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FDI has played an important role in the process of globalization during last three decades by becoming a predominant and vital factor in influencing the contemporary process of global economic development. Moreover, it is often seen as a catalyst for economic growth, especially in the developing nations. As most of the developing counties operate in the low-level equilibrium trap, that is, low savings rate, followed by low investment rate and therefore, low per capita income growth rate, may escape from the trap by importing capital from abroad in the form of FDI (Hayami, 2001). Thus, inward FDI helps to bridge the gap between desired and actual level of capital stock, especially when domestic investment is not sufficient to push the actual capital stock to the desired level (Noorbakhsh et al. 2001). Besides the direct impact of FDI on capital formation, it can also accelerate growth by generating employment, transfer of knowledge and management skills through linkages, managing the huge gap between saving investment demand in the recipient countries (Frenkel et al., 2004). Apart from this, FDI is expected to enhance technological change through spillover effects of knowledge and new capital goods, i.e. the process of technological diffusion. There is a variety of channels through which diffusion of technology can take place such as imports of high technology products, adoption of foreign technology and acquisition of human capital through various means (Easterly et.al., 1994). FDI by MNCs is considered to be a major channel for access to advanced technologies by developing countries. The introduction of new technologies to the host country however requires a minimum level of human capital threshold in order to absorb the anticipated positive spillover effects of FDI. The absorptive capability of the host country together with the introduction of advanced technology is the vital determinant for long-term economic growth (Nelson and Phelps, 1966). Based on these arguments, the emphasis of policymakers in the early 1980s shifted to attract more foreign capital, as a result, most of the developing economies significantly eased the restrictions on FDI inflows and operations of multinational enterprises (MNEs). Consequently, FDI has grown at a phenomenal rate since the 1980s, and developing countries have become increasingly attractive investment destinations. According to World Investment Report 2021, FDI inflows to developing countries accounted for two-third of global FDI in 2020 in which, remarkably, four out of top ten FDI recipients are developing economies. Some of the countries in Asian region, which have developed long-term sources of comparative advantages in the form of superior technological capabilities and supporting infrastructure, have consistently attracted greater volumes of export-oriented FDI (Palit and Nawani, 2007). In India, the growth of FDI inflows was not significant until 1991 due to the regulatory policy framework. In early 1990s, India suffered from a huge economic crisis and being unable to sustain the economy, government introduced a drastic economic reform programme in the form of LPG policy as a pre-condition to receive assistance from IMF. This progressive liberalization, coupled with financial sector reforms, hike in the foreign equity participation limits, reduction of controls on technology and royalty payments and dual route for FDI approval reflected in consistent rise of FDI flows to the country that increased nearly fivefold during the period 2001-10. According to data with the Reserve Bank of India, FDI into India increased from $97 million in 1990-91 to more than $81,722 million in 2020-21 in absolute terms. Lately, India has emerged as the fifth largest recipient of FDI inflows across the world (World Investment Report 2021, UNCTAD). Though, in 2021, FDI inflows into India have waned in comparison to the preceding year dropping by 30 percent to $45 billion in 2021 when equity inflows and reinvested earnings are not included, India’s rank surged to 7th position among top recipients of FDI in 2021 (World Investment Report 2022, UNCTAD). Such a decline can be approximated to massive decline in cross-border mergers and acquisitions (M&As) and downtrend in green-field investments due to regulatory uncertainty and land acquisition problems in various states. Therefore, it is imperative to move towards a more stable policy and regulatory framework as well as improving business environment in the states.

Theoretically, FDI is believed to be a positive contributor to economic growth of host countries both directly as well as by creating positive externalities. Neo-classical growth theory proposed by Harrod (1939) and Domar (1946), postulates that foreign investment leads to higher rates of growth in host countries as a result of addition to capital stock in the short-run. Later, Solow (1956) observed that saving and investment ratio boost economic growth in the short-run, while in the long-run, positive economic growth is largely affected by changes brought by technology, which is determined by exogenous factors like FDI. On the other hand, endogenous growth theory pioneered by Romer (1990) argues that technology transfer through FDI raises the level of human capital, a crucial determinant in the growth process, which further generates increasing returns to capital and stimulates economic growth.

