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Econometric Approach to analyse determinants of FDI

• Larger host country markets like India & China could be associated with higher foreign direct investment due to larger potential demand, customer base, lower costs and scale economies. 

• At individual level, GDP per capita, financial freedom index, investment freedom index, trade freedom index, labour freedom index, business freedom index, judicial effectiveness and government integrity score affect FDI inflows by more than 10%.

• As per results, major determinants of FDI inflows are GDP at purchasing power parity, financial freedom and corporate tax rates.

• Financial freedom explains why probability of attracting FDI by a category one country is 7% more than category three and 6.7% more than category two. In simple terms, it concludes that financial freedom is one of the crucial factors for improving probabilities to attract FDI. 

Foreign Direct Investment (FDI) is one of the most crucial economic parameters, which facilitate reshaping of an  economy. During 1991, India relaxed the norms of foreign investments, which enabled us to achieve higher growth rates in subsequent years. It is widely accepted that the trends towards globalisation and free markets have had major implications on developing economies when it comes to attracting FDI. The proliferation of FDI inflows into developing countries since the mid-1990s indicates that multinational enterprises have increasingly considered these host countries to be profitable investment locations.

In this analysis, we will be considering several factors, which affect FDI inflows. Larger host countries markets are typically associated with higher foreign direct investment due to larger potential demand, customer base, lower costs and scale economies. This is even more apt for large economies like India and China. The second parameter, which may facilitate FDI inflows is political stability. This includes governance, regulatory framework, property rights index and corruption perspective. In addition to this, countries may also be benefit from the presence of external scale economies, where new investors follow the trend of past investment decisions by other investors in choosing where to invest.

Then come the institutional parameters, which are also determinants of FDI. In our analysis, the following institutional parameters are concerned:

1. Financial Freedom Index

2. Fiscal Freedom Index

3. Government Integration Index

4. Labour Freedom Index

5. Investment Freedom Index

Correlation Analysis

With these parameters becoming more and more favourable for the economy, the probability of attracting FDI increases. For initial analysis, a simple correlation between FDI inflows and considered variables is evaluated for 183 economies. Following is the result of the correlation evaluated in STATA.

According to the table, correlations evaluated of each variable corroborate with the literature. Here corporate tax rates are positively correlated with FDI inflows, as the analysis covers domestic corporate taxes. If domestic corporate taxes are higher, then an industry will be uncompetitive, thus giving scope for foreign investors to reap the gap (as they are incentivised). At an individual level, GDP per capita, financial freedom index, investment freedom index, trade freedom index, labour freedom index, business freedom index, judicial effectiveness and government integrity score affect FDI inflows by more than 10%. Unemployment is negatively correlated with FDI inflows with coefficient at -0.0758 and inflation with -0.0174.

Regression Analysis

Now, let’s move to regression results and asses the overall determinants of FDI. Model used here is as follows:

FDI inflows = α + β. GDP + Σ (β. Institutional factors) + error, where α and β are parameters.

As per the results the major determinants of FDI inflows are GDP at purchasing power parity, financial freedom and corporate tax rates. This brings us to the policy implications of the assessment. India needs to focus on financial freedom and corporate tax as a short-term policy plan to ameliorate its FDI inflows. The Financial Freedom index evaluates the extent of government regulation of financial services, the degree of state intervention in banks and other financial firms through direct and indirect ownership, the extent of financial and capital market development, government influence on the allocation of credit and openness to foreign competition. Higher index values denote banking efficiency and independence from government control and interference in the financial sector.

Now when it comes to corporate tax, result does not imply just decreasing corporate tax for burgeoning FDI inflows, rather it says that more incentives need to be given for attracting foreign firms, so that the relative gap between what domestic firms and foreign firms pay remains significant.

One more econometric tool is implemented to see how top economies, according to GDP per capita at PPP, behave differently with the others in terms of probability of attracting FDI. Three categories were created of all considered economies based on the GDP per capita at purchasing power parity. Economies having higher than the mean GDP value are given rank 1, indicating tendency to attract higher FDI. Countries having less than US$ 1,000 of GDP at PPP is given a rank of 3. This benchmark is in line with the benchmark suggested by WTO and World Bank for categorizing a country as a least developing nation. All other countries were given a rank of 2, describing the state of uncertainty. The discussed methodology is adapted on the basis of one of the research papers.

Multinomial Logistic Analysis

Model specified is Category = α + β. GDP + Σ (β. Institutional factors) + error, where α and β are parameters.

Let’s have a look at multinomial logit result:

As we can see, in category one, both GDP at PPP and institutional parameter are explaining the probability to attract FDI, whereas in category two only GDP at PPP explains FDI attractiveness. For GDP factor, probability of attracting FDI by category one, two and three remains same. But for financial freedom, probability of attracting FDI by a category one country is 7% more than category three and 6.7% more than category two. In simple terms it concludes that financial freedom is one of the crucial factors for improving the probabilities to attract FDI.

Here India’s prime focus should be to revamp those indicators, which bolster financial freedom. This includes government regulation of financial services, degree of state intervention in banks and other financial firms through direct and indirect ownership, extent of financial and capital market development, government influence on the allocation of credit and openness to foreign competition.

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