FDI inflow plays a vital role to shape the Indian economy

By Saptarshi Basu Roy Choudhury & Abhinash on November 21, 2018

Foreign Direct Investment (FDI) is a key driver of the growth in the Indian economy in the context of other developing countries. FDI inflow is the investment made by enterprises through joint ventures (JV) or mergers & acquisitions (M&A), to carry out business activities in host countries. Advantages of FDI inflow include:

  • building physical capital,
  • developing the skill of the domestic labour force,
  • employment generation,
  • increasing productive capacity and
  • technology transfer and integration of the domestic economy with the world economy (Jayakumar, Kannan, & Anbalagan, 2014).

This is significant especially for a developing country like India because FDI aims to positively contribute to its growth and development.

The trend of FDI inflow in India between the pre and post-economic liberalisation

The Indian economy is currently one of the biggest recipients of FDI, but it has not always been so. After India gained independence in 1947, the Government started formulating National Five-Year Plans to strategize its growth path. Although the trade policies of the Government consisted of measures undertaken for export promotion, the infant industry argument and import substitution policies protected the domestic industries against foreign competition. Trade was restrictive because of a combination of licenses, quotas, and permits. The role of the private sector in the economy was limited and the economic conditions were not conducive for foreign investment.

As a result of these restrictive policies, the FDI inflow in the country was small. In the financial year ending in March 1991, the FDI inflow in India was a mere US$ 73 million (World Bank, 2018). Compared to this, China and Pakistan were way ahead in attracting inward FDI at that time. In China, for example, the net inflow of FDI inflow was US$ 4.36 billion in 1991. In Pakistan, it was US$ 258 million, more than 3.5 times that in India.

FDI in China was a major component of its liberalization policies and economic reforms which started in the early 1980s’. FDI acted as a stimulant for the economic growth of China by adding to the stock of capital and complementing domestic investment (Tang, Selvanathan, & Selvanathan, 2008). Similarly, in Pakistan, FDI supplemented domestic investment and had a significant effect on the country’s economic growth  (Ghazali, 2010).

Figure 1: Net inflows of FDI in India, China and Pakistan from 1982 to 1991 (Source: World Bank)
Figure 1: Net inflows of FDI in India, China and Pakistan from 1982 to 1991 (Source: World Bank)

It is a well-known fact that the balance of payments (BOP) and the currency crisis of 1991 led the path for economic reforms in India. It is one of the most important events in the history of the Indian economy. As part of the reform, the Government of India adopted Liberalization, Globalization, and Privatization under the New Economic Policies (NEP). Subsequently, these policies acted as the driving force in increasing the participation of the country’s private sector and foreign companies.

In the first decade of reforms from 1991 to 2000, India’s share in the world FDI inflow improved from 0.05% in 1992 to 2.2% in 1997 (Nagaraj, 2003). Since 2000, the majority of FDI inflow occurred in the service sector including information technology (IT) and telecommunications. Furthermore, automobile, pharmaceutical, chemical (other than fertilizers), power and construction industries were some of the manufacturing industries that attracted FDI after the service sector.

Industry wise inflows of FDI in India from April 2000 to June 2018 (Source: India Brand Equity Foundation)
Figure 2: Industry-wise inflows of FDI in India from April 2000 to June 2018 (Source: India Brand Equity Foundation)

The subsequent launch of the ‘Make in India’ movement in 2014, permitted 100% FDI in 25 sectors. From 2013-14 to 2014-15, the FDI inflow in the service sector rose by 46% (Sood, 2015). The trend of the service sector receiving the highest FDI has continued till 2018 with an inflow of US$ 6.71 billion among a total of $44.86 billion inflow in 2017-18. From April to June 2018, the corresponding figures were US$ 2.43 billion and US$ 12.75 billion (IBEF, 2018a). Increasing FDI inflow also helped to reduce the savings-investment gap and expanded the domestic market. The increase in the growth rate of GDP in India in the post-reform period can be attributed to the increasing volume of FDI inflow.