To achieve the objectives of the study, secondary data is used which has been compiled by the previous studies from various sources i.e., World Investment Reports (UNCTAD), United Nations, publications of RBI, Secretariat of Industrial Assistance (SIA) newsletter, economic surveys and websites of World Bank and IMF. The research paper has focused on post-liberalization period by taking into account the studies published from 1992 to 2017. The paper follows a descriptive review which includes a systematic and transparent procedure of selecting the relevant studies and then screening and classifying them on the basis of objectives of the study.

1. International Studies

In empirical literature, the impact of MNEs and FDI on economic growth is ambiguous. Some studies indicate that FDI may have a strong positive effect on growth rates in developing countries, though the size of such impact may vary across countries.

1.1 Direct Positive Impact of FDI

Ram and Zhang (2002) have empirically assessed the role of FDI in economic growth of host countries using the technique of ordinary least-squares (OLS) on cross-country data of 85 countries over the period 1990-97. The paper reflected that with enormous increase in FDI flows, the nexus between FDI and host country’s economic growth seems to be generally positive for the 1990s. In another study, Andreas (2004) has discussed the effect of FDI inflows on host country’s economic growth through technology spillovers and physical capital inflows by using panel data for 90 countries. The results revealed that FDI inflows enhanced economic growth only in case of developing economies and uni-directional causality ran from FDI to economic growth. Bhavan et.al. (2011) explored the effects of FDI on growth in four South Asian countries by using Arellano Bond dynamic model for the period 1995 to 2008 and concluded that FDI in these countries has a significantly positive relationship with growth rate. Rehman and Ahmad (2016) in their study of 21 developing countries, for the period between 1990 and 2013, have applied panel unit root test and pooled mean group (PMG) estimation techniques. The results indicate that there is a positive and significant impact of net FDI on economic growth in the long run. In another study, Saji and Haridasan (2019) made an attempt to compare macroeconomic performance in terms of FDI-led growth of 17 emerging and 14 transition economies by employing a fixed effect panel model. The findings revealed that the causality between FDI and economic growth is bidirectional in emerging economies and unidirectional in transition economies, where 70 percent of the contribution in the former is due to Greenfield investment. In a recent study, Dalaseng et al. (2021) empirically investigated the relationship between trade openness, FDI and economic growth for 105 developing economies. Results revealed a positive impact of FDI on economic growth, though not statistically significant.

1.2 Indirect Impact of FDI

Some of the empirical studies throw light on the fact that effect of FDI may not be significant alone, however, combined with the technological progress, productivity spillovers, absorptive capacity, prevailing infrastructure, local conditions and policies of the host country, FDI inflows significantly influence the economic growth. In their study of 78 developing countries and 23 developed countries, Blomstrom et.al. (1994) found that there was a significant positive effect of inflows of FDI on per capita income growth rate of middle-income countries as they are able to absorb the knowledge spillovers due to their richer skill endowments. However, the effect of FDI on growth was not statistically significant for lower income developing countries as they are too far behind in their technological levels. On the other hand, Borensztein et.al. (1998) in their study of the growth effect of FDI in 69 developing countries reveal that in comparison to domestic investment, FDI contributes more to growth and has an important role to play in technology transfer. Besides, there is a strong complementary effect between FDI and human capital as well. In another study of 84 countries for the period 1970-99, Li and Liu (2005) found the endogenous relationship between FDI and economic growth only from mid-1980s onward. FDI promotes economic growth not only directly, also via its linkages with human capital and technological gap, where the former has a significant positive effect and the latter has a negative impact on economic growth of developing countries. Demissie (2015) explores relationship between FDI and economic growth over 1985 to 2015 and results support the positive growth effect of FDI for the pooled 56 countries and upper middle-income countries. Moreover, the interactive term of FDI and human capital included in model reveals that a minimum level of human capital is essential in order to maximize and absorb the growth effect of FDI. Tsaurai (2017) employed Fisher panel generalization method of co-integration and GMM estimation to examine the impact of FDI on growth. He found that although FDI has a positive coefficient, independently it lays statistically insignificant impact on economic growth of emerging economies. Rather, it is human capital through which FDI significantly influences growth in these economies.

