FDI and Trade in India a Gravity Model Analysis

FDI And Trade In India – A Gravity Model Analysis

Mayank Nagpal

This paper aims to study the impact of Foreign Direct Investment inflows on Trade volumes in India using the Gravity Model Analysis. We use the gravity model to study the motive of foreign investment in India. Even though the results tend to suggest that a major portion of FDI is resource seeking, there seems to ample theory to argue against this hypothesis.

Introduction

Foreign direct investment (FDI) in India has played an important role in the development of the Indian economy.Until 1991,India followed a fairly restrictive foreign private investmentpolicy when compared to industrialized countries and relied more on bilateral and multilateralloans with long maturities. Foreign direct investment was perceived only as a means of acquiring industrial technology not available in India through capital goods import.India’s Foreign policy was very similar to other rapidly industrializing Asian economies with foreign investment being permitted only in designated industries, subject to varying conditions. The Foreign Exchange and Regulation Act (FERA), 1974 restricted foreign firm’s equity holding only up to 40 per cent discretion. Many believe that such a restrictive policy not only retarded the growth of India’s technical capability, but also led to a loss of export opportunity of labour intensive goods. In contrast, growth in exports of such labour intensive goods led to the successful development of many successful East Asian economies.

After gradual relaxation of foreign investments in 1980’s, liberalization in 1991 and deregulation since then helped open India’s markets to FDI. Since then, India has sought to consciously ‘benchmark’ its policies against those of other south-east Asian economies so as to attract a greater share of the world FDI inflows. Over the decade of the 1990’s foreign investment was permitted in almost all sectors of the economy (barring agriculture, and, until recently, real estate). Moreover, laws were changed to provide foreign firms the same standing as the domestic ones.Net FDI inflow in India reached 70630 crores in the 2006-07 financial year, an increase of 187% from the financial year 2005-06 with the largest share of Investment coming from Mauritius followed by US and the UK. The table below shows the share of the top 10 investing countries in India.

Top 10 Investing Countries in India, 1991-2000[1]

Country/Region / Share (in Per Cent)
U S / 20.4
Mauritius / 11.9
UK / 6.4
Japan / 4.0
South Korea / 3.9
Germany / 3.4
Australia / 2.7
Malaysia / 2.3
France / 2.1
Netherlands / 1.9

Source: Handbook of Industrial Policy and Statistics, 2001.

In 1998 and 1999, the Indian government announced a number of reforms designed to encourage FDI and present a favorable scenario for investors. FDI is now seen as a source of scarce capital, technology and managerial skills that were considered necessary in an open, competitive, world. FDI in India has, in a lot of ways, enabled India to achieve a certain degree of financial stability, growth and development. In recent years India has been a favoured destination for foreign investors, mainly due to the large market for their products.FDI investments are permitted through financial collaborations, through private equity or preferential allotments, by way of capital markets through Euro issues, and in joint ventures. On the other hand, FDI is not permitted in the arms, nuclear, railway, coal & lignite or mining industries.

Literature Review

Increasing globalisation and FDI leading to fragmentation of the production process over the world has completely changed the international trade scenario facing the world. This has resulted in the replacement of the traditional inter-industry trade with intra-industry and intra-product trade. Even though the theoretical literature examining the determinants of Foreign Direct Investment assumes that firms either supplya foreign market through exports or establish production facilities in that country, empirical studies have shown that trade between two countries and FDI between them are complementary to each other. In fact most studies,predict a two way linkage between FDI and trade volumes. Studies such as, Blonigen (2001), who finds evidence of both substitution and complementary effects between affiliate production and exports of Japanese auto parts for the U.S. market[2] and Aizenman, Joshua, Noy, Ilan(2005)[3]investigate the two-way feedbacks between various categories of trade have found both a positive and negative relationship between trade and FDI. They analyse whether the impact of FDI on Trade is different for countries in different stages of development.

Other studies and literature on the impact of FDI and Trade (such as Hortsmann and Markusen (1992) and Helpman (1984)) propose two opposing ways of the relationship between trade and FDI. In case of horizontal FDI (i.e. FDI between two countries having similar endowments) Trade and investment act as substitutes to each other as in such a case instead of exporting its products, the Multi- National Enterprise (MNE) would start producing those products in the host country by setting up a production unit there. This can be advantageous if in the long run trade costs are higher than the costs of setting up a plant in the host country. In case of vertical FDI (i.e. FDI between two countries with dissimilar endowments) the production process is split between segments which are relatively intensive in different factors of production. For example if a MNE from a capital abundant country sets up a plant in a labour abundant country those segments which require labour intensively would be produced in the new plant set up in the labour abundant country. In such a case the increased FDI would lead to an increased Trade as the local productionmight require inputs that continue tobe imported, such as componentsand machinery. If a firm can produce a product at a lower cost in the host country than in its home country, it would produce in its new plant and then import the goods produced there. Thus vertical FDI should increase both exports and imports between the two countries.