FDI inflow in different sectors of India

There are several factors that help to attract FDI in India. These factors typically act as important determinants of FDI inflow into the host country. In India, the growth of GDP, low rate of inflation, trade openness, foreign exchange reserves and index of industrial production act as important factors in attracting FDI. First of all, the growth of GDP increased the purchasing power and made a positive impact on the Indian economy. The increased market size, in turn, helped to attract FDI (Vijayakumar, Sridharan, & Rao, 2010). A low rate of inflation indicates a lack of volatility in the economy. Furthermore, a growing foreign exchange reserve of India indicates a strong monetary base. Moreover, a rise in the index of industrial production indicates a growth in the production of manufactured goods.

Since the economic reforms started, the agricultural sector was opened up for FDI which brought improved technology and better quality of seeds. However, the growth in the agricultural sector exhibited inequality among regions. FDI inflow to this sector also suffered due to the fact that all the agricultural yields of India are not in high demand in the international market. Data published by India Brand Equity Foundation (India Brand Equity Foundation, 2018) on sectoral break up of FDI from 2000 to 2018 shows that the major share came in the manufacturing and service sector industries.

India’s economic reforms introduced two different routes of FDI namely the automatic route and the approval route. An automatic route implies that foreign investors do not need prior Government approval for investing. An approval route implies that they need Government approval. Industries in the manufacturing sector mainly benefitted from favourable FDI policies allowing 100% FDI via the automatic route. Manufacturing industries that have attracted a major share of FDI are construction, automobile, pharmaceutical, chemical, and metallurgical industries. FDI inflow in the service sector helped to generate a significant increase in employment opportunities. With FDI inflow, the net exports from sectors like information technology (IT) and information technology-enabled services (ITeS) gained significantly

Factors responsible for variation in FDI among industries

In addition to the liberal FDI policies, other factors namely availability of raw materials, capital and labour at low cost due to low wage rate and large demand for products in manufacturing and service sector industries attracted foreign investors to India. The figure below depicts the percentage of FDI inflows in different industries in India from 2000 to 2018.

Figure 3: Percentage of industry wise FDI Equity inflows in India from April 2000 to June 2018 (Source: India Brand Equity Foundation).
Figure 3: Percentage of industry-wise FDI Equity inflows in India from April 2000 to June 2018 (Source: India Brand Equity Foundation).

Production and FDI in the manufacturing sector influence each other (Chakraborty & Nunnenkamp, 2008). Therefore, the inflow of FDI can be regarded as one of the factors behind the growth of the metallurgical, chemical, pharmaceutical and textile industry. The pharmaceuticals and chemical industries each contributed to 4% of the total FDI inflows. The metallurgical sector contributed to almost 3% of FDI inflows. The textile industry attracted 0.76% of the total FDI inflows.

Returns from industries with high FDI

The chemical industry has had a high rate of growth exhibited in recent years. The industry is the 3rd largest producer among Asian countries in terms of production volume and value. It is also the 7th largest producer globally (India Brand Equity Foundation, 2017). Its market size in 2016 was US$ 139 billion. Exports of inorganic chemicals from India were valued at US$ 1.21 billion and that of organic chemicals was US$ 11.51 billion in 2016-17. The contribution of the chemical industry to the Indian GDP was reported to be 2.11%. Likewise, in the pharmaceutical industry, India is the supplier of more than 50% of the world’s demand for different vaccines. The exports from the industry amounted to US$ 17.27 billion in 2017-18 with a market size of $33 billion (IBEF, 2018c). Figure 4 shows the trend in exports from the pharmaceutical and chemical industries in the recent financial years.

Figure 4: Exports from the pharmaceutical and chemical industry of India (Source: India Brand Equity Foundation)
Figure 4: Exports from the pharmaceutical and chemical industry of India (Source: India Brand Equity Foundation)

Data for exports from the chemical industry in FY 17 includes the period April – October 2016.