A fair amount of empirical evidence on the moderating role of financial sector development in FDI-growth nexus is also available. In one of the studies, Carkovic and Levine (2002) employed system GMM panel estimator and found weak support for an exogenous robust, positive effect of FDI on economic growth. Findings indicate that local conditions such as the development of the local financial markets or the educational level of the country might create hindrance for the host country to take full advantage of FDI. Hermes and Lensink (2003) in their study found a positive impact of FDI on growth of 37 countries (mostly in Latin America and Asia) due to a sufficiently developed financial system. Whereas, for the countries in Sub-Saharan Africa, FDI does not contribute positively to growth owing to weak financial systems. Azman-Saini et.al (2010) explored the link between FDI, economic freedom, and economic growth in a panel of 85 countries and results clearly indicate that there is no direct or positive effect of FDI individually on the growth of output. The positive impact of FDI on growth “kicks in” only after financial market development exceeds a threshold level. Therefore, the outcomes of these empirical investigations suggest that only those host countries that provide most favorable conditions for foreign investment and have well developed financial markets can reap maximum benefits from FDI.

Another set of findings are consistent with the view that FDI inflows do not influence economic growth independently, rather it is the sound economic policies adopted by host countries which may spur both growth and FDI. Balasubramanyam et.al. (1996) studied the effects of FDI on average growth rate of 46 developing countries over the period 1970-85 and observed that the growth effect of FDI was significant and positive only for those countries that pursued export-oriented strategy. Reichert and Weinhold (1999) in their study of 24 developing countries found that in comparison to domestic investment, FDI is more efficient in raising future growth rates of economies that follow open policies, although the relationship is highly heterogeneous across countries. Zhang (2001) studied 11 developing countries in Latin America and East Asia over the period 1960-97. The Johansen procedure suggests that FDI and GDP are co-integrated for only five countries in the long-run (Colombia, Mexico, Hong Kong, Indonesia and Taiwan) and the results of error-correction model (ECM) also indicate a strong causality between FDI and GDP-growth for these countries. The long-run causality between the two variables runs in both directions for Indonesia and Mexico, and for three other countries there is unidirectional causality. In sum, it is clear from the findings that countries with trade liberalization policies, and macroeconomic stability have better chances to boost their economic growth via FDI.

1.3 Neutral Effect of FDI

Apart from the optimistic viewpoint, few studies challenge the widespread belief that FDI generally has a positive impact on economic growth in developing countries and observe that the effect of FDI on growth is neutral and non-significant in some cases. In one of the earliest studies, a study by Fry (1992) suggests that FDI inflow neither increased domestic investment nor it provided any additional BOP financing for the 16 developing countries. In control group of 11 developing countries, FDI reduced the domestic investment; however, FDI raises domestic investment by full extent of the FDI inflow for the five Pacific Basin market economies. While studying the manufacturing sector of Morocco for the period 1985-89, Haddad and Harrison (1993) found no significant relationship between higher productivity growth in domestic firms and greater foreign presence in a sector. Agosin and Mayer (2000) examine whether FDI crowds-in or crowds-out domestic investment in a sample of 32 countries by employing the method of SUR with country fixed effects. They found that for the period as a whole, FDI crowds-in domestic investment in Asian countries, crowds out in Latin American countries, while in Africa, the relationship is neutral, that is, FDI has increased overall investment one-to-one. Therefore, it can be inferred that there is no assurance of positive impacts of FDI on domestic investment and simplistic policies are unlikely to be optimal. Herzer et.al. (2008) re-examine the FDI- growth relation in 28 developing countries and the results reveal that there is no effect of FDI on economic growth in either short run or long run in most of the selected countries. Out of the total sample, FDI has a positive impact on GDP only for 15 percent of the countries in the long run and 18 percent of the cases in the short-run. For some countries, they also find strong evidence of growth-limiting effects of FDI in the long or short term. There is no clarity on relationship between the impact of FDI on growth and the level of per capita income, level of education, degree of openness and level of financial market development in the selected countries. 

