Digital Sector and Foreign Direct Investments: A Case of India

Madhu Bala, Indira Gandhi National Open University, India

Abstract
The emergence of digital economy or digitalisation or knowledge economy,
driven by the process of technological change has brought with itself a new
kind of rich and poor. It has also brought with itself “the digital divide”
between developed and developing countries. This digital divide is not simply
technological but involves much broader societal and economic issues like
education, training and skill development. Varied measures have been
suggested at global, national and local level to bridge this divide both at
general policy level and ITC (Information Technology and Communication)
policy level. Among others, private capital flows particularly FDI (foreign
direct investment) has been considered to be a significant national level
measure to bridge this divide. Therefore, the present paper explores how far
FDI in general and especially FDI in digital sector (taking Telecommunication
as a proxy variable as IT is a part of this) influences the investment in human
capital (a composite variable of literacy rates, increasing enrolment ratios and
labour force). By estimating the Cobb-Douglas production function Model,
the paper draws conclusions and suggests some policy implications for the
years to come.

INTRODUCTION

Information and Communication technologies or the digital sector started influencing the lives of
people in developing countries much earlier than the advent of The Internet in these countries.
For example, Computer industry accounted for more than 74,000 jobs and US $ 4 billion in
revenue by 1990 in Brazil. Similarly, India launched a set of policies in 1988 that fostered a
software development industry whose exports grew to US $ 5.7 billion by 1999-2000 1. However
it was not until mid-1990s that the growth of The Internet led to a new debate on shifting
perspectives and paradigms of development and the emerging interest on the issues like Digital
Divide or the uneven distribution of ICTs between developed and the developing countries.
While recognising the issue of digital divide as a major problem, the concern was to what extent
e-development relates to e-readiness in developing countries, particularly when people in these
countries are trying to cope with the problems of basic amenities like sanitation, illiteracy,
unemployment, ill health and surmounting foreign debts? Hence a number of studies emerged,

1
referring to the growing digital divide and argued that by judiciously incorporating the
technologies for providing solutions to such obstacles, the gap between technology haves and
have-nots can be avoided (World Bank, 2001). Therefore, the present paper endeavors to explore
how far FDI in general and especially FDI in digital sector (taking Telecommunications as a
proxy variable as IT is a part of this) influences the investment in human capital (a composite
variable of literacy rates, increasing enrolment ratios and labour force). The paper starts by
establishing the fact that inflow of Foreign Direct Investments or FDI in information technology
affects the economic development of an economy. This is followed by a brief discussion on the
issue of digital divide and the status of ICT in India. Lastly, by estimating the Cobb-Douglas
production function Model, the article draws conclusions and suggests some policy implications
for the future.

IMPORTANCE OF FDI IN INFORMATION TECHNOLOGY AND ECONOMIC

DEVELOPMENT
Starting with oil and rubber to copper, uranium and ultimately to Colton in the present days;
technical change has strongly affected the FDI flows to developing countries since early
twentieth century because they normally bring with it the latest technology of the day. Similarly
a supportive policy framework, natural resource endowments and the human capital stock also
heavily influence FDI flows and the associated technology transfers (Keller, 1996; Noorbakhsh
et al. 2001; Saggi, 2002).

At present ICT infrastructure and skills are critical in integrating local producers into
international ‘B2B’ networks, and in attracting FDI in services as well as manufacturing. Such
skills have enabled developing countries particularly east Asian countries to create highly
effective partnerships with foreign investors to import, use and develop high technology
(Addison and Heshmati, 2002). It is, in fact, because of these skills that the countries like
Malaysia, Singapore, Taiwan and later China are able to move up the value-added ‘ladder’ from
the manufacturing-intensive unskilled labour. Multinationals providing business services and
consultation also draw on the local ICT skills to develop business solutions for international
clients as is in the case of India. Therefore, ICT not only attracts but also influences FDI to
produce manufactures and services for selling in the host country where the market is large like

