Foreign Direct Investment in India

Post author:Viren Rehal
Post published:April 17, 2024
Post category:Indian Economy
Post comments:0 Comments

Foreign Direct Investment or FDI refers to investments made by entities from one country into businesses or entities in another country, with the aim of establishing a significant level of control and influence. It plays a crucial role in global economic integration, technology transfer, and further economic development. IMF and OECD define Foreign Direct Investment as:

“Investment made to acquire lasting interest in enterprises operating outside of the economy of the investor. The investment is made by an entity resident in one economy (the direct investor) with the objective of establishing a lasting interest in an enterprise operating in another economy (the direct investment enterprise).”
IMF, Balance of Payments and International Investment Position Manual, 6th Edition, 2009

“a category of cross-border investment associated with a resident in one economy (the direct investor) obtaining a lasting interest in an enterprise resident in another economy (the direct investment enterprise). The lasting interest implies the existence of a long-term relationship between the direct investor and the direct investment enterprise and a significant degree of influence by the investor on the management of the enterprise.”
OECD Benchmark Definition of Foreign Direct Investment, 4th Edition, 2008

Econometrics Tutorials

Types of Foreign Direct Investment (FDI)

Greenfield Investments: This involves establishing a new business or facility in a foreign country. This may include building a new factory or opening a new office.
Mergers and Acquisitions (M&A): This involves acquiring an existing business or merging with it in a foreign country. Hence, this can provide immediate access to an established market, distribution networks, or technologies.
Joint Ventures: This involves partnering with a local company in a foreign country to create a new entity, sharing ownership/control.

Foreign Direct Investment or FDI vs FII

Nature of Investment

FDI involves a long-term investment in a foreign business with the intention of establishing a lasting interest and significant control over the management and operations of the invested entity. FII, on the other hand, involves investing in financial assets such as stocks, bonds, or other securities of foreign companies without the intention of influencing management decisions.

Level of Control

FDI implies a degree of control and influence over the invested entity. It allows the investor to participate in strategic decision-making, management, and operations. Conversely, FII does not involve any significant control over the management or operations of the invested companies.

Investment Horizon

Investors aim to establish a durable presence in the foreign market and reap benefits over an extended period in FDI. FII typically involves short- to medium-term investment horizons. Hence,iInvestors buy and sell financial assets based on market conditions, economic outlook, and other factors affecting short-term returns.

Risk and Return Profile

FDI generally entails higher risks and rewards compared to FII. FDI involves direct ownership and control of assets in a foreign country. Therefore, investors may face risks related to political instability, regulatory changes, currency fluctuations, and operational challenges. However, successful FDI can yield significant long-term returns. FII tends to have a lower risk profile compared to FDI. This happens because investors can easily enter and exit financial markets without committing substantial resources or assuming direct operational risks. However, FIIs may be exposed to market volatility, liquidity risk, and macroeconomic factors affecting financial markets.

Impact on Economy

FDI is often seen as more beneficial for the host economy in terms of fostering economic growth, job creation, technology transfer, and infrastructure development. As a result, FDI can contribute to long-term sustainable development by building local capacities, enhancing productivity, and promoting industrial diversification. FII can provide short-term capital inflows to financial markets, contributing to liquidity, price discovery, and market efficiency. However, FII flows can be volatile and may pose challenges to macroeconomic stability. This is especially true in emerging markets susceptible to capital flight.

FDI in India

Since gaining independence in 1947, India’s approach to Foreign Direct Investment (FDI) has evolved significantly. This is due to changes in economic policies, political ideologies, and global economic trends.

Foreign Direct Investment Before 1991

India adopted a policy of economic self-reliance and socialism. Hence, central planning, import substitution, and extensive government control over the economy were its major characteristics.
FDI was heavily restricted, and foreign investment was limited to select sectors deemed crucial for development. These included sectors such as infrastructure, technology, and strategic industries.
The Industrial Policy Resolution of 1956 and subsequent industrial licensing system imposed stringent regulations on foreign investment, requiring government approval for FDI in most sectors.

Foreign Direct Investment After 1991

In response to a balance of payments crisis and other factors in 1991, India embarked on a path of economic liberalization, deregulation, and globalization. It happened under the leadership of Prime Minister P.V. Narasimha Rao and Finance Minister Dr Manmohan Singh.
The government initiated a series of economic reforms aimed at opening up the economy to foreign investment. Consequently, it reduced trade barriers, dismantled industrial licensing, and promoted private sector participation.
The New Economic Policy of 1991 marked a significant shift towards a more open and market-oriented economy. It further allowed for a greater participation of foreign investors in various sectors.
Moreover, the Foreign Exchange Management Act (FEMA) of 1999 replaced the Foreign Exchange Regulation Act (FERA), simplifying foreign exchange regulations and facilitating capital inflows.
Sector-specific policies and initiatives were introduced to attract FDI in areas such as telecommunications, information technology, pharmaceuticals, and automotive manufacturing.

Evolution of Foreign Direct Investment in India

Overall

In 1992-93, the overall FDI Inflows were INR 1,094 crores or $393 million. This amount increased to $6051 million in the year 2004-05. After the Economic reforms and the introduction of the New Economic Policy in 1991, we can see that the FDI inflows increased significantly. Since then, the FDI inflows have been rising and increased to $34,887 million in 2010-11 and further to $45,148 in 2014-15.

