Washington: An Indian American economist suggests that foreign direct investment (FDI) appears to stimulate the development of emerging economies such as India and China. 

"The foreign capital has the potential to deliver enormous benefits to developing nations," says Anil Kumar, an economist in the Research Department of the Federal Reserve Bank of Dallas, in the January issue of its Economic Letter.

"Besides helping bridge the gap between savings and investment in capital-scarce economies, capital often brings with it modern technology and encourages development of more mature financial sectors," he says in an article on Does Foreign Direct Investment Help Emerging Economies?

Examining the effects of FDI on the stability, trade, savings, investment and growth of 19 emerging economies, Kumar finds that a percentage point rise in the ratio of FDI to GDP leads to a half percentage point increase in domestic investment and three-fourths percentage point increase in domestic savings.

FDI also has an effect on an emerging economy's GDP. Growth in the GDP of developing economies rises the year after an increase in FDI, according to Kumar. Countries with barriers to FDI may see increased economic development if they relax those barriers.

However, there are drawbacks to increased levels of FDI, Kumar writes. Foreign firms could over-invest, hurting domestic producers. Also, the majority of an emerging economy's best firms may be financed by FDI, leaving only low-productivity firms for the domestic investors.

Within Asia, China and India have gained FDI share relative to Southeast Asia. Today, these two emerging economic giants are the most attractive markets for FDI, Kumar notes.

China's FDI shot up from $3.5 billion in 1990 to $60 billion in 2004, while India's rose from a paltry $236 million to $5.3 billion. The shift reflects the two nations' more open economic policies, as well as their sheer size and dynamic growth.

"The rush to invest in places like China and India suggests that FDI will continue to be an increasingly important source of development finance, "Kumar writes.

Foreign affiliates were responsible for more than half China's exports in 2001 and 21 percent of Brazil's. They accounted for just 3 percent of India' s. At the country's current rate of economic liberalisation, however, foreign companies are likely to increase their share of India's exports.
 

FDI can also provide a path for emerging economies to export the products developed economies usually sell-in effect, increasing their export sophistication, he says. A new study by Dani Rodrik puts the export sophistication of China, a leading FDI recipient, at least three times higher than that of countries with similar per capita GDP.
 

India, another FDI hot spot, also did well on this score. Some emerging economies are fast becoming attractive destinations for multinationals' research and development centers, suggesting further gains for developing nations, Kumar writes.

Of course, FDI may represent a net capital gain or even "crowd in" domestic investment through a number of channels, such as transfers of technology and key expertise that doesn't exist in host countries.

India, for example, has opened up parts of its retail sector to foreign investment, although it limits outsiders to a maximum 49 percent stake. FDI is likely to spur domestic investment in India's retail sector as existing players partner with such foreign giants as Wal-Mart to open stores.

Despite FDI's potential to boost technology, productivity, investment and savings, economists have somewhat surprisingly  struggled to find a strong causal link to economic growth. Some studies have detected a positive impact, but only if the country has a threshold level of human capital.

This seems to confirm FDI's important role in propelling growth in China and India, which have vast, untapped technical workforces, Kumar writes, noting that China graduates 600,000 engineers every year and India produces 215,000.