Foreign Direct Investment, Spillovers, Linkages and Economic Development: A Case of China and India


The rise of China and India is one of the most important economic phenomena in the world today. Together, they account for 40 percent of the global population of working age and on the basis of purchasing power parity (PPP) 18 percent of the global economy. For two decades, their economies have been growing twice as fast as the rest of the world. According to the present trends, in another two decades their share in the global economy will match their proportion of the global population. Indeed, in a decade, China’s and India’s economy should, in terms of PPP, surpass that of the US and Japan, respectively. China is marching ahead with over 10 percent gross domestic product (GDP) growth rate over the last two decades by following the conventional path of transiting from an agricultural economy to a robust industrial economy—an evolution observed in many developed countries, including the US, Japan, South Korea and Taiwan, and in the process, building vital linkages among its agricultural, industrial and services sectors, and systematically encouraging domestic consumption concomitant with a sharp focus on exports.
This paper aims to examine some issues related to foreign direct investment (FDI). To start with, the issue that India and China, which represent examples of very large emerging markets, perform so markedly different in attracting FDI, despite the increase in the importance of global drivers behind FDI is looked at. It is attempted to understand the fundamental difference in the individual approaches adopted by the two countries to tread the path of economic liberalization. The high profile and much hyped growth of the ITES sector in India and the reasons as to why it has not really made much difference to the India’s mass in terms of improvement in quality of life is also examined here. The paper is divided into four parts. In the first part, some of the landmark studies on FDI are discussed and the need for companies to opt for FDI is analyzed. The two models of growth adopted by India and China and the reasons for which ITES growth has not really done wonders for the Indian economy is examined in the second part. The third part explores the reasons for the difference between these two models. And finally, in the fourth part, some of the lessons, which can be learnt from each other to further optimize the FDI inflows, are taken note of.
Literature Review on FDI: Some Landmark Studies
There is a presumption among many academics and policymakers that FDI is special. One common view is that FDI helps accelerate the process of economic development in host countries. During the last two decades, many emerging economies have dramatically reduced barriers to FDI, and countries at all levels of development have created a policy infrastructure to attract multinational firms. Standard policies to promote FDI include the extension of tax holidays, exemptions from import duties, and the offer of direct subsidies. In this part of the paper, it is examined as to whether or not policies to promote FDI make economic sense. While eliminating barriers to foreign investment is one way of achieving global market integration, promoting FDI goes one step further by favoring one form of integration—expanded foreign control of productive assets—over others, such as increased trade in goods, more international licensing of technology, or larger cross-border flows of portfolio capital. A large empirical literature examines the factors which determine where multinational enterprises locate their production facilities. This literature is discussed briefly in order to identify the potential efficacy of attracting FDI.
MNCs is guided by at least three distinct types of advantages: A firm must own or control a unique mobile asset (e.g., a patent or trademark) it wishes to exploit (`the ownership advantage’); it must be cost-efficient to exploit the asset abroad in addition to, or instead of, in firm’s home country (`the location advantage’); and it must be in the firm’s interest to control the asset’s exploitation itself, rather than assigning the use of the asset to an independent foreign firm (`the internalization advantage’). Moreover, as a matter of fact, headquarters activities are relatively skill- or capital-intensive and production is relatively labor-intensive. But if factor prices are not equalized across countries, then a firm has an incentive to become a multinational in order to exploit differences in factor costs between countries. It could do so by locating its headquarters in a capital-abundant (low-capital cost, high-wage) country and production in a labor-abundant (high-capital cost, low-wage) country. This would give rise to vertical FDI—the creation of a multinational whose country operations specialize each in a distinct vertical stage of production (Helpman, 1984; Helpman and Krugman, 1985).
In the 25 years since China initiated reforms, it has grown at an average of 9.4 percent a year, compared with average growth of 5.8 percent in the 25 years prior to reforms. This sharp acceleration in economic growth has been achieved by the implementation of major structural reforms. The government has focused on improving its human capital with a universal mandatory nine-year education requirement and by implementing aggressive labor reforms. Higher domestic savings, aided by positive demographic changes and rising FDI due to low foreign investment barriers, have helped increase capital accumulation. The accumulated capital has been rightly channeled into development of an infrastructure network to build a scale of operation, which in turn, enables the effective use of cheap labor. A focus on exports supplements domestic demand and improves cost competitiveness.
