Does FDI Promote Sustainable

Economic Growth?
Swagatam Basu

Table of Contents
Executive Summary ........................................................................................................................................................ 2
Introduction ..................................................................................................................................................................... 3
Searching for a Relation ................................................................................................................................................. 3
Are the Benefits Truly Beneficial? ................................................................................................................................ 4
Capital Infusion ............................................................................................................................................................ 4
Introduction of Managerial Skills and Best Practices .................................................................................................. 4
Technology Spill-overs.................................................................................................................................................. 4
Employment................................................................................................................................................................... 4
Access to Foreign Markets............................................................................................................................................ 5
Crowding In .................................................................................................................................................................. 5
Tumbling Down the Rabbit Hole ................................................................................................................................... 5
Infrastructure Capital ................................................................................................................................................... 6
Human Resources ......................................................................................................................................................... 6
Domestic Investment ..................................................................................................................................................... 7
Trade Openness ............................................................................................................................................................ 8
Conclusion ....................................................................................................................................................................... 9
References ........................................................................................................................................................................ 9

Executive Summary
Foreign Direct Investment (FDI); it is unlikely that any other abbreviation has captured the headlines of
financial publications as much as FDI has.
There have been sentiments and arguments both for and against FDI. Academic research has also delved
into finding the possible effects of FDI on short-term and long-term productivity increase in terms of labour,
capital and technology. Efforts have also been made to identify whether there is positive correlation between
FDI and economic growth. Evidence from Asia and Latin America does not show conclusive evidence that
FDI generates positive productivity externalities in the host country. Does FDI actually contribute to
sustainable economic growth or not within a pre-defined term?
The aim of this article is to first look at through what channels FDI can potentially cause positive
externalities. References have been made to researches done in the area to ascertain the validity of those
avenues. Consequently effort has been made to compare the economies of two growing nations China and
India to ascertain what are the underlying reasons that are pivotal in defining the extent to which FDI can
cause sustainable economic growth through increase in productivity.

Introduction
Foreign Direct Investment (FDI) can be referred to as the investments made by a company or an entity of
one country into another company or entity of a different country. Theoretically this might look as a win-win
scenario for both originator and the host companies and countries, but there are quite a few areas which need
to be examined before a verdict is passed.
Robert Solow in his Nobel Prize winning work on economic growth described output through the production
function which says: Output or Y = A * f (K, L). .. [Equation 1]
What is interesting is the fact that using this equation we can say that the output of an economy is governed
by the factor inputs (labour, capital and materials denoted by K and L) and how productively they are used
(which is A or the total factor productivity or TFP). Hence if we want to calculate whether FDI
contributes to sustainable economic growth, we need to calculate its effect on the factor inputs, but more
importantly on the TFP. TFP gives an idea of the long term effects of technological, managerial and
organizational changes.
Searching for a Relation
If we take a look at the change of GDP of the 4 BRIC nations from 1990-2012, we can see that the FDI
inflow graph roughly follows the GDP curve of these 4 emerging economies. Apparently this would lead us
to believe that the left hand side of Equation 1, i.e. the output of an economy has a causal relationship with
the net FDI inflow.

Year

Russian

2012

India

2010

China

1996

1994

1992

2012

2010

2008

0
2006

0
2004

0.1
2002

2
2000

0.2

1998

1996

0.3

1994

1992

0.4

1990

1990

Brazil

2008

10

2006

Russian

2004

India

2002

China

2000

Brazil

FDI inflow in current

Trillion USD

1998

GDP in current Trillion USD

Year

Source: The World Bank

However, evaluation of 8 East Asian economies, found that only in China there is strong two way causality
between FDI and parameters of productivity growth. One way Granger Causality was found in only
Singapore and Taiwan but the effect of FDI on productivity of other economies was minimal (Hee Ng,
2006). On the other hand, research on the BRIC (Brazil, Russia, India and China) + Turkish economies for
the period of 1990-2012 show that FDI has a negative impact on aggregate TFP (Filiz, 2014). Also evidence
from Venezuela suggests that FDIs effect on TFP varies according to the nature of the firms in an industry
(Aitken; Harrison, 1999).

