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Does FDI Promote Growth?

Evidence from Indian Manufacturing Sector

Suresh K G (sureshkg2020@gmail.com) and V Nagi Reddy (vnreddy1941@gmail.com) teach at ICFAI Business School Hyderabad, ICFAI Foundation for Higher Education, Hyderabad.

The spillover effects of foreign direct investment in the Indian manufacturing sector are examined by analysing the financial performance of foreign firms with domestic business group firms and stand-alone firms for selected sub-periods during 2001–15. The study shows that the sales efficiency of foreign firms is not significantly different from that of the domestic firms in all the sub-periods studied, except during 2008–09. The operational efficiency of foreign firms is better than that of the domestic firms till 2009 and, for the later period, there is no significant difference in operational efficiency of domestic and foreign firms.

Capital movements across countries in the form of foreign direct investment (FDI) have been one of the prime features of global economic integration. Home countries, mostly developed economies, promote FDI to get higher returns for their capital. Host countries, mostly developing economies, welcome FDI as part of their outward-oriented development strategy. FDI, mostly contributed by multinational companies (MNCs), is expected to promote economic growth in host countries. The development experience of the newly industrialised economies in Asia is a prime motivating factor for the developing economies to follow outward-oriented economic policies. Developing countries, especially the Asian countries, are competing with each other to get a lion’s share of the FDI flows from developed countries. However, in recent years, outward FDI from emerging economies like China also accounts for a substantial part of global capital flows.

As per the United Nations Conference on Trade and Development’s (UNCTAD) UNCTADstat database, in 2015, the United States (US) received 21% of the world’s inward FDI, followed by China and Hong Kong receiving about 17%. For the pre-crisis year 2007, China and Hong Kong received 7% of world’s inward FDI, and the figures for the US, British Virgin Islands, Russia, and Brazil are 11%, 1.5%, 2.8%, and 1.7%, respectively. India accounted for 2.5% of the inward FDI in 2015 as against 1.26% in 2007. China and Hong Kong have not only emerged as one of the largest recipients of FDI, but they also account for approximately 13% of the world’s outward FDI in 2015 as against the US’s share of 24%. In the pre-crisis year of 2007, China and Hong Kong contributed 4% of the world’s outward FDI and the US accounted for 17%. Appendix Table 1 (p 62) provides shares of the BRICS (Brazil, Russia, India, China and South Africa) countries and the US in world inward and outward FDIs. While the US is the leading nation in both outward and inward FDIs, we find that China has also emerged as a major contributor in outward FDI and receiver of inward FDI.

Motivation for the Study

Despite successful stories of the growth of newly industrialised economies in Asia that have relied on FDI and trade, the empirical literature on FDI provides different arguments in support of and against FDI as well as its spillover and competition effects. Foreign capital is expected to bring sophisticated technology and cheap capital to the host country. Since patent laws make it costly for domestic firms to appropriate full benefits of technology generated abroad through direct technological transfer, FDI is viewed as an indirect channel of technology transfer (Mondal and Pant 2014). Domestic firms may imitate or replicate the sophisticated technology of MNCs used for introducing a new product or a new production process.

As Barrios and Strobl (2002) observed, the spread of this spillover depends largely on the similarity of goods produced by the domestic and foreign firms. However, domestic firms may benefit from the management and marketing technology used by the foreign firms, which does not necessarily depend upon the similarity of goods produced. The direct benefits of the FDI spillover will reflect in the form of exports and employment, and indirect benefits will be visible in the form of productivity, operational efficiency, and profitability of domestic firms. The critiques of FDI put forth the competition effect argument, which suggests that foreign firms with advanced technical and managerial characteristics may make it difficult for domestic firms to continue in the industry, and crowding out would be the end result. The literature on FDI provides evidence for both competition and spillover effects at different levels of openness. Generally, competition effect is present in the initial stages, and appropriation of positive spillover effects is visible in the later stages of openness to foreign firms (Spencer 2008).

Policymakers believe in the positive spillover effect of FDI and argue that this spillover manifests itself in the generous investment incentives offered by governments in developing and developed countries alike (Itzer and Görg 2009). Even though the location preference ofmncs are motivated by the size of the host country market, physical and social infrastructure, and ease of doing business, the investment incentives also could influence the location preference of foreign firms (Tung and Cho 2001). Keeping in line with this, the Government of India has been offering various investment incentives to foreign companies, and the recent “Make in India” campaign has attracted much attention. Since these incentives cost the national exchequer dearly, it is important to analyse the benefits of these incentives to the host country through various spillover effects of FDI. Further, this is crucial for efficient policymaking, as the literature provides both negative and positive effects of FDI on host countries.  

