Most of the economists in India are of the belief that it is absolutely essential for India to improve their investments in order to generate sustained economic growth that creates employment opportunities for their growing workforces in the years to come. They strongly recommend the government to undertake investments in key physical and social infrastructure, as well as pursue structural economic reforms policies that attract large chunk of FDI.
There is substantial evidence to show that the macroeconomic growth and development is spurred by rapid FDI inflows. Also, FDI inflows generate substantial direct and indirect positive spillover effects in the form of transfer of technology. This in turn leads to increased productivity and there by stimulates domestic private investments in the host country (Aschauer, 1989; Bloomstrom & Wolff, 1994; Cuadros et al., 2004; Cardoso, 1993; De Mello, Jr., 1997; Green & Villanueva, 1991; Huang, 2004; Ramirez, 2000; Ram & Zhang, 2002). Higher investments activities would naturally attract the attention of foreign investors and thus improve the foreign investor's perception about the host country.
This paper employs time series data in order to test empirically two critical aspects. One, whether FDI flows have had a positive and significant effect on India's domestic private investments over the period 1975-2006. We also test the role of economic reforms on domestic private investments. We then examine whether FDI inflows have significant impact on domestic private investment activities. Two, whether foreign investors' country rating for India is determined the by investment activities (private, public & foreign)? If so, how important is the role of FDI inflows? Also, examined is the importance of economic reforms process for foreign investors' ratings. In so doing, it is one of the first empirical studies related to India to investigate the complementarily hypothesis between domestic private investment and FDI along with the role of economic reforms for the period in question.
The rest of the paper is organized as follows. Section II presents detailed literature review on this topic. The third section deals with research design and methodology. Section IV presents the empirical results for all the models. The last section summarizes the findings and offers some policy prescriptions for improving the investment climate in India.
2. LITERATURE REVIEW
There are many studies in the literature which have estimated the impact of FDI inflows on domestic private investments (1). The study on transition economies by Krkoska (2001) shows that capital formation is positively associated with FDI and acts as complimentary to domestic capital.
Ramirez (2001) presents theoretical and empirical linkage of complementarily hypothesis between FDI and domestic investments for Latin American countries from 1981-2000. The findings show that FDI and public investment spending have a positive and significant effect on private capital formation.
Hecht, Gad & Shinar (2004) econometrically explore the interactions between domestic investment and various types of capital inflows for sixty-four countries for the period 1976 to 1997. The findings show a significant impact of the domestic investment on FDI inflows after controlling for other factors of these inflows. Nevertheless, in terms of impact on domestic investment, FDI inflows are ranked highest, above the other types of capital inflows.
Desai, Foley & Hines Jr. (2005) evaluate the impact of FDI outflows on domestic investments. They find that OECD countries with high rates of outbound FDI in the 1980s and 1990s exhibited lower domestic investment than other countries, which suggests that FDI and domestic investment are substitutes. In a recent study on FDI and domestic capital relationship.
In a study on Sub-Saharan African countries, Ndikumana & Verick (2008) explore the two-way linkages between FDI and domestic investment. The results show that the impact of FDI on development is through its effect on domestic factor markets, especially domestic investment. They also found that FDI crowds in domestic investment and countries will gain much from measures aimed at improving the domestic investment climate.
The single country time series study Hejazi and Pauly (2002) empirically explores the impact of inward and outward FDI flows on capital formation in Canada. The findings show that higher net investment abroad is associated with a reduction in domestic capital formation, employment and production.
Taking Korea as example for the period 1985-1999, Kim & Seo (2003) study the dynamic relationship between FDI inflows, economic growth and domestic investment. Using vector autoregression model, they find that FDI has some positive effects on economic growth, but its effects seem to be insignificant. On the other hand, they find that economic growth is statistically significant and has high persistent effects on the future FDI inflows. They conclude that FDI crowds out domestic investment in Korea.
Titarenko (2006) analyses the theoretical and empirical issues of FDI effect on capital formation process for Lativa. The results display the evidence of crowding out long-term effect of FDI on investment in Latvia.
Exploring the effects of FDI inflows on domestic investments, exports, imports and GDP growth, Xu and Wang, (2007) used four econometric equations covering 1980-1999 period. The findings show that inflow of FDI has stimulated domestic investment. The growing presence of FDI appears to have enhanced the investment efficiency in Chinese economy.
Changyuan (2007) study the relationship between FDI inflows and economic growth for provincial level in China. Their results found that FDI produced positive effects on China's economy through improving technical efficiency and "crowding" in domestic investment.
The study of Lin & Chuang (2007) examines the effect of the FDI decision on domestic investment in the case of Taiwanese manufacturing firms. The empirical results show that the effect of these manufacturing firms' FDI decisions on domestic investment is significant within the firms. Furthermore, a crowding-out effect of FDI on domestic investment is found when Taiwanese firms engage in defensive FDI. Finally, FDI is found to have a positive influence on the domestic investment of the larger firms, while the influence is negative in the case of the smaller firms.
3. RESEARCH DESIGN
3.1 Dependent Variables
This paper addresses two things primarily. The impact of FDI inflows and economic reforms on:
(a) Domestic private investments and
(b) Foreign investor's country ratings,
Domestic Private Investment/GDP = [[delta].sub.1] + [[psi].sub.2] [Hypothesis variable.sub.it] + [[psi].sub.2] [Control variables.sub.it] + [d.sub.it]
[Foreign Investors Ratings.sub.it] = [[delta].sub.1] + [[psi].sub.2] [Hypothesis variables.sub.it] + [[psi].sub.2] [Control variables.sub.it] + [[member of].sub.it]
To examine these we have created two equations with each of them as dependent variables.