The purpose of this article is to explore the positive effects of FDI and understand the underlying reasons
which govern the potency of its effect on economic growth.
Are the Benefits Truly Beneficial?
Theoretically FDI has many positive externalities. It has the capacity to improve the performance at the firm
level, industry level as well as on the country level. The positive externalities of FDI can be listed as
follows:

Provide capital infusion

Introduction of managerial skills

Technology spill-overs
and best practices

Employment

Access to foreign markets

Crowding in: Bring in other

investors

Capital Infusion
FDI provides a massive amount of investment globally. In 2013, the global FDI amount was approximately
$1.45 trillion and accounted for nearly 2% of the GDP of the world. Of the total global FDI, as much as 20%
flows into the BRIC economies alone.
Introduction of Managerial Skills and Best Practices
Foreign investment allows investing companies to transfer their best practices to the host economy.
Research shows that local firms in the UK have vertical as well as intra and inter industry FDI induced High
Performance Management Practices (HPMP) spill-overs. However, they have been selective when it comes
to adoption of HPMP of Multi National Enterprises (Fu, 2012).
Technology Spill-overs
Technology spill-over is the primary indicator of TFP growth, and the chief avenues of technology spill-over
from FDI are as follows (Zhang; Li; Li; Zhou, 2010):
1. Demonstration Effect: Domestic firms can learn from foreign firms through exposure and imitation.
However, this is dependent on proximity between the local and the foreign firms.
2. Linkages: Knowledge transfer can occur through backward as well as forward linkages in an
industry. In addition to vertical spills, intra-industry spills are also possible when the same channel
partners are used by both foreign and local firms.
3. Employee Turnover: When employees from foreign firms switch over to local firms, they take their
technological expertise with them.
4. Competition Effect: Greater diversity and introduction of foreign players drives the domestic firms to
look for ways of improving productivity in order to remain competitive.
Research on data from 21 OECD countries and Israel indicates that elasticity of TFP with respect to FDI is
less than 1% (Lei Zhu; Bang Nam Jeon, 2007).
Employment
FDI has the capability to create employment opportunities because of increased capacity and necessity of
human resources. For example, Chinese private domestic firms have higher employment growth rates than

domestic non-private firms. Moreover, foreign firms in the area have more advantageous firm characteristics
than domestic firms (Karlsson; Lundin; Sjholm; He, 2009).
Access to Foreign Markets
Higher amount of FDI into different firms, allows firms to use the foreign clientele of the foreign investors
thus providing greater access to more international markets. Access to foreign markets may be adequately
estimated with the export behaviour of firms in an economy. Evidence from Vietnam suggests that FDI has a
significant effect on the export behaviour of a firm and these effects have strong interaction effects with firm
related characteristics (Nguyen; Sun, 2012).
Crowding In
Research shows that FDI has crowding in effect on the private domestic investment in India. The research
also suggests that a bidirectional causality exits between FDI and private domestic investment in the shortrun (Rath; Bal, 2012).
From the above discussion, FDI inflow seems to have a strong positive correlation with all the factors except
TFP or technology spill-overs. This is a curious finding as TFP is the single more important indicator of
actual productivity increase. A careful analysis reveals one underlying fact that every researcher has stressed
upon:
FDI alone is not self-sufficient.
Its potency depends on absorption capacity which is firm and economy specific.
Tumbling Down the Rabbit Hole
In order to find the underlying macro and micro-economic factors that govern the potency of FDI affectivity,
let us look at a comparative analysis of the economies of China and India. China is the only country where
there is strong two way causality between FDI and productivity and such a bi-directional relationship is not
observed in India (Hee Ng, 2006).
Research indicates that high income countries show a higher positive relationship between FDI and
economic growth than middle or low income countries. Economic factors such as infrastructure, education
level, financial development and trade openness play a crucial role in defining the potency of FDI caused
growth (Kotrajaras; Tubtimtong; Wiboonchutikula, 2011). Cyclic factors and distance between FDI source
and host countries is also an important governing criterion (Bhavan; Xu; Zhong, 2011). Quality of financial
intermediation, company level credit analysis and increase in availability of loans to small and mid-level
enterprises increases the impact of FDI (Xu, 2012).
As a part of this article we will look at 4 factors and will try to assess the impact of these factors in deciding
the effect of FDI on economic growth and productivity. The factors are:
Infrastructure Capital
Human Resources
Domestic Investment
Trade Openness