Moreover, even though the view that FDI is a way of firms in the advanced nations fleeingfrom their high-cost domestic productionsites andrelocating productionin low-wage areas may be true to a large extent, it is beneficial to the country in general as well as this cost minimizing behaviour of the firm would result in a higher degree of specialisation.Trade theory suggests that International Trade (which is always welfare improving) is a result of higher degree of specialisation which in this case occurs due to the increased FDI in the labour abundant country.

According to Edward M. Graham[4], ForeignDirect Investment stimulates rather than displacing trade. According to him FDI enables a firm to establish alarger distribution base and thus not only produce a larger number of commodities but also increase the number of products sold in the foreign market.

Faster rising merger and acquisition across the regions over the globe has given a boost to the flow of Foreign Direct Investment.According to the UNCTAD estimates, FDI inflows in 2006 reached at US $1.2 trillion.Though developed nations over the world had attracted a huge sum of FDI in 2006, still the flows to developing nations were significant in the same year. FDI inflows to the developed countries increased by 48 percent over the previous year. A major motive of FDI among developed countries (horizontal FDI) is capturing the market of the country where the foreign capital is invested in. On the other hand in case of firms from developed countries investing in developing countries, the motive seems to be to minimize cost by making use of the cheaply available abundant factor in the host country.

FDI in India is generally considered to be market seeking rather than resource seeking. Stricter labour laws as compared to other developing countries like China discourages foreign firms to make use of the cheaply available resource here, i.e. labour. Thus the incentive for vertical investment in India is less than that of investing in China and making use of cheaper labour there.

Data & Methodology

We have collected data for different variables on a country-wise basis from various resources for the years 1996 to 2004. Data sources for all the different variables used in the analysis have been given at the end of the paper.

We use the Gravity Model analysis to study the effect of FDI inflows into India from various countries on volumes of trade between India and those countries. The Gravity Model of trade is a simple modification of Newton’s law of gravitation in physics. It states that the volume of trade between two countries is positively related to the product of the GDP between the two countries and is inversely proportional to the distance between them. Thus the original gravity model is

The modified gravity model takes natural logs on both sides of the equation and thus its new form is.

In the new gravity model equation for our analysis we use various other relevant variables and run a Tobit regression model to estimate the coefficients and then interpret the results accordingly. We use the panel data approach as it not only increases our degrees of freedom but also helps in capturing the heterogeneity caused by over time. We run the following Tobit regression model for our analysis

With

With

Where,

In case where we take logs in the regression, we add 1 to the value of the variable as for observations where the variables take zero values logs of these would be undefined. As the dependent variable in this case has a large number of zero values we use the Tobit model for our analysis. We run a pooled Tobit Model regression using data for the years 1996 to 2004. The statistical package used for running the regression is STATA 10.

• Exportit- Export from India to country i in year t.
• Importit- India’s imports from country i in year t.
• Distancei- Distance of country i from India
• - Population of country i in year t
• - FDI inflow from country i in year t

• - Exchange rate of country i with respect to US dollars in year t.Ideally we should have used the exchange rates of each currency with respect to Indian Rupees to capture this effect but as this data was unavailable, we have used the exchange rate with respect to dollars. As this rate may be unable to capture the exchange rate with respect to the rupee, we should be extremely careful in interpreting the results.
• Year dummies- The use of time effects tr is motivated by findings in Baldwin & Taglioni (2006)[5]. The paper shows how an exclusion of such time effects may result in significant misspecifications.
• Dummies for Various Continents to take into account the cultural factors which might affect trade between two countries. The dummies take the value 1 if the country belongs to that particular continent and zero otherwise
• Other dummies which take in account the relationship between countries such as common colonial history, common language and if the countries were the same at one time.
• Common border dummy which captures the border effects.

The coefficients of GDP and dummies indicating a historical relationship between countries is expected to positive. On the other hand, coefficient of distance is expected to be negative. The exchange rate of a country’s currency with respect to the Indian rupee is expected to have a positive relationship with India’s imports from that country, whereas a negative relationship is expected betweenexchange rate (with respect to the rupee) and India’s exports to that country.

We estimate two regressions and analyse the revealed effects of various factors on exports and imports separately. A positive coefficient on the variables would imply that they have a positive effect on trade and a negative coefficient would suggest otherwise. For this study the variable of our interest is FDI inflows and we need to analyse the value and the sign of α. A positive coefficient would suggest that FDI and trade are complementary to each other and that increasing FDI in the country would lead to increase in the volume of trade. On the other hand a negative coefficient would indicate substitutability between Trade and FDI.