2
Brazil, China and India. For example, South Korean companies producing locally for the Indian
consumer-goods market are heavy users of local ICT skills that have national capacities to adapt
ICT to local needs (languages, preferences, and regulations). In this context, it is important to
mention here the Dornbusch and Park (1987, 407-9) model. According to this model the relative
wage costs determine the pattern of trade. Drawing upon the Ricardian (two country) model of
trade, it shows the economic implications of importing superior technology (in this case ICT)—
whether directly or through FDI technology transfer. It shows that with the inflow of FDI in ICT,
the country, under question, not only expands the range of goods it produces, but also increases
its own ability to supply ICT services (software development for instance) as well as ICT
intensive services. As a consequence, its wage level rises relatively to the foreign wage level (it
now produces more goods, and this raises the demand for new labour). The rise in the wage level
also enables the country to secure ICT-skilled labour from other developing countries, thus
reinforcing the effect of ICT-division noted previously.

Addison and Heshmati (2003) point out two implications of this mode: i) if the country has the
relevant human capital, it can import the hardware and software and apply its existing stock of
skilled labour for their use. Over time, it can both expand the supply of that skilled labour, and
change it’s training, so that it is not only able to use the imported ICT technology but also to
modify and develop its own. This is the path followed by India, where prior investment in good
quality technical education has provided a ready supply of IT staff. ii) If the developing country
lacks the necessary human and managerial capital, it may try to develop and not import these
softwares and hardwares, which can be too expensive to be executed for the poorest countries to
begin with (emphasis added).

Moreover, the ICT skills that a country needs may be specialised in a particular type of company.
For this, and for budgetary reasons, foreign investments that transfer ICT and the necessary
skills, offer the best option for building domestic ICT to many countries. Foreign investors,
however, are more attracted to countries that already have an ICT infrastructure (indeed such
countries may effectively use ICT to signal their technological advantage to foreign investors)
(The World Bank, 2004). Consequently, poorer countries may find themselves in a ‘low-ICT
trap’: they cannot attract ICT-intensive FDI because they have neither the ICT infrastructure to

3
begin with nor sufficient private or public resources to develop it. Consequently, two groups of
developing countries emerge: those that are attractive to ICT-intensive FDI, and those that are
not. The natural implication of this is, over time what little skilled ICT labour is available in the
latter group may migrate to the former group. Hence over time the ICT gap may not only widen
between developed and developing countries, but also within the developing countries itself.

DIGITAL DIVIDE AND THE ICTS IN INDIA

A number of research studies have pointed out the extent and seriousness of digital divide in
India. Hanna (1994) in his study of the Developed, Newly Industrialized Economics (NIEs) and
Developing countries, found that in India, access to computers and telephones was far below
world average and far behind other NIEs like Brazil and Taiwan. The reasons quoted were
mainly lack of public infrastructure and National Policy Framework.2 A country report released
by the WEF's (World Economic Forum) Steering Committee on Education (2002) stated that
while no country has benefited more than India from the IT revolution, no country has a wider
digital divide than it. Therefore India is emerging as a laboratory for testing out new
technologies and business models for narrowing the digital divide between urban and rural
people in a developing economy on one hand and also between developed and developing
nations on the other.

In this regard, certain efforts have been made by international and national level public and
private sector organizations. Some of the private sector initiatives are from Intel, Hp labs, Te Net
and NIIT. The focus of most of these projects that aim to bridge the digital divide in India is on
building sustainable business models for village entrepreneurs. Although subsidies and grants are
expected in order to give their pilot projects the necessary seed funding, the long-term objective
is to evolve self-sustaining business models for rural access to information technology. Hence
there is clearly a great deal of seriousness on all fronts in India about taking information
technology and communications to rural India, and the villagers are also receptive.3

Growth of ICT Industry in India

The ICT industry in India has witnessed incredible evolution and explosive growth over the last
decade. According to International Data Corporation (IDC) and National Association of Software

