FOREIGN DIRECT INVESTMENT AND GROWTH OF INDIA: DOES FINANCIAL SECTOR DEVELOPMENT HELP IN IMPROVING ABSORPTIVE CAPACITY?

(ProQuest: ... denotes formulae omitted.)1.INTRODUCTIONForeign direct investment (FDI) inflows to India rose from an average US$100 million in the 1980s to exceed US$2 billion in the later 1990s. They peaked to US$43 billion in 2008. These steep increases in FDI are attributed to economic reforms initiated in 1991 and implemented gradually during the next two decades. As regards foreign trade, tariffs were reduced on goods of consumption and capital goods. The average tariffs fell from 87 percent in 1990 to 25 percent in recent years. In the domestic sector, banking sector and capital markets were opened up to foreign banks together with reduction in rates of taxes on individual and company incomes. As a result, after growing at less than 2 percent in earlier decades, India's economy which grew by 5.1 percent in 1992-93 soon after reforms, maintained higher rates of growth during 2010-14, at above six percent.There was notable progress in financial sector development (FSD) as well. The improvements flowed from increases in number of bank branches in both smaller towns and in rural areas not only by the public sector banks but also by the new entrants from the domestic private sector as well as foreign owned banks. Positive results from these improvements are well reflected since 1990s in the indicators such as domestic credit, bank credit and broad money all expressed as percentages of GDP.Since India's gross domestic product (GDP) as well as per capita output recorded rapid growth during the last two decades, there has been a growing interest in conducting empirical studies on the relationship between FDI and economic growth. However, the role of FSD has not received much attention from researchers in the past while conducting empirical studies on FDI-economic growth nexus. Recent studies by Alfaro et al. (2004), Hermes and Lensink (2003); Azman-Saini et a.l (2010) studies have established that the relationship between FDI and growth is contingent upon several factors, the foremost being FSD. Further, they convincingly argued that the well-functioning financial markets reduce the risks involved in investment decisions by domestic investors who innovate along the lines of foreign entrepreneurs through imitation, thereby contributing to improving absorptive capacity. We, therefore, consider appropriate to focus our attention on the role of domestic financial system and interaction between FDI and FSD for the study.Aside from updating the previous studies by way of covering a longer period, this paper specifically includes policy variables representing economic governance. They include real exchange rate, which is the product of nominal exchange rate and the ratio of foreign price and domestic price and trade openness. Given the foreign price level, the domestic inflation is influenced by fiscal and monetary policies of the country, while openness is determined by high degree of trade liberalization.The paper is organized along the following lines: section II presents a brief summary of literature on contributions of FDI and FSD to economic growth; section III reviews the trends in FDI inflows to India and FSD over last three decades; section IV outlines the modeling and methodology adopted for the empirical study; section V discusses the results and; the final section VI presents a summary of the findings with policy implications.2.A BRIEF LITERATURE REVIEWAmongst all sources of external capital, which supplement domestic savings in capital-shortage developing countries, FDI being non-debt flows, have been recognized as the most constructive of all flows. FDI inflows are less volatile and less prone to sudden withdrawal due to shifts in sentiment unlike hot moneys. The FDI inflows, which seek long term returns, promote economic development through the transfer of technology when supported by a high degree of absorptive capacity in terms of human capital and helpful trade regime in the recipient country (Balasubramanyam et al. …