Factors that attract foreign direct investment in India

By Indra Giri on October 8, 2016

The post reform period being the prospective period for strengthening the base of the Indian economical sectors for its growth with liberalization policy. This has increased the expectations of the foreign investors pursuing them to invest in different sectors of India. Also, progressive policies towards liberalisation made the Indian economy a lucrative market to invest. Factors such as, reinforcing the confidence of the investors have further added prospects to the growth of the Indian economy as a whole (Akhtar 2013). There are various determinants which have led to higher inflow of foreign investment in India.

Comprehension of the reason for a larger inflow of foreign direct investment within the economy are determined by certain variables that are responsible in inducing the inflow. While focusing on the issues of foreign direct investment in the recent period with respect to the Indian context, Gross Domestic Product (GDP), Inflation (measured by the Consumer Price Index), Trade Openness (measured by Trade to GDP ratio), Foreign Exchange Reserve and Index of Industrial Production (IIP) can be identified as determinants to act as a positive catalyst. According to Azam & Lukman (2010) and Pattayat (2016), these determinants  influence the inflow of foreign investment to the maximum extent.

High growth rate after the economic liberalisation

Gross domestic product being the most vital factor to determine growth is often considered by the foreign investors to decide relating to their investment in India. According to Himachalpathy & Kavya (2012), Kumar (2012) and Mahapatra & Patra (2014), it is the standard measure considered by the investors to determine the amount of potential investment in India. This is similar to the cases of Japan, China and Korea where the rising growth rate has kindled the interests of the foreign investors (Agrawal & Khan 2011).

GDP of India after 2000
GDP of India after 2000 (Source: Handbook of Statistics).

With the escalation of gross domestic product, the potential return from the investment in India has increased. Therefore, the foreign investors are persuaded to invest in a growing economy (Maggon 2012). There is both the forward and backward linkage between foreign direct investment and economic growth. On one hand inflow of foreign direct investment enhances the economic growth of the country. On the other hand higher economic growth rate in turn attracts larger amount of investment for the country. This leads to further growth of the economy.

Attaining 9% growth rate in the between 2004 and 2010 has given a new dimension to the foreign investors. The rate rising to the maximum of 10.10% in 2006 has made the Indian market a potential arena for investment (Abbas, Qaisar; Akbar, Salman; Nasir, Ali Shan; Ullah 2011). In the last few years the GDP of Brazil being US$1.925 trillion, India has a comparative advantage in attracting foreign investment with a GDP of US$2.346 trillion. China has been the top destination for foreign investment. However the recent slowdown in its economy can shift the flow of foreign investment towards India as India has shown stable and higher growth rate (BBC 2016; Fauzi & Chee 2013).

Lower inflation rate as a determinant of foreign investment

A moderate, eventual and smooth growth of inflation tends to induce the rise in cost of capital and as the valuation increases, economic growth is signified attracting foreign investment in the economy of developing nations (Vijayakumar et al. 2010).

Inflation as one of the determinants of FDI in India
Inflation rate in India since 1991 ( Source : Handbook of Statistics, RBI)

Various studies suggest that inflation rate and the inflow of foreign direct investment are inversely correlated. In other words higher inflation lead to lower amount of investment and vice versa. In India, inflation rate is measured and represented by the consumer price index (CPI). This is because consumer price measures the price of goods and services in day to day life keeping an account of the hikes.

The early post-reform period in India witnessed a high and fluctuating inflation rate of 11.88% in 1992, 10.24% in 1994, and 13.17% in 1998 which had a sharp trough in 2001 to 3.77% (Jha & Kulkarni 2015). In the Indian context the gradual ascend of the inflation rate increases the productivity indicator. This has hence increased the chance of gains from the invests in the Indian markets. Thus, declining inflation rate in India is one of the determinants attracting higher foreign investment (Kaur & Sharma 2013).