Infrastructure Capital
Infrastructure capital in a host country can be broken into 3 major sections: telecommunication network,
power generation capability and communications (air, water and land). Pre-existing infrastructure can
channelize the FDI inflow into all the sectors of the economy and can also allow higher effective utilization.
Overall infrastructure base of the host country helps to increase the marginal effect of FDI. However, power
generating capability has the most significant effect (Nourzad; Greenwold; Yang, 2014).

Infrastructure Indicators as of 2011

540938.56

Ratio
(China/India)
4.50

89.50

0.95

98.40

96.30

1.02

63.70
66050.00
2538667.00
143896696.95
2.43
72.07

53.83
64460.00
695626.00
9979223.76
2.90
73.20

1.18
1.02
3.65
14.42
0.84
0.98

3.52

3.08

1.14

China

India

Energy production (kt of oil equivalent)

2432504.85
Improved water source, rural (% of rural population with
84.90
access)
Improved water source, urban (% of urban population with
access)
Roads, paved (% of total roads)
Rail lines (total route-km)
Air transport, registered carrier departures worldwide
Container port traffic (TEU: 20 foot equivalent units)
Secure Internet servers (per 1 million people)
Mobile cellular subscriptions (per 100 people)
Logistics performance index: Overall (1=low to 5=high)
as of 2012

Source: The World Bank

The above data shows that areas such as roads, railways, and telecommunications and water facilities in
India are quite at par with China. But India is lagging behind in terms of maritime and air transport.
Even though India has the fifth-largest coal reserves in the world it still is the third-largest importer of coal.
The above figure which shows that Chinese energy production is 4.5 times that of India, adds to the picture
in proving that Indias power generation capability is severely low. Owing to the fact that in infrastructure
capital, power generation capacity has the highest significance in FDI spill-over, it can be safely concluded
that this is an important factor that is causing low FDI caused productivity in India. Another important
insight is the logistics performance indicator in the above table which is an indicator of how friendly
companies view the logistic environment of a country. China is rated quite higher than India.
Human Resources
The quality, availability and cost of human resources play an important part in assessing the effect of FDI
led productivity externalities. Research shows that compared to institutional change, human resource led
FDI spill-over is more significant (Xu; Wan; Sun, 2011).
Ratio
(China/India)

Labour Indicators as of 2011

China

India

Literacy rate, adult total (% of people > 15 years old)

Labour force, total
Total Population
Labour force per 100 people

95.10
782422530.00
1344130000.00
58.21

74.40
1.28
475806212.00
1.64
1221156319.00 1.10
38.96
1.49
Source: The World Bank

A comparison between the labour factors of India and China reveal that the literacy rates in China are 1.28
times higher than that of India. In addition to this, China can also provide 1.49 times more labour force per
100 people than India can. These findings contribute to the conclusion that both in quality and availability of
human resources, China scores higher.
Looking at the labour costs,
an interesting trend is
noticed. Till 2005 Indian
labour cost was higher than
China but after 2006, the
trend has reversed.
This does indeed look like an
anomaly. However, we must
note here that higher labour
costs are more concentrated
towards
Eastern
China.
Inland labour charges are
around 10% lower than the
east coast.

