Global economic uncertainties have resurfaced after the 2008-09 crisis with the intensifying sovereign debt problem of the euro zone and prospects of a double-dip recession in the most powerful economy in the world, the US. This is bound to impact the growth prospects of emerging market economies (EMEs). When they need investible resources for development, they face greater volatility of capital flows, especially foreign direct investments (FDI) — in terms of surges and sudden halts, if not reversals.
EMEs experienced substantial FDI inflows just before the 2008-09 crisis, followed by a substantial contraction. The latest numbers indicate that while for some countries inflows have resumed, they have remained subdued in many other countries. India happens to fall in the latter category as FDI inflows declined to $23.4 billion in 2010-11 when compared to $33.1 billion in 2009-10 and $35 billion in 2008-09.
To be sure, there is a substantial literature that has looked into whether FDI makes a difference to growth and other spillovers in host countries. Elif Arbatli’s recent working paper for the IMF* goes further by looking into global and country-specific factors that drive such investments. He has studied the data on 46 countries from 1990 to 2009 with a focus on the effects of the 2008-09 crisis on FDI inflows to EMEs. An interesting part of his research is the effects of political stability and domestic conflict on FDI.
Global factors, especially real GDP growth in the developed G7 countries, have impacted FDI flows to EMEs. A steady increase in growth rates during the 1990s coincided with the first surge in FDI flows and the slowdown in 2000-01 coincided with their decline thereafter. Similarly, the second FDI surge from 2003-07 and contraction from 2008-09 also stems in part from rising growth and slowdown in the G7 — suggesting that FDI flows move up and down in sync with developed-country business cycles.
The persisting regime of low global interest rates also play a role in pushing more FDI flows to EMEs since they make investment projects and mergers and acquisitions easier to finance. The differentials in interest rates with those in EMEs also encourage more capital flows. But this can cut both ways. Weakening growth in the G7 and heightened risk perceptions of investing in EMEs can outweigh the interest rate differential factor and trigger a contraction in FDI to such countries.
As for country-specific factors, Arbatli finds that political stability appears to be crucial in attracting FDI: “Countries that are more prone to domestic conflict and political instability have experienced lower FDI than other countries with similar characteristics.”
If the Indian case is kept in mind, the relevance of political instability and domestic conflict in accounting for the slowdown in FDI to EMEs clearly merits closer attention. To be sure, the global environment has turned adverse, which is bad news by itself for capital flows. At a time of uncertainty, the quality of a country’s legal, political and institutional environment — alluded to in the two open letters written by leading businessmen in India to its political leadership is obviously important.
More From This Section
Post-2008-09, FDI flows to India have slowed due to policy drift.
It was, in fact, the country’s central bank that blew the whistle over the slowdown of FDI, especially during the first half of 2010-11, attributing it to environment-sensitive policies pursued in the mining sector, integrated township projects and construction of ports that appear to have affected investor sentiment. Added to this were persistent procedural delays, travails over land acquisition and the unavailability of quality infrastructure.
In its latest credit policy review, the RBI has argued that India’s external outlook requires closer monitoring; that a greater emphasis needs be placed on attracting more FDI inflows to the country. Although the latest numbers indicate an uptick in inflows during the first half of 2011-12, a big question mark hangs over their sustainability.
But the challenges are equally country-specific since they have a bearing on the general risk perception among foreign investors. India must get its act together on FDI and clear decks for a further acceleration in such inflows by streamlining procedures and removing sectoral caps in insurance, retail trade and financial sector. More FDI will not flow in unless the hassle-component of our regulatory apparatus is reduced. India like other EMEs must compete aggressively to attract more FDI flows
* “Economic Policies and FDI Flows to Emerging Market Economies”, August 2011.
From the Ivory Tower makes research from the academic world accessible to our readers