Global Spillover Effect of FDI

As mentioned earlier, the literature on FDI provides evidence for competition effect and positive spillover effect at different stages of openness in the host country. The spillover effect is analysed in terms of the indirect effect of FDI on the productivity of domestic firms, export intensity and export diversification, etc. A brief review of literature in this area is given below with more focus on studies related to the Indian economy.

Aitken and Harrison (1999) examined the spillover effect of FDI on domestic firms in Venezuela and found a negative effect of FDI on fully owned domestic firms (domestic firms with no foreign collaboration). However, domestic firms with foreign collaborations benefited from FDI as their productivity increased with the presence of foreign firms. Barrios and Strobl (2002) examined the presence of FDI spillover in Spain and concluded that firms with relatively higher absorptive capacity experience a positive spillover effect of FDI. Görg and Strobl (2003) examined the effect of FDI on domestic firms in Ireland using plant-level data. They found a positive spillover effect of FDI on domestic firms. Burke et al (2008) found evidence for a net positive spillover effect of FDI on business start-ups in the United Kingdom (UK). However, at the disaggregate level, they found competition effect in dynamic markets (high churn) and positive spillover effect in static industries (low churn firms).

Wei and Liu (2006) analysed productivity spillover from the presence of foreign companies in the manufacturing sector of China by analysing data for 10,000 indigenous and foreign-invested firms. They found intra-industry and inter-industry productivity spillover running from the foreign firms to Chinese firms within regions. However, firms from Organisation for Economic Co-operation and Development (OECD) countries generate higher inter-industry spillover than other firms. Tian (2007) analysed the spillover effect of foreign firms’ presence in the domestic market of China by using different measures of foreign firms’ presence, such as share in capital, share in product, and share in employment. It was found that foreign firms generate positive spillover through their presence in the share of capital, while the spillover effect through their presence in product and employment is not significant.

Spillover Effects of FDI in India

Feinberg and Majumdar (2001) analysed the knowledge spillover of FDI in the Indian pharmaceutical industry. They concluded that Indian firms have not benefited from the research and development (R&D) spillover, while the spillover effect is present among foreign firms. Kathuria (2001) found a significant positive spillover effect of the presence of foreign firms in the Indian manufacturing sector. However, the extent of spillover varies depending upon the type of industry. The spillover effect is substantial in scientific industries (an industry with higherR&d) compared to non-scientific industries (lessR&D spending). Kathuria (2002) examined the effect of liberalisation on the productivity of firms and the extent of the spillover effect during the post-liberalisation period. He found that the productivity of foreign firms in India has improved after liberalisation and domestic firms with highR&D investment could acquire spillover effects of FDI in the post-liberalisation era. Sasidharan (2006) analysed the vertical and horizontal spillover effects of FDI in the Indian manufacturing sector using firm-level data. The study could not find any significant spillover effects.

Aggarwal (2002) analysed the relationship between foreign equity and exports performance of firms in India. The study found that there is no relationship between foreign equity and exports performance. However, the role of foreign affiliates in the exports of India has increased in the late 1990s. Kumar and Pradhan (2003) analysed the determinants of exports performance of firms in India. They found that foreign companies have performed better on the exports front compared to their Indian counterparts in high-, medium- and low-technology industries from 1989–1990 to 2000–01.

Banga (2006) analysed the direct and indirect effects of FDI on the exports performance of India. FDI from the US has had significant positive impact on the exports intensity at industry and firm levels, while Japanese FDI has had no significant impact directly or indirectly. Joseph and Reddy (2009) examined the effect of FDI on exports performance of domestic firms through backward spillover arising from buyer–seller linkages. They found that domestic firms increased their exports due to the competition effect of FDI in the domestic market. Jadhav and Reddy (2013) examined the spillover effect of FDI on domestic firms in India by analysing the operating efficiency and sales efficiency of firms in the capital goods industry. They found that the operational efficiency of foreign firms was higher than that of domestic firms during the sub-periods 1995–97, 1998–2000, 2001–03 and 2009–10. However, the domestic firms reveal better operational efficiency compared to the foreign firms in the study during 2004–08. The sales efficiency (ATO) of the domestic firms is higher than that of the foreign firms during the period 2004–08. In the other sub-periods (1995–97, 1998–2000, 2001–03 and 2008–10), there is no significant difference between the sales efficiency of domestic firms and foreign firms. This makes it difficult for foreign firms to earn price premium for its products.

