Impact of inflation rate on the inflow of foreign direct investment in India

As reviewed in previous articles, foreign direct investment (FDI), is an investment made by a foreign investor in a host country. Foreign investment is considered to be an integral part of an economy as it helps in accelerating the economic development. As a source of investment, it helps in the modernization of infrastructure, technology and income growth. Similarly it also creates massive employment for the population of the host country. By creating a conducive environment for the foreign investors, the host country benefits by achieving its development goals faster. India has shown an impressive inflow of investment since the liberalisation of it’s economy in 1991. Various sectors have boosted its financial standing. There are many factors like inflation rate determine the inflow of foreign direct investment.

High inflow of FDI in after the liberalization of economy in 1990

Inflow of Foreign Direct Investment in India since 1980 (amount in millions USD) (Source: UNCTAD, 2015)

Inflation refers to the “sustained rise in the general level of prices of goods and services in the economy over a period of time” (McLean et al, 2016). It means that a unit of currency buys fewer goods and services when the price of commodities rise or vice versa. The main objective of this article is to find out the relationship between foreign direct investment and inflation rate in India.

Inflation as a determinant of foreign direct investment

Rate of inflation is a crucial factor in influencing the inflow of foreign investment. A high rate of inflation signifies economic instability associated with inappropriate government policies, especially the monetary fiscal policy mix (Macpherson, 2013). Khan & Mitra (2014) opine that high rates of inflation distort the economic activities, leading to lesser inflow of capital. A low and stable inflation rate acts as a sign of internal economic stability. This is because it reduces uncertainty and boosts the confidence of people and businesses for making investment decisions. On the other hand high inflation rate signifies the inability of the central bank to set appropriate monetary policies. A high inflation rate also impacts capital preservation of foreign investment. It affects profitability as higher prices can lead to increased costs and lower profits. So, stable inflation rate is desirable to attract foreign capital (Aijaz, Siddiqui, & Aumeboonsuke, 2014).

Trends in inflation rate over the years

Inflation in an economy is a measure of the degree of stability. In India there are different price indexes by which inflation rates can be measured such as Wholesale Price Index (WPI) and Consumer Price index (CPI). Until recently in India Wholesale Price Index was used to measure the inflation rate for all policy purposes. However after the Urjit R.Patel Committee’s recommendation, the Reserve Bank of India adopted the  Consumer Price index as key measure of Inflation in 2014 (The Hindu, 2014). Consumer price index accounts for the cost of day to day living.

Trend of inflation rate in India in pre and post liberalisation period

Average inflation rate in India (1980-2015) Source : Planning Commission (2015)

Average inflation rate in India has been high, at 9.3% per year till the end of the 20th century. India has seen both high and low inflation. In 2010-11, inflation was at 9.6% which makes it the highest since 1994-95, when the rate was 12.6%. The rate of inflation in India is currently hovering around the 5% mark. The official consumer price index in the month of August 2016 was recorded at 5.79% (Inflation, 2016). This medium level inflation rate has made India a favorable destination for foreign investment in the recent years.

Relationship between foreign direct investment and inflation in India

An economic instability of a host country can be major factor determining the inflow of foreign investment. A study by Hussaini (2011) tests the degree of correlation between different economic factors and foreign direct investment in India.

Results from the Johanson co-integration test also show that there is long term relationship between inflation rate and foreign direct investment for the period 1990- 2015.

The author found a negative coefficient of correlation of -0.45 between inflation and  inflow of foreign direct investment. This implies that inflation rate and foreign direct investment are adversely related. In other words with an increase in the inflation rate the inflow of foreign investment decreases in India and vice versa.

Examining the long run relationship between inflation rate and FDI in India

Co-integration between inflation rate and foreign direct investment

However it has been found in another study that the correlation between foreign investment and inflation is moderately positive. In 2007 inflation rate was 4.8 and total inflow of investment was $25 billion. However in 2008 it increased by 8.3% and the investment increased to $ 43.4 billion. This indicates that other factors of an economy also play a major role in determining the inflow of foreign investment (Finance India May 2013).

Another finding of a paper by Anitha, 2012 revealed an unexpected positive relationship between foreign direct investment and Inflation. This finding was against the expected negative relationship for the period 2008-2012. The elasticity coefficient between the variables was 0.202. It showed that one percent increase in the level of inflation led to an increase of 0.20 percent in the flow of foreign investment. On the basis of this findings it can be said that inflow of foreign capital depends on a number of factors other than the inflation rate.

Possible reasons behind the negative relationship between inflation and foreign investment

The negative relationship between inflation and foreign direct investment is due to the fact that high level of prices in the country results in rising production costs. This is due to the increase in input prices, cost of raw material, wages of labor, land prices and cost of capital. Such high prices of product also adversely affects domestic as well as foreign demand for commodities. All these factors ultimately lead to the reduction in business profits thus discouraging foreign investment in the countries having a high inflation rate. Similarly high amount of foreign investment indicates a high level of foreign exchange reserves. This reflects the strength of external payments position of a country and helps to improve the confidence of prospective investors.

The Government of India is taking necessary steps to create an environment that will regulate macroeconomic policy variables like exchange rates, trade openness and inflation rate which is highly essential for attracting foreign capital into an economy which will stabilize and strengthen trade relationship with other economies of the world.

References

  • Aijaz, H., Siddiqui, A., & Aumeboonsuke, V. (2014). ROLE OF INTEREST RATE IN ATTRACTING THE FDI: STUDY ON ASEAN 5 ECONOMY. International Journal of Technical Research, 2(3), 59–70.
  • Anitha, R. (2012). FOREIGN DIRECT INVESTMENT AND ECONOMIC GROWTH IN INDIA. IRJC International Journal of Marketing, Financial Services & Management Research, 1(8).
  • Hussaini, N. N. (2011). ASIAN JOURNAL OF MANAGEMENT RESEARCH Online Open Access publishing platform for Management Research Economic factors and Foreign Direct Investment in India: A correlation study. ASIAN JOURNAL OF MANAGEMENT RESEARCH, 348(1), 1–11.
  • Inflation. (2016). Historic inflation India. Retrieved from http://www.inflation.eu/inflation-rates/india/historic-inflation/cpi-inflation-india.aspx
  • Khan, G. S., & Mitra, P. (2014). A Causal Linkage between FDI Inflows with Select Macroeconomic Variables in India – An Econometric Analysis. IOSR Journal of Economics and Finance, 5(5), 2321–5933.
  • Macpherson, D. (2013). Economics: Private and Public Choice. Mason: Cengage Learning.
  • McLean, W., Olsen, K., Moomaw, R., & Applegate, M. (2016). Economics and Contemporary Issues. Content Technologies.
  • PlanningCommission. (2015). Inflation rate in India. Retrieved November 30, 2016, from http://planningcommission.nic.in/data/datatable/index.php?data=datatab
  • TheHindu. (2014, April 2). RBI adopts new CPI as key measure of inflation – The Hindu. The Hindu. New Delhi. Retrieved from http://www.thehindu.com/business/Economy/rbi-adopts-new-cpi-as-key-measure-of-inflation/article5859713.ece
  • UNCTAD. (2015). FDI statistics. Retrieved November 30, 2016, from http://unctad.org/en/Pages/statistics.aspx.
Aishwarya Singh

Aishwarya Singh

Aishwarya is a graduate in economics from Delhi University and a post graduate in economics from Amity University. She has a keen interest in observing the economic trends and economic conditions of different countries of the world. Apart from research analysis, she loves listening to music and reading novels.
Aishwarya Singh

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