The metallurgical industry in India showed a significant compound annual growth rate (CAGR) of 5.72% between 2013-14 and 2017-18 (IBEF, 2018b). Exports from this industry grew from US$ 4.91 billion in 2011-12 to US$ 10.91 billion in 2017. Similarly, the textile industry plays a significant role in the Indian economy. It contributed to 2% of the total GDP and 15% of the total export earnings in 2017-18 (IBEF, 2018d). With a market size of US$ 150 billion, textile exports from India comprise 5% of total global exports. Moreover, the industry also creates employment for over 45 million people in the country. Empirical evidence suggests that at the national level, productivity in the manufacturing sector grew faster in the post-reform years due to increased FDI (Deb & Ray, 2013). Table 1 presents the trend of productivity of the textile sector in the last five years.

Cotton productivityGMS87.3588.9091.0093.0593.02
Blend productivityGMS90.3592.2893.0094.8494.40
Table 1: Factor productivity in the Indian textile industry (Source: Annual Report 2017, Ministry of Textiles)

Data for FY 2018 includes the period April – August 2017.

Impact of FDI inflow on the macroeconomic indicators of India

The main macroeconomic indicators that reflect the performance of the Indian economy are GDP, exports, inflation, total factor productivity (TFP) and employment. Several studies have found empirical evidence of a positive long-run relationship between FDI and GDP and evidence of FDI causing growth in India (Guru-Gharana, 2012; Hansen & Rand, 2005; Ray, 2012).

Impact on the employment rate

In theory, one of the positive impacts of FDI in the host country is the increase in domestic employment (Craigwell, 2006). The below figure shows the trend of FDI inflow and the rate of employment in the post-reform period. The rate of employment is defined as the employment-to-population ratio.

Figure 5: Net FDI inflow and Employment Rate in India (Source: World Bank)
Figure 5: Net FDI inflow and Employment Rate in India (Source: World Bank)

Due to the decreasing trend of the employment rate, it is not conclusive that increasing FDI inflow has any positive impact. One of the reasons for this is that the effect of FDI inflow in the reduction of unemployment was significant in the private service sector only whereas FDI did not help to reduce unemployment in the public sector (Khatodia & Dhankar, 2016). Figure 6 shows the clear increasing trend of the employment rate in the service sector.

Figure 6: Employment Rate in the service sector in India (Source: World Bank)
Figure 6: Employment Rate in the service sector in India (Source: World Bank)

The service sector in India has been able to attract a major share of FDI (shown in figure 2 above) due to the availability of a big pool of educated and highly skilled workforce (Sirari & Bohra, 2011). Foreign investors started investing in this sector, especially in the IT industries in return for services of the best quality. However, the service sector is only one of the contributing sectors of the economy and absorbs only skilled workers. Therefore the sector alone cannot guarantee a positive effect of FDI inflow on the employment rate of India. It implies that semi-skilled or unskilled workers lag behind in terms of finding employment. This explains the reducing trend in figure 5.

Impact on the exports of India

The relationship between FDI and exports is established through the role of FDI in bringing foreign capital, increasing factor productivity, improving managerial skills and providing access to the world market. Consequently, FDI is considered one of the important determinants in the theory of export-led growth. The below figure shows the trend of exports of goods and services from India in the post-reform period alongside FDI inflow.

Figure 7: Net inflow of FDI and Exports of Goods and Services from India (Source: World Bank)
Figure 7: Net inflow of FDI and Exports of Goods and Services from India (Source: World Bank)

It is an increasing trend for exports which clearly indicates that exports from India have increased considerably since 1991. Empirical evidence also suggests the existence of a stable long-run relationship between FDI and exports (Jayachandran & Seilan, 2010), (Sultan, 2013).

Impact on the inflation rate

The economic theory of aggregate demand and aggregate supply postulates a positive relationship between output growth and inflation (Irsania & Noveria, 2014). A moderate rise in the inflation rate, in the long run, is considered good for the economy as it indicates an increase in the level of demand. The below figure depicts a fluctuating trend in the inflation rate in the post-reform years in India. But the rate of inflation in recent years is much less than that in the pre-2000 period except during the years of the global recession. The underlying reason for this is that the Indian Government has been able to control the inflation rate by adopting necessary fiscal measures of taxation and Government expenditure. However, a long-run relationship between the two variables was found to exist through the Johansen Cointegration test. It implies that FDI has not caused the price level to rise. Rather the impact of FDI on inflation is only through its effect on output growth in the long run.

