India’s policy framework is being further liberalised to attract greater foreign direct investment (FDI) for supplementing domestic savings to raise the investment rate and in the context of its widening trade deficit. FDI flows are also expected to bring technology and organisational skills, to create jobs and develop new industries, to expand the base of manufactured exports, and even contribute to productivity impro-vements in the host economy with spillovers of knowledge.

However, FDI inflows vary greatly in their quality. Recent literature has shown that FDI can also crowd out domestic enterprises and actually reduce host country welfare. RIS studies examining the effect of FDI inflows on domestic investments for a large sample of developing countries in a dynamic setting find that 29 countries experience a net crowding out effect while 23 experience crowding in. In general, crowding-out dominates the relationship in Latin America and the Caribbean. In Asia and Africa, cases of Therefore, increasing FDI inflow may be desirable but it is equally important to pay attention to quality, as it is the means for development and not an end in itself.

The quality of FDI should be judged from indirect effects, externalities or the spillovers on economic activity in the host economy. Many host countries employ policies and regulations such as screening mechanisms, performance requirements and incentives to maximise favourable externalities. In general, the objective of such policies is to maximise the chances of FDI crowd-in rather than crowd-out domestic investment. In this context, certain stylised facts may be made, as below.

First, FDI through greenfield investment has better chances of generating positive externalities, compared to the acquisition of a running enterprise (though, at times, acquisition can be favourable). Some countries discourage the latter.

Second, export-oriented FDI has better chances of favourable externalities compared to FDI targeting the domestic market. Export-oriented FDI minimises the possibilities of crowding-out of domestic investment and generates favourable spillovers by creating demand for intermediate goods. Export-oriented FDIs have other externalities— information on export potential for domestic firms, and transfer of best technological practices. Therefore, a number of host countries adopt policies to channel FDI into export-oriented production.

In this context, China’s record is most impressive in pushing FDI through performance requirements to develop export-oriented industries, which now account for 55% of its manufactured exports and as much as 80% of high-tech exports. MNCs, in contrast, account for less than 10% of India’s exports. Experiences of other Southeast Asian countries such as Malaysia, South Korea, and Thailand in this direction—through selective policies and export obligations imposed at the time of entry also deserve careful consideration. India’s own experience with export performance requirements, direct or indirect, has been successful. This has been documented by RIS studies in the food-processing and auto industries.

Third, joint ventures improve the chances of learning by local joint venture partners, absorbing the know-how and building on it. This has been seen in several cases, including the auto industry, where local partners built their technological capability and became globally competitive. Therefore, many countries tend to limit the extent of foreign ownership to encourage joint ventures. India’s vibrant domestic entrepreneurial pool actually makes the joint venture mode an interesting proposition even for the foreign entrant, who can use the resources and networks of local partners to get off the ground quickly.

Finally, FDI in manufacturing generally may have more favourable spillovers, such as employment generation and backward linkages for the domestic economy than in services. For this reason governments have generally been more restrictive to FDI in services. In China, the bulk of FDI is directed to manufacturing.

Thus, quality is as important a consideration for FDI inflows as magnitude, if not more. In particular, India has not been able to exploit the potential of FDI for building export-oriented manufacturing capability. The challenge for India is to effectively leverage the attraction of a large and expanding market for new entrants to push them to use India as an export base, as some MNCs like Hyundai have begun to do for compact cars. Proactive targeting and promotion of export-oriented FDI could also be useful. It may be useful to keep in mind some of the stylised facts summarised above, while considering opening further sectors of the economy to FDI such as retail trade. For instance, it might be useful to insist on joint ventures.

Furthermore, in order to exploit the marketing prowess of foreign entrants, certain export performance requirements may be imposed to prompt them to source inputs from India for their markets in other countries. Export obligations are fully consistent with the WTO’s Trims agreement. Such obligations may actually help these MNCs discover the potential of the country to serve as their global sourcing base. A win-win opportunity, as seen in the case of some companies, in the automobile industry!