1.4 Negative Effect of FDI

On the contrary, few studies have found that FDI also has its own costs in the host economy. It might put more pressure on competition and drive out the local firms due to their oligopolistic power and might deteriorate the balance of payments when the repatriations of profits occur. Edrees (2005) investigated this hypothesis in 39 Sub-Saharan African countries, which included both low income and middle-income economies. The results reveal that FDI coefficient is statistically significant and negative for both the country groups. Likewise, Frimpong and Oteng-Abayie (2006) study the impact of trade and FDI on economic growth of Ghana in the long run by applying the bounds testing (ARDL) approach to co-integration. The results indicate that the coefficient of FDI has a significant negative impact on growth and this confirms that FDI dominance in the mining sector of Ghana does not generate direct growth impacts on the wider economy.

2. Studies In Indian Context

Since the introduction of economic reforms in 1991, India has liberalized its economy to a large extent, which has resulted in a rapid increase in FDI inflows during the subsequent periods. FDI as a strategic component of investment has become essential for sustained economic growth and development of India through creation of jobs, expansion of existing manufacturing industries, short and long term project in the field of healthcare, education, research and development (R & D) etcetera (Mahanta, 2012). Despite increasing flow of FDI in the recent years, only a handful of studies to date have attempted to explain the impact of FDI and provided mixed conclusions.

2.1 Direct-Positive Impact of FDI

Sahoo (2004) explores the impact of FDI inflows into India using granger causality test and panel co-integration technique (PCONT). The major findings of the study at the macro-level suggest that FDI has played a vital role in economic growth of the country and contributed significantly to rise capital formation, though it has not been successful in increasing exports and savings. The findings at sectoral level reveal that FDI inflows to the major sectors in India have made a positive impact in increasing the output, labor, productivities and export. In their study to examine the relation between similar variables for the period 1991 to 2011, Rajput et.al. (2012) structured a model that depicts the contribution of FDI to economic growth. It is observed from the results that FDI is a significant factor influencing the level of economic growth in the country and helps in increasing the trade in international market. Thus, FDI inflows have the potential to give a boost to the Indian economy given that the flow of FDI is high enough for a large economy like India. Guru-Gharana (2012) has investigated the Granger Causality among exports, FDI and growth in India in the post-liberalization period by employing a more recent and robust Toda-Yamamoto-Dolado-Lutkephol augmented VAR (p) technique. Results reveal a significant bi-directional causality between Export and GDP and unidirectional causality running from FDI towards both GDP and Exports. Besides having a direct causal link fostering GDP, FDI is also an indirect channel of influencing GDP through positive impact on Exports. Similarly, Singh (2013) in his study for the period 1970 to 2012 suggests that FDI, capital and trade granger-cause GDP per capita in the long run. While, capital investment and FDI have a significant positive impact, trade has a significant negative impact on per capita GDP in the short run. There exists bi-directional granger-causality between FDI and trade and uni-directional granger-causality runs from FDI to economic growth and economic growth to capital investment. In a study by Dash and Parida (2013), causality results indicate the presence of bi-directional causal relationship between FDI and economic output, services export and FDI as well as between services exports and economic output. At the sectoral level, there is at least a unidirectional causality from FDI and services exports to the output of both manufacturing and services as well as cross-sectoral spillover effects from output of manufacturing to that of services and vice versa. Lately, Choi and Baek (2017) have re-examined the FDI-growth nexus in India by emphasizing productivity spillover effects for the period 1978 to 2010. The co-integrated vector auto-regression approach reveals a stable, long-run equilibrium relationship among FDI, exports and total factor productivity (TFP). FDI and exports are driving variables in the system and significantly influence long-run movements of TFP in India, however, are not influenced by the TFP. India’s inward FDI has positive spillover effects in the form of technological improvements and transfer of advanced managerial skills to domestic firms, which further leads to increase in TFP growth. Thus, it can be concluded from the studies that FDI is the main catalyst for economic growth in India. Rakshit (2021) has empirically investigated the nexus between FDI, trade and economic growth in the long-run, covering the period of pre as well as post-economic reforms. The results reveal a unidirectional causality from FDI inflows to per capita GDP growth in India, though such a relationship was not found in the short-run. Therefore, such policies should be formulated that assist in maximizing the benefits from spillover effects of inward FDI in the long-run.  

