Foreign direct investment (FDI) inflows into India are on the rise. According to the IMF, FDI refers to “an investment made to acquire lasting interest in enterprises operating outside of the economy of the investor.” FDI is considered one of the most stable forms of non-debt creating capital inflows, with significant positive effects on the economy.

In the case of India, FDI inflows have risen rapidly, from $24 billion in 2012 to $44.2 billion in 2015 — a seven-year high. This increase is also fairly broad-based. It is not just the e-commerce (trading) sector that has received more inflows; other sectors such as computer software and hardware, construction, services, autos and the telecom sectors also account for a large share of the increase.

Interestingly, even though China continues to attract larger FDI inflows than India in absolute terms, India has started to close the gap, when FDI is measured as a share of GDP. FDI inflows into China have moderated to 2.3 per cent of GDP in 2015, from 2.6 per cent in 2014. During the same period, FDI inflows into India rose to 2.1 per cent from 1.7 per cent.

Additionally, one could also argue that the quality of FDI inflow into India is much better. Over the last decade or more, China has accumulated a large stock of FDI. As a result, almost half of the FDI inflow into China includes retained earnings. In contrast, almost three-quarters of FDI inflows into India are fresh equity infusions.

Supply chain The resurgence of FDI inflows into India can be traced to both domestic pull factors as well as global push factors. On the domestic front, India has emerged as one of the fastest-growing Asian economies, while China’s growth has stumbled due to large overcapacity and high leverage.

More importantly, ongoing economic reforms in India are likely attracting FDI flows. FDI limits have been increased in various sectors such as defence, railway infrastructure, insurance and construction (to name a few). Incremental reforms aimed at improving the ease of doing business and to improve public infrastructure have perhaps also encouraged long-term investors.

What may also have helped are pull factors such as rising labour costs in China. Rising costs in China have partly pushed multinational corporations (MNCs) into shifting production base to South-East Asia, such as Vietnam. India, belatedly, is possibly benefiting from production facilities moving out of China.

India has not been a part of the Asian supply chain in the past. Because of their widespread operations, MNCs have tended to segregate their production process into various stages, with different countries specialising in different stages based on their relative comparative advantage (vertical FDI). This led to a rapid rise in trade of components and parts across the supply chains located in various Asian countries. India could become a part of this supply chain in years ahead.

Can this trend of rising FDI inflows continue? According to the 2016 AT Kearney Foreign Direct Investment Confidence Index, the most important factors that drive an MNC’s decision to invest in a country include domestic market size, cost of labour and governance issues, such as regulatory transparency, the level of corruption and efficiency of the legal processes. What this implies is that if India continues down the path of economic reforms, both at the Centre and state levels, then the FDI outlook could be significantly more positive.

Early indicators are positive. Electronics manufacturer Foxconn announced an investment commitment of $5 billion in new manufacturing facilities across India over the next five years, and also plans to service Africa and West Asian markets from India. In 2015, General Motors announced that it would invest $1 billion in India over the next few years, to turn India into a global export base for emerging markets. GE and Alstom have already bagged a $5.6-billion contract from Indian Railways for locomotive supply and maintenance.

Rising FDI inflows can have significant positive effects on an economy. For an investment-starved economy such as India’s, they can provide the requisite financial capital while ensuring a stable source of financing the current account deficit. From a real-economy perspective, greenfield FDI inflows can boost growth prospects through job creation, buttressing investments and by enabling higher productivity and competitiveness.

The writer is Executive Director and India Economist, Nomura

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