Figure 8: FDI inflow and Annual rate of Inflation in India measured by the Consumer Price index (Source: World Bank)
Figure 8: FDI inflow and Annual rate of Inflation in India measured by the Consumer Price index (Source: World Bank)

Impact on the total factor productivity of India

FDI increases factor productivity and productive capacity by adding to the capital stock, technology transfer, improving managerial skills through technical know-how and enhancing labour productivity through advanced technological changes (Sultan, 2013). Total factor productivity in India shows an increasing trend alongside FDI in the post-reform years. A previous article on the impact of FDI inflows on total factor productivity in India also established a positive and significant impact of FDI on TFP through time series regression analysis.

Figure 9: FDI net inflows and Total Factor Productivity (TFP) Level at Current PPP for India (Source: World Bank and FRED Economic Data)
Figure 9: FDI net inflows and Total Factor Productivity (TFP) Level at Current PPP for India (Source: World Bank and FRED Economic Data)

The increasing trend of FDI coupled with an increase in the level of exports, TFP and a lower rate of inflation proves that FDI has had a positive impact on these macroeconomic indicators.

Impact on GDP

The neoclassical growth theory identifies a positive relationship between FDI and GDP through its role in capital formation and technological progress. In the endogenous growth models, FDI causes growth via increasing returns through technology spillover and technology transfer. Figure 10 below shows the trend of FDI and the annual growth rate of GDP in the post-economic reform period. It reveals that the trend of FDI had fluctuations due to the global financial recession in 2008-09. In absolute values, however, FDI has been increasing after 2000 in comparison to the first decade of liberalization.

Figure 10: Net inflow of FDI and Growth Rate of GDP in India (Source: World Bank)
Figure 10: Net inflow of FDI and Growth Rate of GDP in India (Source: World Bank)

The trend of the growth rate of GDP also shows fluctuations. This is characterized by a slump in 2008-09 due to the recession and recovery thereafter. But the trend is more stable than that of FDI and does not exhibit an increasing pattern. One of the reasons for this is that the inflow of FDI has generated an increase in employment in only some industrial sectors of the economy. The study by Rizvi & Nishat, (2009) did not find any significant impact of FDI on employment creation in India. Despite this, it caused a positive and significant impact on the GDP of India as found in a previous article.

The necessity of FDI inflow to strengthen the Indian economy

The relationship of FDI with macroeconomic indicators and the trends of GDP, exports and total factor productivity in India till 2017 suggests that FDI is responsible for fostering Indian economic growth. India enjoys relative advantages in attracting FDI compared to other countries due to its cheap labour resulting from a low inflation rate and geographical proximity to OECD countries. On one hand, the high growth rate of GDP in the post-reform period raised the return on investment. This helped to attract foreign investors and bring FDI which, on the other hand, impacted the growth rate of GDP.

According to recent reports, inward FDI in developing countries outweighs that in developed countries. To a large extent, it is attributed to the developing economies of Asia, including China and India. In India, new foreign direct investment policies announced in 2017 by the Department of Industrial Policy and Promotion (DIPP) are important steps in boosting the morale of foreign investors. Therefore, the increasing trend of FDI is expected to continue in the coming years.

The cost of economic growth

The price of anything is the amount of life you exchange for it.

Henry David Thoreau

It is evident that FDI has played a vital role in shaping the Indian economy. The major share of FDI in India has been coming from the service sector and the manufacturing sector. However, the production of many industries in the manufacturing sector emits Greenhouse Gases (GHG) and chemicals in the form of by-products and wastes.  Manufacturing industries along with electricity production, the transport sector, and fugitive emission generate the maximum amount of (71%) of GHG emissions especially carbon dioxide in the country’s environment (DNA, 2016). The large plants in the textile industry are responsible for discharging at least 25 kilolitres of effluent every day (Bahel & Kanchan, 2016). The rise in the concentration of GHG in the atmosphere has affected the global temperature (Kweku et al., 2018).