Malik (2014) analysed the technology spillover of foreign investment in India. The study found that horizontal spillover is high in high-technology industries compared to the low-technology industries. Further, it is evident that minority-owned foreign firms are more prone to technology spillover than majority-owned foreign firms. However, domestic firms in high-technology industries are able to benefit from technology spillover from majority-owned foreign firms as well as minority-owned foreign firms. Mondal and Pant (2014) analysed the effect of FDI on the competitiveness of domestic firms in India by using firm-level data from 2000–01 to 2006–07. They found that domestic firms benefit substantially in terms of competitiveness from the presence of foreign firms in India than from purchasing foreign technology. Further, the spillover effect of foreign firms on domestic firms depends on the absorptive capacity of domestic firms and the level of competition (institutional factor) in the domestic industry.  Sahu and Solarin (2014) analysed the effect of foreign equity on the productivity of firms. The authors found that foreign equity has significant positive effect on the productivity of firms.

The current study examines the spillover effect of FDI on domestic firms in the Indian manufacturing sector during 2001–15 by using firm-level data. In line with Jadhav and Reddy (2013), we analyse the sales and operational efficiency of domestic and foreign firms to examine the spillover effect for the full period of 2001–15 and for different sub-periods: 2001–03, 2004–07, 2008–09 and 2010–15. Jadhav and Reddy’s (2013) study is confined to the capital goods industry from 1994–95 to 2009–10, and we extend this by including firms from all industries during 2001–15. Further, we analyse the spillover effect of FDI on Indian stand-alone firms and business group firms separately, which is missing in the previous studies.

Methodology

The spillover effect of FDI is expected to be reflected in the financial performance of domestic firms. Hence, in the presence of the spillover effect, the operational and sales efficiency of domestic firms are expected to be equivalent to or higher than that of foreign firms. In the absence of the spillover effect, the financial performance of foreign firms is expected to be higher than that of domestic firms. This is justified by the fact that foreign firms possess sophisticated technology and modern management practices, which are expected to provide better productive efficiency to foreign firms.  

To measure financial efficiency of firms, we use two indicators: asset turnover ratio (ATO) as a measure of sales efficiency of the firms, and return on capital employed (ROCE) ratio as a measure of the operational efficiency of firms. The ATO is a ratio of net sales to total assets and ROCE is a ratio of operating profit to long-term capital employed. Foreign firms possess sophisticated technology for new products and process, and this is expected to provide a price premium for their products. The price premium for sophisticated products and brand name would make it possible to have a higher ATO for foreign firms. However, if domestic firms could appropriate the sophisticated technology introduced by foreign firms in the domestic market, the products of domestic firms would be technologically competitive and foreign firms would not be able to charge a price premium for their products. Hence, the ATO is not expected to be different for foreign and domestic firms in the presence of the spillover effect from foreign to domestic firms.

However, as mentioned earlier, the extent of technological spillover depends mainly on the similarity of goods produced by domestic and foreign firms. The spillover effect may occur even with the absence of similarity of goods, as the domestic firms may benefit from the best operating practices followed by foreign firms. The presence of foreign firms in the domestic industry may facilitate labour turnout from foreign to domestic firms and vice versa, and the domestic firms would get trained labour or management professionals from foreign firms.  Hence, the domestic firms can adopt the best operating or management practices of foreign firms and this is expected to reflect in their operating profit. Since we expect that domestic firms are benefited from the best management practices followed by foreign firms, we do not expect any difference in the operational efficiency of domestic and foreign firms, that is, the ROCE is the same for domestic and foreign firms. 

We use dummy variable regression to examine whether the ROCE and ATO are different for domestic firms and foreign firms. We classify the domestic firms into two categories—stand-alone firms and the business group-affiliated firms—and we examine whether the performance indicators of these categories of firms are different from those of foreign firms.

The following models are used to examine the difference in performance indicators among foreign (FDI), Indian stand-alone and business group firms:

ATOi = 0 + 1DDFDI + 2DDBG +3 lnsalesi +ei ... (1)

ROCEi = 0+1DDFDI+2DDBG +3 lnsalesi +ei ... (2)

This model uses two dummy variables.DDFDI is the FDI dummy where we assign “1” for foreign firms, and “0” for business group and stand-alone firms. DDBG is the second dummy where we assign value “1” for business group firms, and “0” for Indian stand-alone and foreign (FDI) firms. Hence, Indian stand-alone firms are the reference variable.

