Unanticipated consequences of FDI

The conventional argument for foreign direct investment (FDI) is that it brings in foreign exchange. The conventional argument against FDI is that it displaces domestic manufacturers. Both arguments are mainly wrong. Above all, FDI brings in knowledge and marketing links that can create comparative advantage where none existed before. These unanticipated consequences of FDI are far more important than the initial dollars investment.

Consider automobiles, where FDI was once a liability. Foreign auto companies did not enter for low-cost production: they believed car manufacturing in India was uneconomical. Yet they expected it to be profitable, thanks to a ban on auto imports, which was later relaxed but with astronomical import duties. FDI in autos was the tariff-jumping variety, driven not by efficiency but profitability from uncompetitive manufacturing shielded by Indian protectionism. Foreign companies opposed the import of second-hand cars, including their own models, to maximise gains from protection.

Worse, several Indian states tried to attract foreign auto companies through tax breaks and cheap land. In effect, bankrupt states were sacrificing precious future revenue to subsidise inefficient manufacturing. Economists called this a race to the bottom between states. I was among those who lambasted this as the worst form of FDI. Today, I must eat crow. FDI in autos is beginning to convert India into a global auto power.

Foreign companies entered under the illusion that India had a huge middle class dying to buy cars. They made the same mistake in China. In both countries, they found the market small, competition fierce, and profits non-existent. But once established in China, they found that domestic component manufacturers had remarkable potential, which could be harnessed to lower costs through new design and know-how. Foreign investors started exporting, reaped scale economies that further lowered costs, and became profitable.

Ditto in India. Having lost millions in the domestic market, foreign companies are now making India a global supply base. They have helped Indian auto ancillary manufacturers to bring down costs and become globally competitive. Some foreign investors are now making India an R&D base.

Consider some highlights.

  • Ford is exporting over half its production.
  • Suzuki is using India as a base for exporting the Alto, and is considering an R&D center here.
  • Hyundai is making India a global export base.
  • Daimler-Chrysler is exporting cars, and also accounted for eight per cent of all auto component exports in 2001-02. Its global component purchases total 100 billion euros. If India gets one per cent of this, that means one billion euros.
  • Ford is outsourcing $120 million to $160 million of auto components over the next two years.
  • Delphi, the biggest auto component company in the world, plans to export $330 million to $350 million of components by 2005, of which it will manufacture one-third and outsource the rest from Indian ancillaries.
  • Timken, one of the world’s biggest producer of automotive ball bearings, is going to double its capacity and set up a Rs 23-crore global research centre in India. No wonder the Auto Components Manufacturing Association plans to step up its export target for 2010 from $2.5 billion to $10 billion.

Could this have happened without FDI? Could the indigenous auto industry have developed to this extent simply by licensing know-how from abroad? Not a chance. India has long been a minor exporter of auto ancillaries. But only after the biggest multinationals entered India did they seriously look at and help upgrade India’s tiny ancillary companies, which were (and in many cases still are) too small and unknown to meet global demand.

In effect, auto FDI became a university for developing skills and excellence in auto ancillaries. FDI even helped convert Hindustan Motors from an import-substituting dinosaur into a supplier of world-class engines to Ford and General Motors. Indian cars are now competitively priced, and the Maruti 800 is probably the cheapest car in the world. In our globalising world, one-third of all international trade is trade between branches of MNCs. Increasingly, foreign trade is the internal trade of MNCs. The lesson: attract FDI and you will create exports, often in unexpected areas (watch-manufacturer Titan is now exporting car clocks).

MNCs will nurture your small and medium companies, and convert them into giant exporters. Ford, for instance, is using small and medium companies that most readers have never heard of, such as Cooper Tire, Visteon, and Synergy Dooray. A medium company called Motherson Sumi has won a huge export order of $125 million for dashboard components.

So, even the worst tariff-jumping FDI can become a boon because of its unanticipated consequences. Forget the dollars brought in by FDI and focus on the consequences, which should no longer be called unanticipated.

What do you think?