Foreign direct investment and credit market reform in a developing economy: Could these be alternative policies?

We examine the welfare consequences of foreign direct investment (FDI) flows and credit market reform in a small open developing economy using a 2 x 2 full-employment general equilibrium model with both labour market and capital market distortions. Apart from factor market imperfections, there is a tariff on the import-competing sector, which creates commodity market distortion. We find that either of the two policies can lead to welfare improvement under reasonable conditions. Subsequently, using a two-sector, specific factor Harris-Todaro type mode; like that of Beladi and Naqvi (1988), we have verified the robustness of the result that have earlier obtained in the full-employment case. We have found that although the effects of FDI flows on both welfare and urban unemployment are ambiguous, credit market reform unequivocally improves welfare and mitigates the unemployment problem. Considering both the cases together, it might be concluded that as a policy, credit market reform is distinctly superior relative to investment reform. The results could be useful for policy making in a developing economy like India where multiple distortions coexist.