Over the past few years, the government has been pushing hard to secure FTAs (Free Trade Agreements), CECAs (Comprehensive Economic Cooperation Agreements), and CEPAs (Comprehensive Economic Partnership Agreements) with many of its major trading partners.
Recently, India signed CEPAs with the UAE and Mauritius, taking India’s economic relations with these countries to a new level. Meanwhile, deals with UK, EU, and Canada are in the works. What has often lacked attention is the potential benefits such agreements can offer in terms of increased FDI flows between the signatories.
FDI inflows are influenced by various factors such as infrastructure, human capital, market size, resource endowments, tax policy, and regulatory environment, to name a few. In addition to these factors, recent studies have pointed out the FDI-enhancing effects of FTAs. These studies have highlighted the existence of multiple channels through which FTAs can lead to increased FDI flows.
Primarily, the lowering of trade barriers between the countries facilitates the movement of intermediate or final goods between the parent firms in the source country and the foreign subsidiaries operating in the FDI-host country.
Horizontal vs vertical
In addition, increased FDI flows may arise due to the provisions included in the agreements that ease restrictions on the movement of capital between the parent firms and their affiliates operating in the partner country. That said, FTAs can have varying impacts based on the type of FDI i.e., whether the FDI is vertical or horizontal. Vertical FDI investments are those where a company invests in a foreign firm operating in the same supply-chain and may or may not be in the same industry.
On the other hand, horizontal FDI are those when a company invest in a foreign firm operating in the same industry. An Indian pharma manufacturer investing in overseas companies that supply it raw materials, say active pharmaceutical ingredients (API) is an example of vertical FDI. Whereas, an Indian cloth and apparel manufacturer opening stores in US can be termed as horizontal FDI. Firms engage in vertical FDI to benefit from cheap and abundant factors of production available in various countries.
On the other hand, horizontal FDI leads to the duplication of existing production facilities in foreign countries. Studies have shown that FTAs usually tend to positively impact the vertical FDI as the trade of intermediate goods to the members of FTA and the import of final goods from these countries to their home countries becomes cheaper. The evidence of a positive impact on vertical FDI assumes significance given that today’s international trade is dominated by Global Value Chains (GVC).
According to the OECD, 70 per cent of today’s international trade involves GVCs. Not all countries may witness increased FDI flows by signing FTAs, as locational advantages also play a critical role in attracting FDI. Empirical evidence indicates a complementary relationship between FTA and investments if the partners are in different stages of development.
For example, a study of South Korean FTAs revealed that FTAs positively impact the outward FDI to developing countries and inward FDI from countries having a higher income than Korea. Vietnam has been successfully attracting FDI in manufacturing and taking advantage of the China-plus-one strategy. Studies have indicated that FTAs with its partner countries have contributed to the rising FDI flows in addition to its locational advantage.
It is to be reiterated that signing FTAs does not automatically lead to higher FDI as various other factors such as location, tax policies, market size etc. play a critical role.
Signing FTAs and CEPAs will be a shot in the arm not just for India’s international trade but also for enhancing FDI flows. For example, the India-UAE CEPA is comprehensive and covers various aspects like trade, investment, healthcare, and IPR.
Trade flows
In the first eight months after signing the deal, the bilateral trade between India and UAE grew by 27.5 per cent. Bi-directional FDI flows have picked pace, with inward FDI flows clocking around $3 billion between April and December 2022 compared to $843 million in the same period last year.
Outward FDI flows to the UAE in the first nine months of FY23 were around $930 million, which is already higher than the figures for last year. A detailed look at the partner countries that India is aiming to strike deals with reveals that these destinations not only provide a wider market for Indian goods but are rich sources of investment, technology, and IP.
Indian firms have increasingly undertaken outward FDI in both developed and developing countries in the past decade. Being party to such agreements may help them satisfy their global aspirations by gaining easier access to modern technology, natural resources, technical know-how etc.
Given the backdrop of the China-plus-one strategy gaining traction among many MNEs, India must try to leverage its strength to incorporate provisions in CEPAs that facilitate setting up subsidiaries in India and vice-versa, particularly in the manufacturing sector.
Efforts must be taken to align provisions in the Production Linked Incentive (PLI) scheme with those of CEPAs, as a one-size fits all strategy may not work for the successful implementation of the PLI scheme. Policy reforms aimed at improving the business environment should be continuously undertaken for the seamless integration of the Indian economy with the global trade and investment networks.
Krishnan is a research scholar and Padmaja M is an Assistant Professor at NIT Trichy; Gopalakrishnan is Fellow and Former Head, Trade and Commerce, NITI Aayog