Making the most of FDI

India is growing robustly, in spite of high oil prices and a global economy that shows signs of slowing. Domestic business confidence is high: the NCAER April-September 2006 business confidence index reached its highest level since November 1994. Foreigners, too, are optimistic. While the growth in portfolio flows is likely to slow, FDI is projected to continue to increase, and its flows will probably overtake net portfolio investment in 2006-07. The sectoral and regional scope of FDI remains narrow and these foreign capital flows are still relatively small. But given their potential growth, it is useful to assess the evidence on the impact of foreign capital on developing countries.

Recently, several economists, including Raghuram Rajan, the IMF?s research director, have been marshalling evidence that not only is capital flowing from poor to rich countries, but the impact of foreign financing on developing countries is negligible or negative. My colleague Joshua Aizenman, with co-authors Brian Pinto and Arthur Radziwill, drives home this point by constructing a self-financing measure , which turns out to be positively correlated with growth, even after controlling for the quality of domestic institutions.

Empirical studies tend to find somewhat different, more positive results for developed countries. This is consistent with a hypothesis that adequate domestic financial development is needed for foreign capital to be absorbed effectively. Direct tests tend to bear this out as well. In addition, Rajan and co-authors Eswar Prasad and Arvind Subramanian find that industries relying more on external finan-cing, as opposed to retained earnings, grow faster. And, of course, many studies find that FDI, specifically, has a positive impact on economic growth.

What are the lessons for India? First, one should not read too much into these studies, since they typically look at heterogeneous cross-sections. While the empirical patterns should be useful guides to policy, they do not reveal any magic bullets, one way or the other. Nevertheless, one can glean some in-sights into policy directions. First, the studies suggest that a focus on domestic savings and improved fin-ancial intermediation at home can have growth payoffs. The evidence tends to suggest that savings are pulled up by economic growth, rather than vice-versa, and since domestic savings can be wasted or exported, perhaps having good financial institutions matters the most. India has a lead in this area, especially in equity markets, and policies that help deepen and extend India?s financial sector ought to be a high priority, from this perspective.

Second, if the cross-country evidence is accepted, foreign capital inflows will have a higher payoff the better domestic financial intermediation becomes. In any case, FDI seems a better bet for spurring growth than other foreign financing, since it typically comes packaged with technological and organisational know-how. Contin-uing to push policy towards smoother FDI approvals and fewer restrictions seems to be indicated by what we know about developing country experience. FDI in the financial sector has some special issues. On the one hand, it provides the general benefits alluded to above. Greater competition may also lead to stronger domestic firms, as they respond to entry. On the other hand, there is the danger of cherry picking by foreign entrants. Actively consolidating and strengthening domestic incumbents (especially public sector banks) is indicated in this case. Everything suggests that Indian policy is proceeding in this direction in a measured fashion. One area where boldness can pay off is higher education?the severe constraints in that sector can be met by opening up to foreign investment more confidently than the timid approach recommended by the CNR Rao committee. China is doing just that.

What about capital account convertibility? If it leads to volatility and an even greater likelihood of crises, as some (but not all) other studies suggest, and has no obvious growth benefits, then maybe it is not a good idea. However, there is evidence that capital controls have costs in terms of forgone trade. Further, they can lead to distortions and corruption. Again, a measured, integrated approach towards openness on the capital account seems reasonable (especially since so much has been done piecemeal since 1997), and the general policy direction is right, though some of the specific recommendations of the second Tarapore committee are hard to fathom, as made clear in member Surjit Bhalla?s dissent.

Finally, what about infrastructure, the pressing constraint for India? RBI governor YV Reddy, in a September 28 speech, said that, ?the financial sector in India is no longer a constraint on growth and its strength and resilience are acknowledged, though improvements need to take place. On the other hand, without the real sector development in terms of physical infrastructure and improvement in supply elasticities, the financial sector can even misallocate resources, potentially generate bubbles and possibly amplify the risks.? I think the crucial point is really somewhat different?the financial sector in India has to be developed in a way that it can assess and finance large, complex infrastructure projects that may even have public sector components. The sector?s development can then facilitate infrastru-cture development, with foreign money a key potential source of funds. This has yet to occur in any significant way.

The weaknesses here also lie with governance institutions?corruption and incompetence can sometimes loom large as barriers. The old two-gap model postulated savings and foreign exchange gaps as constraints to development. Neither one matters for India any longer. Instead, the country?s main problem continues to be its governance gap.

?The writer is professor at the University of California, Santa Cruz