Sector-wise Distribution of Foreign Direct Investment

In 2005-06, the Electrical Equipment sector, which includes computer software and electronics, received the highest FDI inflows of $841 million. Additionally, the Services sector received the second highest FDI inflows of 462 million followed by Cement and Gypsum Products at $452 million.

Later, the Services sector overtook the Computer software and hardware sector to bring in the highest FDI inflows. In 2019-20, the Services sector received $7,854 million FDI inflows. It accounted for approximately 17% of the Total FDI inflows from 2000 to 2020. The Services sector is followed by the Computer Software and Hardware sector. It received $7,673 million FDI inflows in 2019-20 and accounted for 10% of the inflows from 2000 to 2020.

Other than these, the Telecommunications (8%), Trading (6%), Construction Development (5%) and Automobile Industry (5%) have received the most FDI inflows from 2000 to 2020.

Region-wise Distribution of Foreign Direct Investment

From 2000-2005, Delhi received the highest FDI Inflows amounting to $4,891.9 million. Further, Delhi was followed by Maharashtra ($3,956.7 million) and Karnataka ($1,427.2 million) in the total FDI Inflows received from 2000 to 2005.

In 2019-20, Maharashtra received the highest FDI Inflows of $7,263 million, 30% of the total inflows. Karnataka received the second highest FDI Inflows equal to $4,289 which accounted for 18% of the total. Moreover, Delhi and Gujarat received high FDI inflows at 17% and 11% of the FDI inflows respectively.

Data source: Department for Promotion for Industry and Internal Trade

Advantages of FDI in India

Economic Impact of Foreign Direct Investment

Increased Capital Inflows: FDI has led to increased capital inflows into the Indian economy, therefore, providing much-needed investment for infrastructure development, technology transfer, and industrial expansion.
Job Creation: FDI inflows have contributed to job creation across various sectors, including manufacturing, services, and technology. This has helped reduce unemployment and underemployment, particularly among the youth.
Technology Transfer: Multinational corporations (MNCs) bringing in FDI often transfer advanced technologies, managerial practices, and technical know-how to domestic firms. This has enhanced productivity, efficiency, and competitiveness in Indian industries.
Export Growth: FDI has further boosted India’s export capabilities by facilitating access to global markets, promoting exports of goods and services, and integrating Indian firms into global value chains.

Social Impact

Skill Development: FDI inflows often necessitate the training and upskilling of the local workforce to meet the requirements of modern industries. Hence, this has led to the development of human capital and the acquisition of new skills among workers.
Improved Living Standards: Economic growth driven by FDI has resulted in higher incomes, improved living standards, and better access to goods and services for many Indians. Hence, this has contributed to poverty alleviation and socioeconomic development.
Urbanization: FDI inflows have further stimulated urbanization as industries and businesses cluster in urban centres, leading to the growth of cities and towns. This has led to changes in lifestyle, consumption patterns, and social dynamics.

Cultural Impact

Cultural Exchange: FDI has facilitated cultural exchange and cross-cultural interactions through the presence of multinational corporations and expatriate employees. This exposure to different cultures, languages, and perspectives has enriched India’s cultural landscape.
Diversity and Pluralism: Moreover, the influx of FDI has contributed to the diversification and pluralism of Indian society by fostering interactions between people of different nationalities, ethnicities, and backgrounds. This has promoted tolerance, understanding, and appreciation of cultural diversity.

Disadvantages of FDI in India

Economic Disparities and Labour Market Concerns

Regional Disparities: FDI inflows may be concentrated in certain regions or urban centers, leading to regional disparities in development and economic growth. This can further exacerbate inequalities between urban and rural areas and among different states.
Income Inequality: The benefits of FDI may not be evenly distributed, leading to widening income disparities between those who benefit from FDI-related opportunities (such as skilled workers and urban residents) and those who do not.
Job Displacement: While FDI can create jobs, it may also lead to the displacement of workers in traditional or informal sectors who cannot compete with the efficiency or productivity of foreign firms. This can result in unemployment or underemployment for certain segments of the population.
Wage Suppression: FDI inflows may exert downward pressure on wages, particularly in sectors where foreign firms employ cheap labour or engage in labour-intensive production processes. This can lead to stagnant or declining real wages for workers.
Monopolistic Practices: Some multinational corporations may engage in monopolistic or anti-competitive practices that limit consumer choice, stifle innovation, and distort market dynamics. This can, therefore, hinder the development of domestic industries and entrepreneurship.

Cultural Homogenization

Loss of Cultural Identity: The presence of foreign brands, products, and media facilitated by FDI can lead to the erosion of indigenous cultures, languages, and traditions. As a result, we see the homogenization of cultural expressions and the marginalization of local customs and heritage.
Westernization of Lifestyles: Exposure to Western consumer culture through FDI can further influence preferences, attitudes, and behaviours, leading to the adoption of Western lifestyles, values, and norms at the expense of indigenous cultural practices.

Econometrics Tutorials