2.2 Indirect link between FDI and Economic Growth

On the contrary, few studies have pointed out that causality mostly runs from the variable of economic growth towards FDI and inflows of FDI have indirect impact on the growth of host country. Chakraborty and Basu (2002) have analyze the link between FDI and growth for India by employing a structural co-integration model with vector error correction mechanism. It is found that there exists two co-integrating vectors between GDP, FDI, the unit labour cost and the share of import duty in tax revenue, which captures the long run relationship between FDI and GDP. The results of VECM reveal that FDI does not granger-cause GDP, that is, causality runs more from GDP to FDI and, there was some positive impact of trade liberalization policy of India on the FDI flows in the short-run. Sahoo and Mathiyazhagan (2002) examined the relationship between FDI, export promotion and economic growth using quarterly data for the period 1991-I to 2000-IV. The results of Johansen co-integration test demonstrate that there is a long-run relationship between GDP, FDI and export, and industrial production, FDI and exports. The elasticity coefficients between exports and GDP, and exports and IIP are positive. It implies that FDI does not matter in the growth of the economy, yet it contributes significantly to the exports in India. Therefore, in order to achieve higher economic growth, it is advisable to open up the export-oriented sectors in India. Finally, Sarbapriya (2012) has attempted to analyze the causal relationship between FDI and economic growth in India for the period 1990-91 to 2010-11. The empirical analysis on basis of ordinary least square method suggests that there is a positive relationship between FDI and GDP and vice-versa. The results also confirm that the two variables are co-integrated in the long-run and uni-directional causality runs from economic growth to FDI. Yadav & Jain (2022) in their empirical analysis examined the role of absorptive capacities of a host economy in the FDI-growth relationship. They discovered that if variables such as, financial development, institutional quality, technological capability, and trade openness exceed a certain threshold level, FDI has an invigorating impact on economic growth. However, the interaction of FDI with infrastructure and human capital has a stimulating impact on growth only in case of non-linear analysis.

2.3 Negative Effect of FDI

The studies that have attempted to measure the sector wise FDI inflows have found differential impacts of direct foreign investment due to its non-homogenous nature across sectors. Chakraborty and Nunnenkamp (2008) have attempted to assess the dynamic relationship between FDI and economic growth in the post-reform period across 15 industries in primary, secondary and tertiary sectors by employing Granger causality tests. The results reveal that there is a strong bi-directional relationship between FDI and economic growth in both short-run and long-run, though this causality is relatively weaker in the whole 15 industries. There is no presence of any causal relationship between FDI stocks and output in the primary sector, though these variables mutually strengthen one another in the manufacturing sector. Remarkably, the effects of FDI on output are transient in the services sector. In another one of a kind study in India, Jana, Sahu and Pandey (2019) have examined the impact of FDI inflows in three economic sectors- agriculture, manufacturing and services on their respective growth  and employed techniques such as, VECM, Granger Causality test and variance decomposition analysis. The study, unlike manufacturing and services sector, finds that in agriculture sector, FDI inflows fail to exert any positive influence and even have a negative impact on its output growth in the initial years. The study, thus, recommends policy makers to continuously encourage FDI in primary sector and improve its vitality by upgrading the infrastructure and technology base.

The FDI-economic growth relation in India is still inconclusive, as past studies have provided mixed conclusions. Despite the fact that most of the reviewed literature has revealed a positive effect of FDI inflows on the growth of Indian economy, still numerous studies have shown that foreign inflows in form of direct investment may not exert any influence or even affect the growth in a negative way for some sectors. Further, the studies have employed similar econometric techniques to test the causal relationship between FDI and economic growth in India. Such econometric techniques suffer from various shortcomings as they provide asymptotically non-reliable results due to the possibility of size distortions and inference biases (Lutkephol, 2004). The only exception is study by Guru-Gharana (2012) which has used a more recent and robust TYDL-augmented VAR technique for testing causality. So, the existing studies did not fully control for simulative bias, country specific effects and industry specific effects.

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