Trade openness

With increasing openness of the country with regards to foreign trade and integration of regional sectors, the flow of foreign direct investment is potentially increased (Azam & Lukman 2010). The liberalisation in the trade policy is one of the most revolutionary step taken by the policy makers. The path of globalisation and modernisation, for the openness to trade made the economy close to various modern technology and amenities (Singhania & Gupta 2011).

Trade openness as one of the determinants of FDI in India
Trade to GDP ratio in India since 1991

Trade openness measured by the ratio between trade and GDP permits to evaluate the relationship between trade and inflow of investment. As India is exposed to trade with several countries, the inflow and outflow of goods and services are leading India to open markets to different countries. This in turn welcomes investors as it offers a global platform. Owing to the inflow of foreign reserve for increased trade, Indian market has evolved as a hub for foreign investors.

On the other hand the inflow of foreign investment also increases exports. This will further lead to increase in investment as the host country becomes more attractive destination (Jadhav 2012).  the current government introduced the “Make in India” campaign in 2014. Due to the campaign, manufacturing sector of the country is now more exposed to a fresh threshold of investment from outside. The initiative attracted the investors to be a part of the built-in India program. Therefore, in 2014-15 India witnessed an unprecedented growth of 717 percent, to US $ 40.92 billion of Investment by Foreign Institutional Investors (Sangwan 2015).

Foreign exchange reserve

The determination of monetary base and the ability of the country to sustain itself in times of adversity is identified by the foreign exchange reserves the country holds. Thus, a larger sum of reserve makes the country lucrative for the foreign investors (Sahni 2012). Considering inflow of foreign reserve, it increases the capital inflow in India and using the resources of the country such as manpower, educational strength the foreign investors find a probability to flourish.

Foreign reserve as one of the determinants of FDI in India
Total foreign reserve in India ( Source : Handbook of statistics, RBI)

The foreign reserve of India has increased over the years. It was 314.61 billion US dollar in 2008 which has increased to 322 US dollar in 2015. This is higher than the foreign reserve in the early years of post-reform that had the maximum value of 24 US billion in 1997 and gradually rose to 30.49 billion US dollar in 1999 (Mirchandani 2013). With respect to the reform of India and opening the Indian market to foreign trade, it has paved the path to inflow of foreign currency to the country and investment (Sarasa & Morris 2014).

Index of Industrial Production (IIP)

The growth in the Index of Industrial Production (IIP) indicates an escalation in the production of manufacturing goods such as mining, engineering goods etc. The strength of the prospect and trend of industrial production in the post reform years initiates the inflow of foreign investment in the economy (Maheswari 2015). The increase in the index reflects the growth of the manufacturing sector of India. Similarly this makes it available for the investors to evaluate their potential gain from investing in the market. Therefore, persuading them and increasing the flow of foreign direct investment in the Indian market (Himachalpathy & Kavya 2012).

IIP as one of the determinants of FDI in India
Index of Industrial Product in India ( Source: Handbook of Statistics, RBI)

The above figure shows the trend of IIP after and before the reform of the Indian economy. As the figure shows  there was rise in 1991-1992 followed by consequent fall and rise with a sharp crest in 2007-2008

Focus on sectorial equality to attract foreign direct investment

Although, the determinants have induced the inflow of foreign direct investment in the economy. However, there is a lacunae of overall growth in all the sectors. Due to hindrance in focus to all the sectors of the economy equally, there exists disparity and inequality among the various sectors. Some  sectors are growing at a greater rate and some lacking the attention. While the service sector drew 46% of the total direct investment inflow in 2014. The agricultural sector received a low of 15.35% the same year.

The inequality in the whole process lead to the increase in inequality in development across sectors. To have an overall growth and development in the economy the government requires to concentrate on those sectors that are weak. Similarly the government should introduce strategized policies to attract investments. The manufacturing sector is not performing as expected. Exports from India are declining with the depreciation of the Indian currency. To make India a favourable destination, the government should focus on improving the major determinants.


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