Inferring from the data above, China does score higher when it comes to the availability and quality of
labour which contributes to positive FDI spill-overs. But, cost of labour is increasing at a rapid pace and in
future it does have the capability of negatively affecting investment intentions of foreign firms.
Domestic Investment
We have discussed in detail about investment from abroad and its impact on economic growth, but we also
need to look closely at the importance of domestic investment. Studies have shown that domestic capital
formation significantly accelerates the economic growth in India (Saha, 2014). In spite of this, the domestic
investment in India has been substantially low compared to China and other countries. Bank Credit to GDP
ratio signifies the financial resources provided to the companies by financial institutions of the country.
As the figure indicates,
developed economies such as
United States and United
Kingdom have a BCGR of as
high as 198% and 165% of
GDP. Developing economies
like China and Brazil have a
BCGR of 140.01% and 70.68%
of GDP.
Among the sampled countries,
India has the lowest BCGR at
only 51.82% of GDP which is
one-third that of China.

Bank Credit to GDP % (as of 2013)

250.00
198.01

200.00
135.02

140.01

Brazil Germany Korea,

Rep.

China

150.00

156.14

165.18

95.58

100.00
51.82

70.68

50.00
0.00
India

South United United

Africa Kingdom States

Source: The World Bank

A possible reason of this might be the risk-averse nature of the Indian investors which might be caused by
factors as diverse as slow judicial system, preference of the Indian bureaucracy towards large businesses

rather than the key middle-level and low-level businesses and the multitude of economic and business
regulations and regulatory bodies rather than a centralized system.
Ease of Doing
Ranking (2013)
4
7
10
21
41
96
116
134

Country
United States
Korea, Rep.
United Kingdom
Germany
South Africa
China
Brazil
India

Business

We have used the Ease of Doing Business Ranking (2013) released by The World Bank
to throw some light on why BCGR is so low
in India. The rating shows that investors
believe that the perception of regulatory
environment in India is the lowest among the
8 countries sampled above. (The ranking
ranges from 1, meaning most conducive to
189 meaning least conducive)
China is 38 places higher than India in the
ratings.

The objective of using the BCGR and the EoDB Ratings is to illustrate the point that though India is
receiving a large amount of FDI, it must not be forgotten that domestic investment has a huge part to play in
economic development. Compared to China, Indian investors are still risk averse (shown by the huge
difference in BCGR) and the non-conducive regulatory environment in India does indeed contribute to lower
investment friendliness of India as compared to China.
Trade Openness
Trade openness and export orientation of an economy positively impacts FDI inflows (Pradhan, 2010) as
well as shows productivity enhancing effects (Fillat; Woerz, 2011). It can be considered as an important
criterion which influences the absorptive capacity of FDI and induces productivity spill-overs. Trade
Openness is measured by the trade-to-GDP-ratio and measures the combined importance of export and
import of goods and services in an economy.

Export + Import as a % of GDP

China

India

80
70
60
50
40
30

20
10
2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

Source: The World Bank

As can be seen from the above results, from 1990 to 2011, the trade openness of China has been higher than
that of India, a trend which has changed recently. But we must note here that the above figures are

cumulative of export and import. As of 2013, China and India export goods and services worth 26.4% and
24.8% of their GDP respectively. Hence we can conclude here that owing to the higher export orientation
and trade openness, China has had higher FDI inflows as well as greater FDI led productivity spill-over than
India.
Conclusion
China and India were nearly on equal footing in 1990 with comparable per capita GDPs. But over the next
25 years, China has increased its per capita GDP to more than 4 times that of India today. Through the above
discussion an effort has been made to show that FDI induced economic growth is dependent on the
absorptive capacity of the economy. Absorptive capacity enabling factors such as higher infrastructure
capital, greater availability of human resources, more domestic investment and higher trade openness and
export orientation, have allowed China to surpass India in economic growth in the last 25 years.
Hence to ensure sustainable economic growth through FDI, governments of developing nations like India
should not only focus on acquiring more FDI, but they should also focus on improving the absorption
capacity of the host economy through investing in better infrastructure and education and also through
policy modifications for improving trade openness as well as general domestic investor sentiment.
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