Role of FDIs and FII in Economic Growth

INTRODUCTION

Prior to 1991, the government had imposed several types of controls in the form of licenses, quotas, and permits. It was realized that several shortcomings had emerged as a result of these controls. Corruption, undue delays, and inefficiency increased manifold. Hence it was paramount to have a shift from a Monopoly market to a Competitive Market.  The New Economic Policy,1991 characterized by liberalization, privatization, and globalization has attracted FDI(Foreign Direct Investment) and FII(Foreign Institutional Investment) in the dynamic Indian economy. This free play of the market forces has resulted in multidimensional growth and is playing a significant role in the economic development of the country. In this context, this essay focuses on a brief about FDI and FII, differences between the two terms, the factors driving financial growth, routes through which India gets FDI and FII, economic growth and FDI, pros and cons of the policy, and the statistics related to the same.

BRIEF ABOUT THE FDI AND FII

Foreign investment refers to investments made by the residents of a country in the financial assets and production processes of another country. Different countries observe different effects because of this foreign investment. Foreign investment provides a channel through which countries can gain access to foreign capital. It has two forms-

1) Foreign direct investment

2) Foreign institutional investment

 Foreign Direct investment is made by a particular company when it takes control of  ownership in a business entity in another country. While engaged in an FDI these companies have their day-to-day operations overseas in different countries. This investment comes into play when an investor invests in foreign business operations or acquires foreign business assets in a foreign company. This means they bring in with them not only money but also knowledge, skills, and technology.

Foreign Institutional Investment is an investment made by an investor or an investment fund in a country outside their own registered headquarters. This term is often used in India where foreign entities invest in our nation’s financial markets. FII’s include hedge funds, insurance companies, pension funds, investment banks, and mutual funds. These FII’s can become a really good source of capital development in the nation but many developing nations like India have restrictions on how much equity shares can a particular company buy. This helps limit the influence of FIIs on individual companies and the nation’s financial markets.

DIFFERENCES BETWEEN THE FDI AND FII

If we compare the benefits accruing both FDI and FII, FDI is most important for any economy because it is a type of permanent investment in the country, which leads to long-term growth and prosperity. In this context, the Make in India Campaign launched by PM Narendra Modi on 25th September 2014 aims to attract foreign capital to invest in Indian manufacturing companies which would create more employment options and  transform India into a manufacturing hub. If this initiative is implemented properly, India could soon be on the right path in becoming a $5 trillion economy as envisioned by our Prime Minister.

ROUTES THROUGH WHICH INDIA GETS FDI AND FII

AUTOMATIC ROUTE: Under the Automatic Route, the non-resident investor or the Indian company does not require any approval from the Government of India for the investment. The Reserve Bank of India is in charge of the Automatic Route.

GOVERNMENT APPROVAL ROUTE: Under the Government Approval Route, prior to investment, approval from the Government of India is required. Proposals for foreign direct investment under the Government route, are considered by respective Administrative Ministry/ Department

The Foreign Investment Facilitation Portal (FIFP) facilitates the single window clearance of applications that are through the approval route.

FACTORS OF ECONOMIC GROWTH

The financial or the economic growth of a nation can be affected by some simple factors. The following 6 factors of economic growth have a major impact on the economy:-

1) NATURAL RESOURCES

 The discovery of natural resources like oil and minerals can lead to growth in the economy as these increase the nation’s production possibility curve. Resources also include land, water, forest, and natural gas. It is rare and difficult if not impossible to increase the natural resources of a nation so as to increase the total production of the nation. Rather the nation needs to take care of the supply and the demand of the already available natural resources so as they don’t get depleted soon. Example of such an economy that grows on its natural resources is Saudi Arabia which runs its economy due to oil.

2) PHYSICAL CAPITAL OR INFRASTRUCTURE

Increasing investments in roads, factories, and machinery cause the output to grow. Better factories and infrastructure will be far more productive than manual labour and will give far greater output. For example, having a robust highway system can reduce inefficiencies in moving raw materials or goods across the country, which can increase its GDP.

3) POPULATION OR LABOUR

With the increase in population, there is an increase in the workers or the employees, resulting in a higher workforce. The downside of having a big population is that there could be a high unemployment rate.

4) HUMAN CAPITAL

A good investment in human capital can really affect the whole economy. The investment will improve the quality of the labour force. The improvement in quality means an increase in the number of skilled labour. The significant effect created by skilled labour is quite high because their productivity is higher as well.

5) TECHNOLOGY

Technology can increase productivity at the same level as labour, and increase growth and development with it. Investment in technology means that factories can be more productive at low costs. Technology is more likely to lead a sustained and long-run increasing growth.

6) SOCIAL AND POLITICAL FACTORS

Social factors involve customs, traditions, values, and beliefs, which contribute to the growth of an economy to a considerable extent. As an example, some societies with conventional beliefs don’t like to live like the modern world and hence resisting these investments. Apart from this, political factors, such as the participation of the government in formulating and implementing various policies, have a major part in economic growth.

