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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