Is the Indian Government correct in recently allowing FDI Reforms based on Indo-US Trade Agreements under United States India Business Council (USIBC) recommendations?Let’s take a look at both sides of the debate.
First
of all, the topic is quite intense and I need to take help of a few economic theories
in this article. I have tried to eliminate most economic theories and formulae
and tried to illustrate it in plain English wherever possible, but if the
reader is not able to understand a particular concept, I request them to please
skip that line and move forward and guarantee that you won’t miss the essence
of article.
Over time, and especially in the aftermath of the East Asian crisis of the late 1990s, it is almost universally believed that financial integration due to FDI has caused the crisis.
The FDI involves Phenomenon of “uphill flows of capital profits” from non-industrial to industrial countries and thus, I analyze here whether this pattern of capital flows has hurt growth in non-industrial economies.
Some analysis make it
clear that non-industrial countries that have relied on foreign capital have not
grown faster than those that have not relied on foreign capital.
Thus, surprisingly, I
find that there is a positive correlation between current account balances and
growth among non-industrial countries, implying that a reduced reliance on
foreign capital is associated with higher growth.
Equally clearly, though,
the reliance of these countries on domestic rather than foreign saving to
finance investment comes at a cost which hampers the growth not only in that
sector but other dependent sectors too in the long run.
But, this result is
weaker when we use panel data rather than cross-sectional averages over longer
periods of time, thus, in no case do we find any evidence that an increase in
foreign capital inflows directly boosts growth.
But what is now the best policy towards capital account openness or FDI?
Certainly, the answer is
not to go backward, but instead toward more context specificity in assessing
the merits of capital account openness, and more flexibility and creativity in
managing it.
Even the famous skeptical economist Keynes said, “Yet, at the same time, those who seek to dis-embarrass a
country of its entanglements should be very slow and wary. It should not be a
matter of tearing up roots but of slowly training a plant to grow in a
different direction.”
He meant that even if a
country is facing slow-down due to foreign money chains, they should not tear itself
apart from the chain but try to manage it in a way that the benefit should
reach all corners.
Then, what explains
these results, which are contrary to the predictions of conventional
theoretical models?
The truth is: even the successful
developing countries have limited absorptive capacity for foreign resources,
either because their financial markets are underdeveloped, or because their
economies are prone to overvaluation (inflation) caused by rapid capital
inflows.
Certainly, the role of
foreign capital in expanding a country’s resource constraints may be limited. A
more optimistic read would see a research and, eventually, policy agenda in determining
how to increase the capacity of poor countries to absorb foreign capital.
As countries develop,
absorptive capacity grows. The recent strong growth of the emerging economies
of Europe, accompanied by rising current account deficits, probably has a lot
to do with the strengthening of their financial sectors, in part through the
entry of foreign banks. (Only time will tell what effects there are on the
exchange rate and on competitiveness, as well as whether this phenomenon is
sustainable, and so all conclusions from this episode have to be tentative.)
Development itself may
be the antidote to the deleterious effects of foreign capital and may be
necessary for countries to absorb more capital, only some forms of FDI may play
a direct role in the development process.
How?
The level of financial
integration, as measured by the stock of external liabilities to GDP, is not
correlated with TFP (Total Factor Productivity) growth. But splitting up the
stock of external liabilities reveals an interesting result.
FDI in equity inflows
(cumulated over decade-long periods) contribute to TFP growth while FDI in debt
inflows have the opposite effect.
But the negative effect
of stocks of external debt liabilities on TFP is almost negligible in economies
with better developed financial markets and better institutional quality.
In sum, the results
suggest that insofar as the need to avoid overvaluation is important and the
domestic financial sector is underdeveloped, greater caution toward certain
forms of foreign capital inflows might be warranted. At the same time, however,
financial openness may be needed to spur domestic financial development. This
suggests that even though reformers in developing countries might want to wait
to achieve a certain level of financial development before pushing for
financial integration, the prospect of financial integration and ensuing
competition may be needed to spur domestic financial development.