ECONOMIC GROWTH AND FDI & FII

There is a close nexus between the foreign direct investment and economic growth in India. Though FDI is seen as a vital factor in inducing growth rate, it will only lead to growth if its inflows are properly managed. The degree up to which FDI can be exploited for economic development depends on conduciveness of climate. In the absence of such a climate FDI may be counterproductive; it may thwart rather than promote growth. Since the initiation of the economic reforms in India in 1991, the role of foreign investment in the growth process has been acknowledged by the policy makers. Greater emphasis on FDI inflow has been laid in recent years by allowing 100 per cent FDI in various economic activities. Various existing literature argued that foreign direct investment inflow positively influences economic growth through technology diffusion, human capital formation, etc. FDI is the major monetary source for economic growth in India. The wave of economic liberalization in India gathered its momentum during the economic crisis of 1991 and since then FDI has steadily increased in India. Higher FDI inflow in India in recent periods can be argued to be facilitated by the relatively stable GDP growth rate, which in turn acted as a major boost towards a sustainable high domestic investment.

FII is different from FDI. FDI targets a specific enterprise with the aim of increasing its productivity or changing its management control whereas in case of FII,  investment flows into the secondary market with the aim to increase capital availability in general rather than capital availability to a particular enterprise. FII plays a vital role in stock markets and causes market volatility. This embosses a larger effect on domestic financial markets like stock market, money markets and foreign exchange markets. FII are the profit makers in the stock market and active role players. Still they were not significantly caused to raise the economy as FDI does. The capital they are bringing to India is not stable. In this way, they are just causing stock exchanges to breeze and break. So, along with the tax relaxations and exceptions, there must be a strict locking period for long term investments. The value of R-square is 0.35 which means 35% changes in GDP are due to changes in FII and remaining 65% changes in GDP are due to other factors like interest rate , exchange rate, savings, inflation rate, governance etc. R-squared (R2) is a statistical measure that represents the proportion of the variance for a dependent variable that’s explained by an independent variable or variables in a regression model.

The following depicts the investment made by both the foreign direct investment and the foreign institutional investments.

PROS AND CONS OF FDI & FII

PROS

1. VIBRANT ECONOMY- With growing FDI and FII in the country, India’s economy has become vibrant. Post LPG reforms of 1991, India recorded a GDP growth of 8 percent per annum
2. STIMULANT TO INDUSTRIAL PRODUCTION- As a result of foreign investment, the Indian economy has been introduced to better technology which has resulted in better returns from Industrial production.
3. CONSUMER SOVEREIGNTY- As a result of new choices due to increased competition, Consumer sovereignty has increased. This has resulted in an increase in the level of the overall expenditure of the households which has led to a better quality of life for citizens.
4. CHECK ON FISCAL DEFICIT- As a result of foreign investment, government expenditure has been kept under control. Hence mounting fiscal deficit has been kept under control. From as high as 8.5 percent of GDP has been brought down to around 3.5 percent of GDP.
5. RECOGNITION OF INDIA AS AN EMERGING ECONOMY- Due to reforms related to foreign investment, India’s ranking on the World Bank’s Ease of Doing Business has improved from 142nd position in 2014 to 63rd position in 2020. This improved ranking of India boosts the confidence level of investors.

CONS

1. NEO IMPERIALISM –Due to the increase in foreign investment, the fear of Neo imperialism has crept in. It is the new wave of imperialism reflected by the use of power and economic influence to dominate smaller countries. Modern imperialistic practices like the economic desire for new resources and markets and a “civilizing mission” ethos can be termed as neo-imperialist strategies.
2. STATE CRONY CAPITALISM CREEPS IN – The state is withdrawing from its earlier welfare policies and is becoming minimalist in nature( primary role restricted to law and order, security) The heads of the major companies become subordinate government agencies. Through forceful control of the state, worker organizations are robbed of their rights to the representation of their interests and forcibly incorporated into the planned system.
3. SPREAD OF CONSUMERISM- Greater choices in front of people has resulted in people becoming more spendthrift, going beyond their means. This exacerbates poverty as poor people ascribing to the demonstration effect spend excessively, leading to increased borrowing and a vicious cycle is formed.
4. CULTURAL EROSION- With the excessive impact of western culture, our traditional value system is getting eroded. Collectivistic Indian culture is giving way to Individualistic Western culture, which leads to the deterioration of the rich cultural ethos of our country.

The Department of Promotion of Industry and Internal trade should work out a clear process and precise regulations as to the level of foreign investment in India in order to maximize the benefits of FDI and FII and at the same time minimize negative impacts.

 IMPACT OF COVID-19 PANDEMIC ON FOREIGN INVESTMENT

Recently, India has revised its FDI rules amid the Covid-19 pandemic. Under the revised norms, the automatic route is now closed to investors from India’s land neighbors, with special reference to China. This new regulation is based on the fear that China may take advantage of the rock-bottom valuations of the firms of national importance in the backdrop of the lockdown. For example, recently People’s Bank of China purchased shares of HDFC Bank at a very low price. However, India is facing a dilemma on this front, as the foreign capital remains crucial to the country’s economic success, and will be doubly important as India tries to revive its economy. Thus, India needs to balance between its economic needs and combating the neo-imperialist tendencies of China. At the same time, as global supply chains shift from China, India should emerge as a good destination for investors. A robust and easily accessible FDI regime, thus, should be ensured. Economic growth in the post-pandemic period and India’s large market shall continue to attract market-seeking investments to the country.

CONCLUSION

The upshot of the above is that since the initiation of economic reforms in India, the flow of FDI in India has accelerated. During the period of the study, there has been an increase in GDP of India with the increase in the investment by FII but this association is found to be statistically insignificant. It indicates that apart from investment by FII, many more factors like inflation rate, savings, price stability, interest rate etc. contribute to the economic growth of India.

The article was submitted by Purvansh Keprate & Shreya Jain