Causal Dynamics Between FDI and the Informal Economy in India: A MIMIC and VAR Approach

Abstract

This study investigates the impact of foreign direct investment (FDI) on the informal economy in India during the post-liberalisation period from 1993 to 2018. Given the vast size and significance of the informal sector in the Indian economy, understanding its interaction with FDI is crucial. The informal sector output is measured using the Multiple Indicators Multiple Causes (MIMIC) approach, which offers a comprehensive estimate of informal activities. The study employs a vector autoregression (VAR) model, Granger causality test and Johansen cointegration analysis to examine both short- and long-run dynamics between FDI and the informal economy, while controlling for gross domestic product (GDP), Human Development Index (HDI), Corruption Perception Index (CPI) and trade openness (TO). Empirical findings suggest that FDI negatively and significantly affects the informal economy in the short run and long run, while the informal economy does not exert a significant influence on FDI inflows. The unidirectional causality from FDI to the informal economy is confirmed through Granger causality tests. The results have strong policy implications, indicating that while FDI promotes formal-sector growth, it may displace or suppress informal economic activity.

JEL Codes: F21, O17, C32, F43, E26, F63