Growth in IT Sector and Economic Development
While India rides the IT wave, the growth is chaotic with relatively insignificant domestic linkages and consumption. The argument that the IT sector can serve as the backbone for India’s resurgence on the global economic front is weak. India lags behind China in creating the infrastructure to sustain and grow economic activities. Little attention is paid to create jobs for masses, or to formulate policies that touch the masses for sustained development. A strategy that relies on the movement of white-collar jobs from developed nations to India is difficult to sustain. Many of these jobs, especially those related to business process outsourcing (e.g., call center jobs); create little or no intellectual property for Indian firms. With few barriers to enter or exit, these jobs will shift to other countries for the same reasons they moved to India. The case for sustainability is only marginally stronger in the software development sector, where tacit and explicit knowledge regarding software design and processes can provide some sustainable competitive advantage.
The Labor Flexibility Issue
Another area of radical difference between India and China is in employment relationships. India has one of the most formally protected labor markets in the world, yet this protected enclave coexists alongside an unregulated labor market that is much larger. The organized industry and services sector account for 27 million jobs (just 7 million in manufacturing), while the total Indian labor force is about 406 million. Any registered firm, that is one employing more than 100 people, is required to seek permission from the state government to retrench its workforce under Section 5B of the Labor Code. In China, the right to hire and fire has been enshrined in SEZ Regulations since 1982. Moreover, in India, there are strict regulations which stipulate that contract labor is only allowed work of a temporary nature. By contrast, the World Bank survey (2002b), estimates that firms in Guangzhou employ more than 20 percent of the labor force as non-permanent workers. Of course many Indian employers find ways circumvent the regulations through outsourcing and less formal means but the current system undoubtedly reduces flexibility.
The Road Ahead: Greater Focus on Manufacturing is Inevitable for India
Although the higher growth in services outsourcing will help, an increased focus on manufacturing and construction of an adequate infrastructure will be inevitable to accelerate overall economic growth and maintain social stability. Increased investment in manufacturing, construction and agriculture is necessary for generation of mass employment, ensuring that the lower income strata can participate in economic progress. A rising share of the working population alone will not be enough. Accelerating growth in the stock of people employed in productive work would act as a virtuous driver for higher income, savings and investments. However, a greater presence in manufacturing would require higher savings for India to be able to invest in the much needed development of its physical infrastructure. A policy change to facilitate a turnaround in public savings and allocation of resources targeting creation of productive employment opportunities are critical for improving overall savings. This capital formation needs to be augmented further by encouraging more FDI and privatization or disinvestment in the public sector. India also needs to initiate investments in creating world-class infrastructure, if not for the whole country, at least in pockets by creating SEZs, etc. Investment in infrastructure sectors needs to be increased to at least 9 percent of GDP (about US$65 bn) from about 6 percent currently, to sustain the GDP growth at 7 percent.
Another front which warrants attention is taxes. Indian tax rates are currently among the highest in emerging economies. In today’s fast-globalizing world, where import tariff barriers are reduced by all countries, India still has interstate trade taxes. India needs to adopt a consolidated value-added tax (some states have not adopted it yet), instead of multiple point and multiple rate production and sales taxes. Moreover, indirect taxes are inherently regressive and affect productivity adversely. India’s labor laws remain restrictive. However, relaxing only the labor laws will not help unless some of the other relevant reforms, such as encouraging investment in labor intensive-sectors—for example, agriculture, rural non-farm activities (village industries) and construction—are made to reduce the negative impact of restructuring-related job losses.
Lessons for China
With the next wave of globalization likely to be in services, China may need to start looking at opportunities in IT services exports and business process outsourcing. China’s biggest challenge in sustaining its current high growth trend lies in strengthening institutional framework and implementing financial sector reforms. Although China has left India far behind in terms of success in implementing many of the macro reforms, it has not really focused on the creation of an institutional framework, especially in terms of legal system, capital markets and financial markets. China’s biggest problem relates to its banking system. There is hardly any competition in the banking system and there is overdependence on the banking system to finance business investments. Another issue where China needs to work on is to focus on tertiary education and create environment to encourage private entrepreneurs. China reasonably placed greater emphasis on primary education at the initial stages of the development of its economy; it now needs to ensure adequate emphasis on tertiary education to match its growing needs. Moreover, China has created limited opportunities for homegrown private entrepreneurs. The government continues to be the major player, owning by far the majority of the country’s production
Over the next three to four years, India and China will continue to be complementary destinations in the global business environment, with China being the factory for global manufacturing and India the services workshop to the world. However, India is keen to participate in manufacturing outsourcing and China will eventually build a presence in services. Hence, the case for taking a view on `India or China’ may arise in five to ten years from now, but in the meantime, it is `India and China’.
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