On Dynamic Relationship between Foreign Direct Investment (FDI) and Macro-Economic Factors: The Indian Experience

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 SP 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.