Infrastructure holds the key to FDI

Foreign direct investment (FDI) forms the single largest component of net capital inflows to emerging markets such as ours. For example, despite the recent financial meltdown, FDI inflows into developing economies totalled over $700 billion in 2009. Researchers in economics have highlighted several beneficial effects of FDI inflows on the domestic economy. First, incoming FDI increases the domestic stock of capital dollar for dollar. Second, FDI inflows increase the productivity of local upstream suppliers and downstream customers. The increase in the domestic stock of capital as well as the increase in the productivity of local manufacturers contributes not only to growth in the domestic economy, but also to employment. With the slowing of FDI investments into India over the last couple of years, attracting FDI remains a policy focus for the central and state governments. In this article, I argue based on a careful research study that providing first-rate infrastructure in those districts, which already have a threshold level of infrastructure, can be very effective in attracting FDI.

The graphic plotting how FDI in a district varies with the infrastructure index of a district, captures our findings in essence. Each of the dots corresponds to one or more districts while the smoothed line fits the statistical relationship between infrastructure and FDI. As observed by the non-linear statistical fit, we find that FDI inflows remain insensitive to infrastructure till a threshold level of infrastructure is reached; thereafter, FDI inflows increase steeply with an increase in infrastructure. On the one hand, our results help to explain why marginal improvements in bottom-rung countries fail to bring in FDI. On the other hand, the results help explain the spectacular performance of countries like China in achieving rapid industrialization and economic growth by focusing on pockets of high infrastructure—the special economic zones approach—rather than by spreading the investment in infrastructure uniformly across the country.

From the Indian perspective, our results suggest that enhancing infrastructure in districts that already have a certain threshold level of infrastructure would maximize the chances of attracting FDI.

In a ranking of districts with respect to the overall infrastructure (as measured by the infrastructure index), Dimapur (ranked 24) in Nagaland and Aizawl (39), the capital of Mizoram, were among the top 40 because of their relative strength in road transportation, access to electricity and telephone connections. However, these districts lag behind considerably with respect to the number of scheduled commercial bank branches. To bring FDI into these districts, which can be quite instrumental in furthering economic growth in the North-East, increasing the number of scheduled commercial bank branches must rank as the immediate priority.

We also noticed that Ernakulam (17) and Kottayam (31) in Kerala, south Goa (25) and Aizawl (39) need better road transport (when compared with the other top 40 districts). Despite the telecom revolution, the percentage of households with a telephone connection is one element of infrastructure lagging behind the other three components. Telecommunications facilities need to be enhanced across the board in most districts. Even metropolitan cities such as Kolkata (3), Chennai (4) and Pune (14) lag behind considerably when compared with west (7) or south-west Delhi (11) with respect to their telecommunications facilities. We also notice that increasing financial access by increasing the number of scheduled commercial bank branches has to be a matter of urgent interest in order to be able to attract FDI.

In sum, within the limited objective of attracting FDI, concentrating on enhancing infrastructure in these 40-odd districts would generate a greater bang for the buck than spreading resources across all districts in India. In particular, since state governments vie with each other to attract FDI, they should focus on those districts in their states that belong in the top 40 districts across India and focus on developing first-rate infrastructure in these districts.

Krishnamurthy Subramanian is a PhD in finance from and is currently a faculty in finance at the Indian School of Business

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