Foreign Direct Investment and Macroeconomic Factors: Evidence From the Indian Economy

Abstract

FDI in India has – in a lot of ways – enabled India to achieve a certain degree of financial stability, growth and development. According to Ernst and Young's 2010 European Attractiveness Survey, India is ranked as the fourth most attractive foreign direct investment destination in 2010. The factors that attracted investment in India are stable economic policies, availability of cheap and quality human resources, and opportunities of new unexplored markets. Mostly FDI are flowing in service sector and manufacturing sector recorded very low investments. Besides these factors, there are a number of macroeconomic factors that are expected to affect FDI in India.

This paper examines the relationship between FDI and six macroeconomic factors – Exchange rate (Rs. per $), Inflation (WPI), GDP/IIP (proxy for Market size), Interest rate (91days T-bills), Trade Openness and S&P 500 Index (profitability) using monthly and quarterly data for the period starting from July 1997 to December 2011. Besides using the standard techniques such as ADF and PP Unit root stationarity test, Bi-variate and Multi-variate Regression analysis and Granger Causality test, we use advanced econometric techniques such as Johansen’s Co-integration test, Vector Auto Regression (VAR) and Impulse Response analysis to check for long run and short run dynamic relationship.

We find a significant correlation between FDI and macroeconomic factors (except for Exchange rate). Regarding causality results IIP/GDP, WPI and S&P 500 Index are granger causing FDI inflows in India, Trade Openness is granger caused by the same. All the macroeconomic variables considered (except Exchange rate) are significantly affecting FDI inflows and the overall explanatory power of the regression model is 75.7%. The results of Johansen’s Co-integration test reveal that there is long run causal relation between FDI and IIP; FDI and S&P 500, FDI and Trade Openness and FDI and WPI. This implies that select macroeconomic factors have direct long run equilibrium relationship with FDI. Vector Autoregression and Impulse response analysis show that FDI is caused more by its own lagged values rather than past values of other macroeconomic factors. A shock generated in real economy (IIP or GDP, Exchange rate and Interest rate) has a negative effect on FDI inflows which lasts for about two months, while the response of FDI to shocks created in foreign trade policy and stock market is positive and significant.

The research findings have important implications for policy makers and foreign investors. Policy makers need to push reform agenda in domestic market so as to attract more FDI in the Indian economy. Since, there is positive relationship between FDI and stock returns, a higher investor’s confidence in domestic market acts as a stimulus in attracting FDI inflows.

Keywords: Foreign Direct Investment, Macro-economic factors, Unit root stationarity, Granger causality test, Johansen’s Co-integration test, vector auto regression, Impulse Response analysis

JEL Classification: F23, E11, C22, C19, C32