One approach worth considering
might be a firm commitment to integrate financial markets at a definite future date;
this would allow time for the domestic financial system to develop without
possible adverse effects from capital inflows, even while giving participants
the incentive to press for it by suspending the sword of future foreign
competition over their heads.
In summary, using
macroeconomic data bolsters the microeconomic evidence (based on firm- or
industry-level data) that financial integration, especially if it takes the
form of FDI or portfolio equity flows, leads to significant gains in efficiency
and TFP growth.
Moreover, in tandem with
the recent literature showing that TFP growth rather than factor accumulation
is the key driver of long-term growth and thus, our results suggest
that—despite all the scepticism surrounding it and despite all of the potential
costs and risks associated with it— Capital account liberalization and FDI
deserves a thumbs up.
Why does it look like
someone is growing at a better speed than us?
First, why do you care?
Just be happy that you are growing at a better rate than earlier.
But to answer the question, the industrial countries use the resources better than the non-industrial countries use that money. Thus, it has nothing to do with the FDI, it is just the use of money inefficiently, which can be overcome only via better technology and facility which comes hand in hand with FDI.
Then why is anyone
opposing FDI if its for the greater good in the long run?
Other than Political
rivalry, there are a few other reasons for this:
1. Timing: The timing of
the adjustment of TFP and output to greater financial integration is different.
When the FDI is invested it takes at least 2-3 years to setup the business and
promote and flourish. So is it the right time or should we wait?
2. Technology: TFP
growth is often associated with the introduction of new technologies. Thus, if
the said technology is a general purpose technology affecting a number of
players in different sectors, this increases the rate of obsolescence of both
physical and human capital of the players not using the technology and the benefits
is reaped by a single player who has that technology. Thus, this could potentially
slow down the growth rate of general output in the short run. Thus, it is hated
by the persons who don’t want to upgrade themselves and don’t want the
government to let others upgrade and take their position.
3. Unemployment: Financial
openness might influence the reallocation of outputs and inputs (raw materials,
land, skilled labour etc.) across individual players. Thus, affecting the
return to capital, it could lead to changes in the entry and exit decisions of
firms/plants. Thus, the older firms will have to either reinvent or leave their
business due to low productivity. To the extent that this does not have a
negative effect on net entry, aggregate factor productivity will increase
because new plants are more productive than exiting older plants. This
reallocation from less productive to more productive plants would ultimately
increase total factor productivity. But on the assumption that the older plants
who took exit were labour intensive and the newer plant were technology and
machinery intensive thus, that leaves us with large scale unemployment in the
short run.
4. Long run adjustment: There could be some adjustment costs that
delay the realization of the positive effects of TFP on output growth in
developing countries. As the adjustment of the capital stock to new
technologies is completed, these effects are expected to disappear making the
impact of financial openness on economic growth in the long run more visible.
In light of the short history of the recent wave of financial globalization,
which began in earnest only in the mid-1980s, perhaps it is easier to detect
its positive effects on TFP growth than on output growth.
I would like to make a
few quick summarizing points in simple words:
1. FDI brings new money
into the Indian financial system. Trading within the family does not make a
family richer because if one member is gaining then other is losing, thus
overall the total money remains the same, but when a member earns from outside
the family, the family prospers.
2. Better competition
among the producers which make the goods and services cheaper for the ultimate
consumers.
3. To bring in new or
copyright protected or patented technology from outside, FDI is necessary to
give the technology a perfect platform in the form of Investment to utilise the
technology to its utmost potential. Developing countries need these
technologies but people don’t have that kind of money required to make it
commercial. Indian investors could be a substitute for these FDIs but the Indian
counterpart does not have the risk appetite which the foreign counterpart has
thus Indian investors restrain from investing, thus leaving FDIs the only
option for growth.
4. Moreover, when the
industries grow due to FDI the demand for raw materials and other primary
sector goods increases exponentially. India being the boss in Primary sector
with almost unlimited resources (when compared to other developing countries)
is the best place where FDI should be encouraged.