In the context of the ongoing worldwide discussions on climate change, Paris Agreement is the most recent and very important step taken by the United Nations Framework Convention on Climate Change (UNFCCC). India ratified the Paris Agreement in October 2016 to become the 62nd nation that entered the agreement. The essential element of the agreement requires the member nations to take preventive actions. These aim to restrict the rise in temperature this century below 2 degrees Celsius above the pre-industrial levels. It also requires the member nations to make further efforts to limit the rise to 1.5-degree Celsius above the pre-industrial levels (UNFCCC, 2018).

Finding the ray of hope for a cleaner and greener future

The ratification by India implies that it is considering the effects on the environment of increased economic activities in a serious manner. India is accountable for 6% of the global emissions of carbon dioxide (CO2) (Shrivastava, 2016) and is the third highest carbon dioxide emitter after China and the US. A report published by the Intergovernmental Panel on Climate Change (IPCC) in 2018 stated that it will be difficult for South Asian economies including India to reverse the pattern of increase in temperature because India is largely a developing economy and its resources are limited (Awasthy, 2018). This puts the country under the pressure from the consequences of climate change.

In its response to the Paris Agreement, the Indian Government has undertaken several climate policies through Nationally Determined Contributions (NDCs). These include increasing the share of non-fossil-fuel-based electricity, creating additional forest carbon sinks, climate change adaptation policies, mobilization of funds, developing and transfer of technology and creating a cleaner path for economic development (Agarwal, 2017). Studying the policy changes that have already been initiated and those that are planned to be implemented in future will help to understand the strategies that are key to fulfilling the commitments made by India under the Paris Agreement.

Assessing the tribunal cases

Environmental laws of a country are vital to the protection of the environment. The environmental laws in India comprise The National Green Tribunal Act (2010), The Air (Prevention and Control of Pollution) Act, 1981, The Water (Prevention and Control of Pollution Act), 1974 and The Environment Protection Act, 1986. The National Green Tribunal (NGT) was set up in 2010 to look into cases related to environmental protection.

So far, NGT has passed judgments on many important cases. As of 2017, there were more than 3500 cases that were under consideration with the Tribunal (The Economic Times, 2017). There were significant cases in which judgments made by NGT indicated its proactive role. Focusing on some of the significant cases where NGT made its judgment and some significant ongoing cases will help to determine how seriously the Indian legal system is taking into account those development projects or activities that are affecting the local environment.

Post-2000, the largest share of FDI came in the service sector. One of the major requirements of the service sector is the acquisition of land. In India, the acquisition of land by states is often a source of dispute because the land is an important resource and state acquisition of land causes a deprivation of land rights of people followed by migration (CPR, 2017). The Land Acquisition, Rehabilitation, and Resettlement Act (2013) came into force on January 1, 2014, to look into compensation, consent, social impact assessment, rehabilitation, and resettlement.

However, the issue of balancing industrial development and the needs of landowners has remained a challenge (Seetharaman, 2018). Furthermore, it emphasizes studying the consequences of land acquisition by the service sector. These include focusing on the type of acquired land, the pattern of migration, relocation, and resettlement of the migrated people. It will shed light on the effect of the development of the service sector on land including agricultural land and forestland.

Can the environment sustain the growing Indian economy?

In the financial year 2016-17, Mauritius brought the maximum FDI in India which was 21.8 % at market value (The Hindu Business Line, 2018). USA, UK, Singapore, and Japan were the sources of the next highest FDI shares. Major reasons for these countries to invest in India include their stable regimes of fund management and favourable tax treaties with India (Coutinho, 2018). Singapore is responsible for 0.11% of global emissions. But the country has adopted green building design and a city-in-a-garden setting. Studying the environmental scenarios of these countries and comparing those with that of India will help to understand the cost of development and economic growth.


I am currently working as a Research Associate. My work is centered on Macroeconomics with modern econometric approach. Broadly, the methodological research focuses on Panel data and Times series data analysis for causal inference and prediction. I also served as a reviewer to Journals of Taylor & Francis Group, Emerald, Sage.