Further, we added more firm-specific variables as control variables in the same equations given above to examine whether there is any difference in performance among foreign firms, Indian stand-alone and business group firms.1 We used leverage,R&D intensity, marketing intensity, exports intensity and size of the firms (total assets) as control variables. We found a high correlation exists between net sales and total assets (size), and excluded net sales from the final estimation. Leverage is defined as a ratio of total debt and total assets at the start of the current year. Hence, the leverage we have used is a lagged one and this will avoid a possible endogeneity problem in estimation. Equations (3) and (4) are used to examine the difference in performance of foreign stand-alone and business group firms. For examining the difference in performance among foreign, domestic stand-alone and domestic business group firms, we added dummy variables for foreign and business group firms as given in equations 3 and 4:

ATOi= 0 + 1DDFDI + 2DDBG + 3Lnsalesi + 4R&Di + 5Mkti + 6Levei+7lnSizei+8Expi+ei ... (3)

ROCEi= 0+ 1DDFDI + 2DDBG+ 3Lnsalesi+ 4R&Di + 5Mkti +6Levei+7lnsizei+8Expi+ei ...(4)

If the coefficients of DDFDI are significant (in equations 3 and 4), we conclude that there exists significant difference in the sales efficiency (ATO) and operational efficiency (ROCE) among Indian stand-alone, business group and foreign firms. Any difference in operational and sales efficiency between foreign and domestic firms (classified as stand-alone and business group firms) is considered as the absence of the spillover effect.

Since the performance of firms is highly influenced by macroeconomic factors prevailing in the domestic and global economy, we have performed the analysis by dividing the entire study period (2001–15) into different sub-periods. We have identified four sub-periods based on the macroeconomic conditions in the economy: 2001–03, 2004–07, 2008–09, and 2010–15. The global economy suffered from the dot-com bubble in 2000–01 and we refer to 2001–03 as the period after the crisis or the recovery period. The Indian economy has registered impressive gross domestic product (GDP) growth rates during 2004–07 and we refer to it as growth period. The high growth euphoria has not extended beyond 2008 due to the advent of the global financial crisis in 2008 and we identified 2008–09 as the crisis period in the Indian economy. By analysing the financial performance of firms, we would like to examine the effect of the global crisis on different types of firms. The post-2009 period, that is, 2010–15 is called the post-crisis or recovery period. The analysis in different sub-periods is expected to bring more insights into the performance of firms in different macroeconomic conditions and the comparison would be more meaningful.

We have computed the average values of firm-specific variables for each sub-period and employed a cross-sectional regression model.

Description of Firms under Study

We have collected data from the Prowess database maintained by the Centre for Monitoring Indian Economy (CMIE). We have used the ownership classification of Prowess to identify foreign and Indian firms. From the manufacturing sector, we have identified 888 firms for the analysis based on the availability of data during 2001–15. Among these 888 firms, 135 are foreign and 753 are domestic firms; 267 are stand-alone firms, and 486 are business group affiliated firms. Table 1 (p 59) provides descriptive statistics of the firms under study in the different sub-periods.

Interpretation of Results

Tables 2 and 3 provide estimated results for Models 1 and 2. Table 2 provides performance comparison using the ATO. We did not find any difference in the sales efficiency of stand-alone firms and foreign firms in any of the four sub-periods studied. However, sales efficiency of business group firms are lower than that of foreign and stand-alone firms during 2001–03, 2004–07 and 2010–15 periods. During the crisis period, there is no difference in the sales efficiency of the three categories of firms analysed.

Table 3 provides performance comparison using ROCE. As shown in Table 3, foreign firms performed better than Indian stand-alone and business group firms in the first two sub-periods. The operational efficiency of two types of Indian firms is not different in the first three sub-periods. However, during 2010–15, Indian stand-alone and foreign firms performed better than business group firms. During the crisis period, there is no significant difference in the operational efficiency of the three categories of firms.

As a next step, we estimated equations (3) and (4) by using more firm-specific variables as control variables. The results provided in Table 4 reveal that the sales efficiency of foreign firms is better than that of Indian stand-alone and business group firms only during the crisis period of 2008–09. Indian stand-alone firms performed better than business group firms during 2004–07. This indicates that domestic firms could appropriate the spillover effect from the foreign investment during the study period, and they acquired sales efficiency similar to foreign firms. Marketing intensity had a positive impact on sales efficiency of firms during the crisis period (2008–09), while during 2004–07, marketing intensity had a negative impact on sales efficiency. Exports intensity has had a significant positive effect on sales efficiency during the crisis period of 2008–09 (at 10% level) and during 2010–15. Leverage has a significant negative effect on sales efficiency in all the sub-periods.R&D intensity has a significant positive effect on sales efficiency during the sub-period 2001–03 and in other sub-periods, the coefficient ofR&D intensity is not significant. The size of the firms (total assets) has a significant negative effect on sales efficiency in all the sub-periods studied.