4
and Service Companies (NASSCOM), the share of IT industry in GDP has risen from 0.59 % in
1994-95 to 1.19 % in 2002-03. Compounded annual growth rates since 1990 have been over 50
% – almost twice the growth rate experienced in the US software sector during the same period.
However in 2001, similar to the trend worldwide, the Indian IT industry also witnessed a lower
growth rate of 32 %. IDC expects the market to firm up and the industry to grow at a compound
annual growth rate of 30 % by 2006.4 Moreover to reiterate, the global financial community is
showing considerable interest in the Indian software and service sector particularly to bridge the
digital divide, and in addition, sustaining the growth of the software industry is at the forefront of
the Government of India’s agenda.

To begin with, the Indian information technology industry, which includes computer hardware,
software and peripherals, networking and training sectors, expanded at a phenomenal rate in the
nineties. NASSCOM estimates PC volumes to reach around 3.0 millions in 2003-04 and further
to around 4.0 millions in 2004-05. However, despite an outstanding growth in the number of
installed computers, there were only 5 computers per 1000 persons (Singhal and Rogers, 2001).
Akin to the international trends, the adoption of computers and the Internet in India in the
nineties has affected its economy and society. It has created a new class division of information
haves and information have-nots. As compared to other mass media like radio, television, films
and computers; the Internet has increased the inequalities and have led to information gap.
Moreover, while creating a new kind of job market and a hope for increasing productivities with
its competitive advantage, it has also led to the deskilling and unemployment in the traditional
sectors of the economy (Singhal and Rogers, 2001).

Among all the major components of computer industry, it is the software industry that has taken
an edge over others. The Indian computer software industry has been built predominantly upon
an export driven model. Presently, India is acknowledged the world over as an important base for
offshore IT services5, with more than one-third of the Fortune 500 companies outsourcing their
software requirements to India. According to NASSCOM survey, there is structural shift in the
delivery models of Indian IT Industry in the last decade. In 1991-92, offshore services accounted
for 5 % and on site services for 95 % of the total exports. However during 2001-02, offshore
services contributed more than 49 % of the total exports and in 2002-03 this share increased to

5
58%. Within a short span of six years, the share of Indian IT and service exports increased almost
four times from just 4.9 % in 1997-98 to 20.4% in 2002-03. Similar to the direction of India’s
exports in other commodities (Bala: 2002), the main destinations of Indian software exports in
2001-02 were North America (63%) followed by Western Europe (26%) and Japan (4%). The
following year i.e. 2002-03, however, observed the emergence of some new players and the main
destinations of Indian software exports were North America (68%), Western Europe (21%), Latin
America and rest of the world (5.9%), Asia-Pacific (3.2%) and Japan (2%). In fact, India with its
competitive advantages of the largest pool of low cost scientific and engineering manpower,
which is also English speaking has an inherent competitive advantage in terms of software
exports and the high growth rates that provide the country with a strategic opportunity in the
world market (Hanna, 1994). Many global companies already source IT-enabled services from
India.6 Despite this India’s share in the world software market is however, still comparatively
low. According to Patibandla and Peterson (2002), “the export competitiveness, achieved in
India, however, is without a domestic market base and inefficient input industries and
infrastructure”. Thus the challenges faced by the Indian ICT industry are many that are deterrent
to its growth. One of them has been the lack of adequate ICT infrastructure that includes
unreliable power supply and bandwidth costs, The government of India has, however, taken
suitable initiatives towards this by adopting policies in this direction.

Unlike IT exports market, which is completely software and service segment driven, Indian
domestic IT market has a strong hardware component, which includes peripherals, networking
and hardware services. Out of the total domestic market, hardware had a major share of 56 %,
followed by IT services with 24 % share and packaged software with 10 % share in the total.
According to the data provided by IDC, India Limited, in 1999-2000, the domestic IT market
grew by 30 % per annum. The domestic IT spending, however, slowed down subsequently and
the growth rate recorded were 10 % per annum. As per NASSCOM reports, IT has created
92,000 new jobs and 2,50,000 indirect jobs in the year 2001-02 and it continue to rank among the
fastest growing sectors in the economy. It has penetrated in almost all sectors of the economy.
Out of the total penetration, most prominent domestic sectors in 2002-03 were the IT/Telecom
(22%) with maximum share, closely followed by Banking and Finance (21%), Manufacturing
(15%), Government (14%) and Education (11%).

