Foreign Direct Investment and Intra-industry Trade in India’s Manufacturing Sector

Published date01 November 2017
Date01 November 2017
Subject MatterArticles
Foreign Direct Investment
and Intra-industry
Trade in India’s
Manufacturing Sector:
A Causal Relationship
L.G. Burange1
Pooja Thakur2
Hemangi K. Kelkar2
The post-liberalization era has witnessed a significant increase in foreign direct
investment (FDI) inflows and intra-industry trade (IIT) of India. Considering this
fact, the article attempts to investigate a causal relationship between FDI and IIT
in the manufacturing sector of India for the period 1992–2013. Causality across
various industries of the manufacturing sector has also been analyzed. For the
manufacturing sector, causality tests depict unidirectional causality from IIT to
FDI. The results at industry level vary across different industries. For majority of
the industries, it is found that FDI inflows have led to an increase in IIT for the
manufacturing sector of India.
JEL: F14, F2
FDI, IIT, Granger causality, manufacturing
India stepped into the era of liberalization with the enactment of New Economic
Policy (NEP) of 1991. Amongst the various policy measures initiated under the
NEP, significant importance was laid on liberalization of foreign trade and foreign
Foreign Trade Review
52(4) 203–218
©2017 Indian Institute of
Foreign Trade
SAGE Publications
DOI: 10.1177/0015732516660797
1 Department of Economics (Autonomous), University of Mumbai, Mumbai, India.
2 Research Scholar, Department of Economics (Autonomous), University of Mumbai, Mumbai, India.
Corresponding author:
Pooja Thakur, Research Scholar, Department of Economics (Autonomous), University of Mumbai,
Mumbai, India.
204 Foreign Trade Review 52(4)
investment. With respect to trade, several measures relating to reduction in trade
barriers were adopted so as to promote free trade. The traditional import-substitu-
tion policy was replaced by an export-promoting one. This led to an increase in
simultaneous exchange of goods and services between industries (inter-industry
trade) and within industries (intra-industry trade, IIT). As a result, India has
emerged as a major contributor in world trade in the recent years. The share of
India’s foreign trade in its GDP was 14.73 per cent in the year 1992 which rose to
41.52 per cent in the year 2013 (World Bank, 2013). In a similar manner, the
reform process encouraged foreign investment, especially foreign direct invest-
ment (FDI), in various industries of the Indian economy. Due to concentrated
efforts of the government, FDI inflows in India have increased considerably. India
attracts highest amount of FDI inflows in the South Asian region and is the second
most preferred destination for FDI (UNCTAD, 2013).
The literature on FDI and trade is extensive. The earliest studies trying to
establish a link between FDI and trade considered foreign investments as a
substitute to trade. They relied on the foundations of Heckscher-Ohlin theorem
which stated that differences in factor endowments formed the basis of trade. In
such type of a model, factor mobility was restricted. Mundell (1957) stated that
once mobility of the factors of production was taken into account, factor price
differentials between the countries would be eliminated. If production functions
across the trading countries were identical, foreign investment would substitute
foreign trade. This approach was challenged by studies comprising Agmon
(1979), Helpman (1984), Markusen, Venables, Konan and Zhang (1996),
Markusen (1997) and Markusen and Maskus (1999). According to them, FDI
would replace trade under the conditions of perfect competition. However, in
the case of imperfectly competitive markets with economies of scale, techno-
logical changes and product differentiation, FDI and trade would complement
each other. Thus, FDI would lead to an increase in foreign trade, especially IIT.
Agmon (1979) stated that FDI would boost IIT as the factors determining FDI
inflows and IIT were similar. Helpman (1984) propounded the ‘factor propor-
tions approach’ which stated that within FDI, it was vertical FDI (production
process of multinational enterprises fragmented in different locations) that gave
an impetus to IIT. Markusen et al. (1996), further, presented the knowledge–
capital model in which vertical FDI and IIT took place under the regimes of free
trade and investment liberalization.
Despite this, empirical literature dealing specifically on FDI and IIT is meagre.
Most of the empirical studies have analyzed the relationship between FDI and
trade. Some of the important studies are that of Hsiao and Hsiao (2006), Dash
(2007), Jayachandran and Seilan (2010), Cho (2013) and Sultan (2013). In the
Indian context, empirical work pertaining to IIT and FDI is carried out by Goldar
and Banga (2007). They analyzed whether IIT led to an increase in FDI inflows in
India for the period 1991–1992 to 1997–1998. By using panel data techniques for
78 industries belonging to the manufacturing sector at three-digit level, the impact
of IIT on FDI was evaluated at industry level and state level. The results at indus-
try level revealed that trade liberalization, reduction in tariffs and policy aimed
towards export promotion, had a positive impact on the growth of IIT. It was

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