Growth in Foreign Trade in Liberalized India: The Relevance of FDI

Driven by the need of an economic model that can explain the foreign direct investment (FDI)–export relationship, especially in post-liberalized context, we make a special inquiry on whether FDI has a significant export-promoting impact in India under a time-varying parameter model with vector autoregressive specification. The Johansen’s co-integration test suggests a significant and positive long-run co-movement between FDI and export. The vector error correction model (VECM) confirms a unidirectional long-run causality from export to FDI. However, the Granger causality test establishes a bi-directional causal relationship between these variables in short run. Further, the foreign trade (FT) is found to be a strongly exogenous variable as per the variance decomposition analysis. Again, the impulse response function analysis suggests that the responses generated from a positive shock of FT to FDI and vice versa are small and initially negative, afterward remain steadily positive at a constant level. The study finally recommends the policymakers to channelize the inward-FDI into tradable goods industries rather than only linking it to service sector growth to reap the long-term benefit. In this regard, China’s effort to channelize inward-FDI into manufacturing sectors and the resultant momentous success in export performance can be taken as a classic example for FDI-led foreign trade promotion.