6
Despite sharp diffusion of the Internet worldwide during the nineties, India estimated a mere
number of 15 million Internet users in 2000 as against 300 million users globally (Singhal and
Rogers, 2001). However the number of Internet users at the end of 2001 was around 500 millions
and accelerated to around 650 million during 2002 (NASSCOM: 2004). Despite this remarkable
increase in the number of the Internet users, domestic opportunities for web-based applications
and e-commerce, however, have not yet matured. Computer dispersion is mostly restricted to
English speaking cities. There are efforts to develop applications and peripherals in local
languages, but they are haphazard and miniscule.

THE MODEL
A few research studies have tried to estimate the impact of ICT investment on economic growth.
For example, Pohojla (2000) used an augmented neo-classical model (Mankiw, Romer and Weil:
1992) to study the impact of ICT investment on economic growth. Similarly, Gholami, Lee and
Heshmati (2003) investigated a simultaneous casual relationship between ICT, FDI and
economic growth by using Johansen co-integration tests. Addison and Heshmati (2003) used a
panel data technique to estimate the casual relationship between FDI, GDP growth, trade
openness and ICT for a large sample of countries.

However, a fairly straightforward measure to assess the impact of FDI and digital sector or
digitalisation on the growth of GDP of a country and the growth of human capital is to use both
GDP and human capital as dependent variables separately and estimate them in two different
models. We therefore first regress standard measures of economic development i.e. GDP on
measures of human capital and foreign capital along with other variables. Starting with an early
form of production function, i.e.

Y  A L1 ,
If we expand this function to include human capital and a measure of digitalisation, it will write
like
Y  f ( K , L, HK , D ) ……….(1)

Where Y, K, L, HK and D refer to GDP, capital, labour, human capital and digitalisation
respectively. K can further be bifurcated into domestic capital (DK), foreign capital (FK), and

7
foreign capital in digital sector (FKd). In fact, the model can be extended to cover m types of
capital by writing the production function in Cobb-Douglas form (Nonneman and Vanhoudt,
1996).

The variables used for the model are in the form of proxy variables, %ages, and composite
indexes. Due to the lack of consistent data on human development indicators, a proxy variable
has been used, which is a composite index encompassing an output indicator i.e. literacy rates
and an input indicator i.e. gross enrolment ratios at secondary level. Domestic capital is
measured as gross domestic investment as a per cent of GDP, foreign capital as capital imported
through FDI as a per cent of GDP and FDI in digital sector as a per cent of GDP. Digitalisation is
also a composite index of variables like radio per thousand, TV sets per thousand, cable
subscribers per thousand, Personal Computers per thousand, Internet hosts per thousand, fax
machines per thousand, and telephone mainlines per thousand.

Data used to estimate the model is from different sources. Sources used to collect data for the
model include World Development Indicators, Economic Survey and SIA newsletter of Ministry
of Industry, Government of India. Due to the non-availability of consistent data the period
chosen for analysis is 1991 to 2001.

It is important to point out here that economic growth also results in educational and human
capital growth. It has been pointed out in several research studies that schooling system is a
prerequisite to economic growth (Easterlin, 1981). Moreover, it has also been pointed out as
mentioned earlier that the quality of human capital in fact commands the ability of capital inflow
to a country that adds to economic growth. Similarly index of digitalisation reflects the
importance of digital economy in the economic growth of a country.

Equation stated above at 1, takes human capital as given that attracts FDI in an economy.
However FDI inflow combined with the index of digitalisation will have spillover effects
including the human capital accumulation in the host country, Therefore this impact on human
capital accumulation will be estimated in the following model i.e.