Results

We run Tobit Model regressions with Export and Import as the two dependent variables in two separate regressions and get the results given in the appendix.

As expected we get a positive and significant coefficient for log of GDP for both the regressions implying that the data supports the hypothesis that GDP has a positive impact on trade between two countries, i.e. India would trade more with a country having higher GDP than with a country having lower GDP. The data suggests that an increase in GDP by a single percent would lead to an increase in imports by 1.47% and exports by 0.62%.The rise in imports is because increase in GDP of the partner country would mean that a larger amount and variety of goods are produced there which might lead to increased demand of their products in India. On the other hand, rise in exports is due to the rise in production. Population of the partner country has a positive and significant impact on India’s export. This may be due to higher demand for India’s exports in highly populated countries. This effect does not hold for India’s imports indicating no such relationship between the value of goods imported by India from a country and the population of the country. The coefficient indicating the effect of exchange rate of the partner countries currency with respect to US dollars is insignificant for both exports and imports. This is along expected lines as the exchange rates with respect to US dollars may not be able to capture the effect of a fall or rise in that currency’s exchange rate with respect to the Indian rupee.

The positive coefficient on the year dummies indicate that with respect to the trade value in 1996 the trade value seems to be higher for years after 1999-2000. This may be due to the effect of globalisation and improving trade relationships between India and the rest of the world.

The negative and significant coefficient on the same country dummy depicts the negative impact that worsening of relations with a country like Pakistan has had on trade between the two countries. Even though the positive coefficients on common border and common language contradict the aforesaid observation, this may be due to the good relations India has with countries like Bangladesh, Nepal, Bhutan and Sri Lanka. Also border effects and ease of trade with neighbouring countries have positive effects on trade.

Unexpectedly, the coefficient on distance is not significantly different from zero implying that distance between India and other countries does not have any effect on the volumes of trade between the two countries. The result seems to suggest that gains from globalisation, improved relations and trade seem to have overshadowed the negative effects from transport costs and other trade costs. This might suggest that, with globalisation and technology the trade hindering effects of distance seem to have reduced. But we need to be doubly sure before making such conclusions as most studies have predicted that even after taking into account the huge effect of globalisation and reduced trade costs, the effect of distance on Trade seems to be negative. Thus we cannot make any conclusions from the coefficient of distance without further analysis of the theory.

The variable of interest in our study, i.e. FDI inflows into India has a positive and significant coefficient for both the regressions implying that FDI inflows in India are complementary to trade. The coefficients suggest that one percentage increase in FDI would increase imports by 0.19% and exports by 0.22%. This would normally indicate vertical FDI, where capital is invested so as to make use of the factor available cheaply in the host country. The data therefore suggests that the bulk of the FDI inflows in India are aimed at making use of the cheaply available factor, i.e. labour to minimise production costs and then import back the goods produced here cheaply. The data seems to suggest that rise in exports from the partner country to India is due to the export of inputs, required for the production of these labour intensive products, to India. FDI may also result in an increase of exports from India to other countries as well as MNEs may use the production units here to produce goods which are exported to these countries. This seems to be against our expectations as FDI in India is majorly believed to be market seeking rather than resource seeking. Moreover the above mentioned export is found to form a very small part of the total exports Strict labour laws and other controls discourage resource seeking FDI in India and thus we need to be careful in interpreting the coefficient.

Conclusion

The results indicate a positive relationship between FDI and exports as well as FDI and imports. It is found that the complementary relationship between FDI and trade dominates.The data thus suggests that a major portion of FDI is aimed at making use of the cheap labour available in India. At First, they may invest in order to reduce their overall production costs by exploiting regional differences in labour costs, tax regimes and transportation costs among other factors. These differences occur due to the difference in endowments of the two countries. But with time these production units may be transformed in to export platforms from which they serve both national and international markets. Given the large consumer base in India, even though, initially a firm may have a resource seeking motive for investing in India, after some time the firm’smarket seeking motive would be combined with its resource seeking motive. Thus even though, the results suggest that FDI has a positive effect on trade in India, it does not necessarily imply that FDI in India is primarily resource seeking or vertical in nature. In fact, as explained above even market seeking FDI may result in an increase in exports, as in addition to capturing the home country’s market, the production center also exports the produced goods to other countries in the international market. Another reason for the unexpected positive coefficient on FDI could be that the factors which effect Trade and FDI, such as diplomatic relations between two countries and their GDPs could be common to both. Thus the coefficient on FDI may just be capturing the effects of these variables on both FDI and Trade rather than the effect of FDI on Trade.