotion of private ownership; clear and stable policies; easy entry/exit policies; efficient financial markets; other support.

• Macro policiesManagement of crucial macro variables; ease of remittance; access to foreign exchange.

• Trade and industryTrade strategy; regional integration and access to markets; ownership controls; competition policies; support for SMEs

• FDI policiesEase of entry; ownership, incentives; access to inputs; transparent and stable policies.

MNE strategies• Risk perceptionPerceptions of country risk, based on political factors, macro management, labour markets, policy stability.

• Location, sourcing, ,integration transfer.Company strategies on location, sourcing of products/inputs, integrationof affiliates, strategic alliances training , technology

FDI IN DEVELOPED AND DEVELOPING COUNTRIES :-

The ten largest developing and developed host countries economies for FDI for 2001, and their inward FDI flows between 1997 and 2001. Among developing economies, China, Mexico, and Brazil had the largest inward flows, while among developed countries, the US, the UK, France, and Belgium and Luxembourg were the largest recipients of FDI flows. In assessing the relationship between taxation and FDI in these diverse countries, it is important to keep in mind several factors concerning FDI. First, FDI in the service sector, and particularly in finance, has increased at a greater rate than FDI in manufacturing. According to the World Bank (2003), the world stock of inward FDI increased at an annual rate of 12.2 percent in manufacturing and

13.8 percent in services between 1988 and 1999. In developing countries, the difference in the annual increase in the composition of the inward stock of FDI was even more marked: a 19.6 annual growth rate in manufacturing versusa 28.2 percent annual growth rate in services. The potentially important role of the financial sector is evident in the data for Belgium and Luxembourg in Table 2. While obviously small countries, in 2000 Belgium and Luxembourg overtook Germany and came close to overtaking the US in total FDI inflows.

Second, the composition of FDI can differ significantly from country to country, sometimes even within regions. Brazil, for instance, has seen greater inflows in the tertiary (service) sector than the secondary (manufacturing) sector in every year from 1996 to 2002. Mexico, while having significant inflows in the tertiary sector, had higher inflows in manufacturing in every year from 1994 to 2000.

Third, FDI inflows are geographically diverse both across host countries and within a given host country. Hence, host countries need to keep in mind different home country tax systems when evaluating the effects of tax policy. For instance, the bulk of FDI inflows into Mexico come from the United States.

While the US is also a significant provider of FDI in Brazil, a large part of FDI inflows in Brazil have come from Western Europe. Moreover, the geographic origin of flows into Brazil have changed significantly during the 1990’s, with Spain, France, and the Netherlands currently the largest investors from Western Europe.

Fourth, developing countries are usually characterized by greater FDI inflows than outflows, while developed economies’ inflows and outflows tend to be closer, with FDI outward stocks often greater than inward stocks. For instance, during the period 1985-1995, developed economies’ inflows average $127.5 billion annually, while annual outflows averaged $181.7 billion. During this same period, developing economies’ inflows averaged $50.1 billion annually and outflows averaged $21.5 billion. In 2000, China’s inflows were $40.8 billion while outflows were only $0.9 billion. In some sense, then, the challenges facing developing and developed economies are different.

Fifth, it is important to recognize at the outset that taxes usually are notthe most important factor in attracting FDI, although they can have marginal impacts. A number of studies have shown that an attractive investment climate including factors such as the rule of law and low levels of corruption, good infrastructure, agglomeration economies, as well as geographic proximity, are the most important factors at work. Moreover, the reputation of a country is important. Are a country’s policies likely to be time consistent – that is, will tax or other incentives granted today be honored in the future, or may a government renege on future promises, perhaps even confiscating a company’s assets? Country risk is important and may be endogenously determined by government policies (Eaton and Gersovitz).

Finally, it should be noted that FDI often has an uneven impact within a country. For instance, NAFTA is generally thought to have impacted Mexico unevenly, increasing incomes more along the wealthier northern border than in the poorer southern states. This can have important political ramifications as those that lose or do not gain as much will tend to be opposed to policies that might benefit the country as a whole.

Why Does India Attracts the Maximum FDI Inflows?

India is potentially active in terms of investments and provides a galore of opportunities to the foreign players into the market. Foreign companies who aspire to become a global player would grab the opportunities, India provides in terms of investments. The foreign companies enjoy the rights to set up branch offices, representative offices, and also carry out outsourcing activities in terms of software developmental programmes in India. All these have opened up innumerable options for the foreign investors to expand their businesses at a global level. These are some of the factors which led to FDI Inflows in India. Market Potential in India for Attracting FDI Inflows-

India is claimed to be the fifth largest economy across the globe and ranks third in the Gross Domestic Product in the entire Asia, which is one of the most significant factors responsible for FDI Inflows in India. India is also known to be the second largest country amongst all other developingcountries. Besides, India belongs to those rarest of countries, which offer growth and earning opportunities through various industrial units. India offers maximum opportunities for foreign investments, which have been a major cause behind the flourishing economy of the country. The FDI Inflows in Indian

market as accounted for the year 2006-07, stood at USD 2,171 million.