Home / Opinion / Online Views /  Why not invest abroad instead?

Capital mobility, said Kumar Mangalam Birla in a recent interview, allows companies a choice to invest abroad. They allocate capital to countries with a more attractive business environment where the future is clearly visible, regulatory clearances and approvals aren’t as opaque and where entry into new businesses is less of a gamble than in India.

The plain speaking is more disturbing given the macro situation. Domestic savings and investment rates have been falling while outbound investment has been sustained although its levels are lower after the financial crisis.

Is outward investment at the cost of domestic investment? It is hard to say at this point. Outbound foreign direct investment (FDI) flows averaged only 1.2% of gross domestic product in the last seven years, compared to an average 32% rate of gross fixed capital formation. A lot depends on whether firms are investing abroad to enhance efficiency and expand markets or acquire strategic assets. On these measures, current symptoms portend a future threat if domestic competitiveness continues to decline and uncertainty governs business dynamics. Birla’s concerns should therefore be noted.

Unlike Brazil and China, Indian FDI isn’t mainly plugging into oil, gas and other natural resource-based industries. Instead, it concentrates on services and manufacturing; of the latter, agriculture machinery and equipment, basic organic chemicals, drugs, medicines and allied products and sugar are some focus industries (2010-11). The worry then is of production relocating abroad to become more competitive. It can, in some cases, replace domestic exports too. Either way, FDI outflows due to such motivations can reduce domestic investment as private savings move out of the country and liquidity to finance new domestic investment gets reduced.

The effects are more severe for a capital-deficit nation like India and when firms use internal financing (internal accruals financed much of the overseas acquisitions by domestic firms in 2009 and 2010). Domestic savings have a large role to play in domestic investments; that the two are highly positively correlated is a well-documented economic fact. Other than domestic investment, what this could mean for the current account balance is obvious.

Are such concerns overblown? Empirical evidence confirms domestic investment can be crowded out. OECD and other advanced countries faced a dollar-for-dollar reduction in domestic investment due to outbound-FDI flows from the 1960s right through to the 1990s. Research by the International Monetary Fund for 121 countries over 1990-2010 shows that $10 of outward FDI reduces domestic investment by $2.9 in the short run and $7.8 in the long run; on the other hand, a percentage point increase in FDI inflows stimulates domestic investment by about 55%.

Combining trends with theory and evidence suggests that improving domestic productivity and the institutional environment for domestic investments should be an urgent policy priority. Since it is the rate of physical capital accumulation that subsequently determines the rate of economic growth, ensuring domestic investment is not diverted abroad is critical for realizing the growth objective.

Renu Kohli is a New Delhi-based macroeconomist; she is currently Lead Economist, DEA-Icrier G20 Research Programme and a former staff member of the International Monetary Fund and Reserve Bank of India.

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