Table 5 provides results of operational efficiency comparison by adding firm-specific variables as control variables. The foreign firms have better operational efficiency compared to the two categories of Indian firms in the first three sub-periods (2001–03, 2004–07 and 2008–09). However, during the post-crisis period (2010–15), operational efficiency of the three groups of firms were not significantly different. Business group firms performed better than stand-alone firms during 2008–09 (significant at the 10% level of significance) and there is no difference in the operational efficiency of stand-alone and business group firms in other three sub-periods. Among the firm-specific control variables, leverage has had no significant effect on operational efficiency of firms in any of the sub-periods studied.R&D intensity has had a significant positive effect on operational efficiency during 2001–03 and 2004–07. Coefficient for total assets (size) is significant for the period 2008–09 at the 10% level of significance. But, the coefficient has a negative sign during the crisis period, signifying that small firms performed well during the crisis period. Marketing intensity coefficient is significant (with a negative sign) for the high-growth period (2004–07) and during 2010–15 (at the 10% level). Exports intensity is significant (at the 10% level) and has a negative sign during 2010–15.

Conclusions

In this study, we examined the presence of the spillover effect from foreign to domestic firms (classified as business group firms and stand-alone firms) in the Indian manufacturing sector. We have examined the spillover effect in terms of operational efficiency and sales efficiency. Foreign firms are expected to have higher operational efficiency and sales efficiency. We have used dummy variable regression to examine whether the sales efficiency and operational efficiency of foreign firms, Indian stand-alone firms and business group firms are different. Foreign and domestic firms are expected to have the same level of operational and sales efficiency in the presence of the spillover effect, as the domestic firms are likely to benefit from the presence of foreign firms.

However, our research suggests that there is no difference in sales efficiency of domestic firms (both stand-alone and business group firms) and foreign firms (except for the crisis period of 2008–09), when we control for firm-specific variables. Without controlling for firm-specific variables, we found a difference in the sales efficiency as foreign firms are equivalent to stand-alone firms in all the sub-periods, and stand-alone firms perform better than business group firms (except for in the crisis period). This shows that as Indian stand-alone firms offer products similar to foreign firms in terms of quality, foreign firms are unable to charge a price premium on their products. Since theR&D spending of Indian firms is generally lesser than that of foreign firms, it is evident that Indian firms are importing sophisticated machinery to compete with the foreign firms (as Jadhav and Reddy [2013] observed). The exports intensity of business group firms is equivalent to zero and for foreign firms, it is either zero or negative. The Indian stand-alone firms are the net exporters in Indian manufacturing sector.

In terms of operational efficiency, by controlling for firm-specific variables, we find that foreign firms were performing better than domestic firms (including two categories of firms) till 2009. Even after 2009, there is no significant difference in operational efficiency among the three categories of firms. Operational efficiency of domestic stand-alone and business group firms are not significantly different (except for in the crisis period, where business group firms have high operational efficiency). Without controlling for firm-specific variables, we find that foreign firms were performing better than both types of domestic firms (stand-alone and business group) till 2007, and the operational efficiency of foreign and domestic stand-alone firms did not differ during 2008–09 and 2010–15. However, domestic stand-alone firms  dominate over domestic business group firms in the post-2010 period with higher operational efficiency.

We found a significant spillover effect of foreign multinational presence in the Indian economy in terms of sales efficiency. The Indian firms are equivalent to or even better than foreign firms in terms of sales efficiency. This indicates that Indian firms could appropriate the indirect technology spillover from foreign companies and could offer products similar to foreign firms that prevented them from charging a price premium. However, in terms of operational efficiency, the domestic firms lag behind foreign firms till 2009 and perform at par with foreign firms in the post-2010 period. Since the exports intensity of foreign firms is either negative or zero, and zero for business group firms, it is evident that the government cannot rely on foreign or business group firms to promote exports. The foreign firms tend to focus more on the domestic market and business group firms invest in foreign markets instead of exporting from India.

Note

1 Recently, Jadhav and Reddy (2017) have written about the role of business group firms in the Indian economy.

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Updated On : 7th Sep, 2018

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