HK  f ( K , L, D) ………..(2)

8
where HK, K,L and D are same as above in the case of equation 1.

The relevant equations can be re-written as follows

ln y     ln l   ln dk   ln fk   ln fk d   ln hk   ln d ………..(3)

and ln hk     ln l   ln dk   ln fk   ln fk d   ln d ……..(4)

where  ,  ,  , , , and represent the elasticity of production relative to labour, domestic

capital, foreign capital, and foreign capital in digital sector, human capital and digitalisation
respectively.

With all these qualification in the mind, an empirical test on our log linear statistical model was
tested. The results of which bring the following equation

ln y  10.36  0.16 ln l  0.15 ln dk  0.19 ln fk  0.04 ln fk d  0.004 ln hk  2.26 ln d ………..(5)

(0.96) (0.25) (0.30) (0.68) (0.41) (0.02) (3.02)*

R square = 0.98, R-adjusted = 0.96, F =45.5 (6,4 99%), N = 11 and figures in the brackets show
‘T’ values where * means significant at 95% level of significance.

The model shows that the variables selected provide most of the explanation for the change in
GDP as R2 = 0.98 and P value for the F statistics indicates the overall significance of the model at
1% level of insignificance.

In normal circumstances, the signs of the coefficients in the equation no. 5 are mostly
insignificant however, opposite to the expected positive signs, which may be due to the
limitation of small number of the observations available for the comparable and consistent data.
The opposite signs of coefficients, which are, however, insignificant, do tell a story of variables
like labour and capital (disaggregated), influencing economic growth. Despite this the model
given at 5, is however, indicative of the fact that index of digitalisation is the most important and
significant factor in the economic growth of the country.

9
Considering the logic as given earlier that capital inflow combined with the index of
digitalisation will have spillover effects including the human capital accumulation in the host
country, Therefore this impact on human capital accumulation has been estimated in the
following model i.e.

ln hk  26.60  1.59 ln l  0.80 ln dk  0.81ln fk  0.30 ln fk d  1.60 ln d …(6)

(1.83)** (1.86)** (1.00) (2.51)* (2.6)* (1.52)

R square = 0.78, R-adjusted = 0.58, F =3.75 (5,5 90%), N = 11, figures in the brackets show ‘T’
**
values where * means significant at 95% level of significance and means significant at 90%
level of significance.

Similar to the model estimated at (5), the model at (6) also shows that the variables selected
provide a fair amount of the explanation for the change in Human Capital (HK) as R 2 = 0.78 and
P value for the F statistics indicates the overall significance of the model at 90% level of
significance.

The coefficient of digitalisation, although negative, is statistically insignificant implying that it

has a positive impact on the growth of human capital. The negative sign may be due to the
availability of less number of consistent observations. However, the equation at (6) does indicate
certain trends compellingly i.e. the inflow of foreign capital do have spill over effects and
contributes significantly to the human capital accumulation in India. As the coefficient of foreign
capital, which is 0.81, despite limitations of data, is positive and also statistically significant.

In fact regardless of low literacy rates, India has a history of support for technical education and
has produced large number of technically qualified people. It is because of this that the country
could export engineers and scientists to USA, some of which have become backbone of the rapid
IT growth in India. “In 2000, of the total venture capital funding in India, 38 per cent came from
the firms headed by India-born investors”.7 According to NASSCOM, “From a base of 6800
knowledge workers in 1985-86; the number increased to 522,000 knowledge workers in 2001-
02.”8 This number is however, very less for a country, where labour force is counted as hundreds
of millions. Despite this hardly any worker in any office is likely to remain untouched by one
way or another in future-be it railway reservations, banking services, health services or postal

10
services indicating a positive impact of FDI and ICT on human capital. However, in a labour
abundant country like India, policy makers not only have to ward off against the new jobs being
replaced by the old ones but also ensure ‘on the job trainings’, which is an integral part of human
capital accumulation.

