Dynamics between trade openness, FDI and economic growth: evidence from an emerging economy
DOI | https://doi.org/10.1108/JITLP-01-2021-0004 |
Published date | 11 October 2021 |
Date | 11 October 2021 |
Pages | 16-41 |
Subject Matter | Strategy,International business,International business law,Economics,International economics,International trade |
Author | Bijoy Rakshit |
Dynamics between trade
openness, FDI and economic
growth: evidence from an
emerging economy
Bijoy Rakshit
Indian Institute of Technology, Ropar Humanities and Social Sciences,
Department Rupnagar, Punjab, India
Abstract
Purpose –This paper aims to examine the dynamics between trade openness, foreign direct investment
(FDI) and economic growth in India over the period1979 to 2017. This study further considers the role of pre
and post-economicreforms in the analysis of these dynamics.
Design/methodology/approach –The authors apply the autoregressive distributed lag model to
investigate the possible long-runassociations among the variables. Zivot-Andrew unit root test was applied
to detect the structural breaks present in the data series. Toda-Yamamoto causality approach has been
applied to examinethe direction of causality among the variables.
Findings –Findings show that trade openness exertsa negative impact on economic growth in the long-
run. Although FDI inflow promotes economic growth in the long-run, FDI inflow does not seem to affect
growth in the short-run.As far as causality analysis is concerned, findings confirm a unidirectionalcausality
is flowing fromFDI inflow and labour force to per capita gross domesticproduct growth in India.
Practical implications –The negative impact of trade opennesson growth suggests that policymakers
should implement more export-oriented policies to boost economic growth in the long-run. The ratio of
exports to the total volume of trade has not increasedsatisfactorily over the years. Additionally, appropriate
policiesshould aim at extracting the benefits of FDI inflow in the long-run.
Originality/value –Although several theoretical and empirical literature has investigated the nexus
between FDI(or trade) and growth, this study, as a fresh attempt, investigatesthe long-run dynamics between
trade openness,FDI, capital formation, labour force and economic growthin India.
Keywords India, FDI, Economic growth, Trade openness
Paper type Research paper
1. Introduction
Opening up the economy to the rest of the world has made India one of the fastest-growing
emerging economies inthe world. Several reform measures introduced during 1991changed
the entire landscape of the Indian economy remarkably. Ahluwalia (2019) highlights that
despite achieving higher growth rates in the post-reform period, the liberalization measures
contributed to eradicating the growing incidence of poverty in the country. India’s growth
rate on average stood at 6.0% in the past few years from 1992–1993to 2001–2002. India has
also experienced above 9.0% growth for three consecutive years (9.48% in 2005–2006,
9.57% in 2006–2007 and 9.32% in 2007–2008). World Bank national accounts data reveals
that from 2014 to 2017, India has been maintaining an average growth rate above 7.0%,
which appears impressive for an emerging country like India. A fundamental question
arises: what drives India’s economicgrowth? What are the factors that propelled the growth
rate in the economy?
JITLP
21,1
16
Received24 January 2021
Revised4 August 2021
Accepted2 September 2021
Journalof International Trade
Lawand Policy
Vol.21 No. 1, 2022
pp. 16-41
© Emerald Publishing Limited
1477-0024
DOI 10.1108/JITLP-01-2021-0004
The current issue and full text archive of this journal is available on Emerald Insight at:
https://www.emerald.com/insight/1477-0024.htm
Several empirical studies emphasized trade openness as one of the crucial determinants
contributing to the economic growth trajectory post-liberalization (Bajpai, 2001;Topalova,
2004;Dash, 2009;Burange et al., 2019). International Monetary Fund recognizes trade openness
to be an integral part of the structural adjustment programmes for many emerging economies.
One of the important channels through which trade stimulates growth is importing superior
production technology from advanced economies (Frimpong and Abayie, 2006; Belloumi, 2014).
Frankel and Romer (1999) contend that export-oriented trade relations can implement recent
innovation and technology from an internationally competitive market by acting as
subcontractors to foreign firms. In an open economy, it is perceived that the import-
substituting firms tend to face greater competition in the host economy from their foreign
counterparts. As the products produced by foreign firms are capital-intensive, it provides the
domestic firms’the facilities to adopt capital-intensive production technology for their
production process and motivates the firms to compete with fierce competition. The
Government of India in 1991 had introduced few changes in its existing trade policies, foreign
investment, tariffs and taxes under the flagship programme of “New Economic Reform”.Asa
result, India has witnessed a more thanfive folds increase in its total exports [1].
The booming foreign direct investment(FDI) inflow has been instrumental in promoting
economic growth in India (Chakrabortyand Nunnenkamp, 2008). Under endogenous growth
models, the growing inflow of FDI promotes growthin economies, especially those suffering
from capital scarcity. FDI acceleratesgrowth by increasing the volume and the efficiency of
physical capital investment (Romer, 1986;Lucas, 1988; Grosman and Helpman, 1991).
Among all developing economies, India has become one of the highest FDI recipients from
2001 to 2010 [2]. In the face of liberalization, many economists, including Bajpai and Sachs
(2000, p. 1), have recommended India’s policymakers and government to openthe economy
to attract higher FDI inflow, which is likely to bring “huge advantages with little or no
downside”. Empirical literature extends mixed and inconclusive findings on the impact of
FDI inflow on economic growth (Chakraborty and Basu, 2002;Agrawal and Khan, 2011;
Choi and Baek, 2017).
Furthermore, capital formationplays a vital role in influencing FDI inflow and economic
growth in an economy. Neo-classical growth theories accentuate that emerging economies
characterized by the lowerinitial capital stock level are likely to get a higher marginal rate of
returns and growth rates if adequate capital stock is injected (Adhikary, 2011). The
development of new endogenous growth theories emphasized the increased level of
investment brought by FDI, providing a comparative advantage to the capital scarce
economies to converge to developed economiesin the long-run (Romer, 1986). Given the role
of capital formation in economic growth, this paper examines the importance of capital
formation whilstexplaining the dynamics between FDI, trade and economicgrowth.
Given this background, we are motivatedby the following points. Firstly, earlier studies
either investigated the effect of trade openness and FDI inflow interaction on growth
(Carkovic and Levine, 2005;Adams,2009) or (and) the associations between FDI and growth
or the relationship between trade openness and growth. These studies largely concluded
that FDI inflow and trade openness contribute to the enhancement of economic growth.
However, they failed to extend conclusive evidence on the relation in general and the
direction of causalityin particular.
Secondly, the direction of causality, particularly for many developing economies,
including India, has not been adequately addressed by the previous studies. Chakraborty
and Basu (2002) find that in India, gross domestic product (GDP)is not Granger caused by
FDI and they empirically documented the causalityto be running from growth to FDI only.
Kumar and Pradhan (2002) considered the trade-offbetween FDI-economic growth granger
Trade
openness, FDI
and economic
growth
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