CONCLUSION
In order to fully harness the benefits of digitalisation for the benefits of the masses particularly in
the rural areas where a vast market still needs to be tapped, a lot more effort is required on the
part of the state not only at the policy level but also at the level of the implementation. UNCTAD
(2003), based on the indexes of connectivity, access and policy, calculated from the different
indicators of information technology for developing countries, points out that India lags behind
as far as indexes of connectivity and access are concerned, and is going ahead as far as the policy
index of IT is concerned. Connectivity, access and infrastructure are still larger issues that need
special attention. India therefore has attracted FDI in the ISP sector to provide better services.
The 802.11 technologies have paved the way to handle the traditional bottlenecks of higher costs
of landline phone tariffs and PC prices, which were hindering PC penetration especially in the
rural areas in India.

Some initiatives have already been taken in collaboration with Government of India and private
sector both at national and international level. Lots still is required if digital divide has to be
bridged. Despite a major policy thrust on attracting FDI in the absence of adequate funding into
the newer areas of ICT like banking, health, telecommunications and infrastructure; yet these
initiatives have focused basically on international, national and urban aspects to bridge the
divide. The rural dimensions, though mentioned at the policy level, have not yet been given due
attention particularly in terms of availability of committed resources. There is, in fact, need to
spread these ICT technologies into the remote areas thus helping in bridging the internal as well
as international digital divide.

State level initiatives need to be expedited in India. Despite state governments like Karnataka9,
Andhra Pradesh, Maharashtra and Tamil Nadu, enacting some state level policies to attract
foreign investment and implement local ICT projects, other states are yet to follow the suit. A

11
report by Ministry of Information and Technology10 based on indicators like network access,
network learning, network society, network policy, e-governance and network economy; pointed
out that except Karnataka, Andhra Pradesh, Maharashtra, Tamil Nadu, Delhi, Gujarat and
Chandigarh; other states and union territories were relatively less e-prepared. Therefore, steps
need to be taken in this regard.

While states have a significant role to play in terms of providing infrastructure and policy
support, the research studies have shown that a timely intervention from the private sector has
made significant contributions in the successful diffusion of ICTs and human capital
development. Therefore, private investments with two-fold objectives need to be attracted that
would help not only in providing upgraded technological assistance but also cater to local needs
including local languages. Rural projects that are successfully running in some areas also need to
be replicated in other parts of the country so that domestic along with international digital divide
can be adhered to some extent.

In this regard, the regression model estimated in this paper, do show us that while FDI
contributes significantly to the growth of human capital in India, digitalisation and human capital
indicator contribute to the economic growth of India significantly. The trend in the last decade
has shown that the top sectors that have attracted FDI (in the period under review) is in the
telecommunication sector and electronics including computers sector. Economic Survey 2002-03
reports that the telecom sector was the major recipient of the FDI during August 1991 to June
2002. Therefore, the natural implication of this analysis is that attracting foreign direct
investment in information technology will contribute not only to economic growth but also help
in the human capital growth as part of spill over effects.

12
1
NOTES
Steinberg, 2003, p.45
2
pp.14-15
3
http://www.wcld.net/digital.htm
4
IDC; 2002. “ Indian IT Industry to Cross $ 45 B.by 2006”, A Report, International Data Corporation.
5
Services provided by working on Indian Land
6
Two key elements of IT-enabled services are outsourcing and out-location. A third element - web-based services – is also
emerging as the Internet energises newer business models and allows companies to centralise services and/or operations at
an optimal global location, and to enhance customer reach. India’s strengths as mentioned earlier, are based on the
availability of a large pool of English-speaking and computer literate manpower at per capita cost that is quite attractive
when compared with developed countries markets.
7
www.economictimes.com, February 21, 2001
8
NASSCOM (2003, 2004), Indian IT Industry: A Success Story, Fact Sheet.
9
Karnatka was the first state government in India to enact a state level policy in 1997.
10
Ministry of Information and technology, 2003, “E-readiness of Indian States,” A report submitted by NCAER to the
ministry, Government of India, Ch.2

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