IMPACT OF ECONOMIC DETERMINANTS OF FDI IN PAKISTAN

A Synopsis of the MS (Economics) Thesis submitted to the Board of Advanced Studies and Research (BASR) for approval

Submitted by : HUNAIN ZAKI Supervisor : Prof. DrShafiqurRehman Date: _____________

1. INTRODUCTION: The significanceof foreign direct investment (FDI) flows is well documented in literature for both the developing and developed countries .Over the last decade foreign direct investment have grown at least twice as rapidly as trade (Meyer, 2003).The shifting methods of worldwide business and the cross border mobilization of factor wealth in hunt of transactional manufacture, novel proportions for unrelenting financial development. Globalization has opened the boundaries of different countries for foreigners to avail opportunities in the host countries. Foreign Direct Investment is characterized as the foundation of acquirement of administrative power via a trade venture of overseas nation into a host nation. Foreign direct investment is a section of a nation's countrywide monetary accounts. Its the outlay of alien resources interested in national compositions, apparatus, along with businesses. It doesnt incorporate foreign investment into the stock markets.

Accordingly during early 1980s, the government in Pakistan has initiated market-based economic reform policies. These reforms began to take hold in 1988, and since than the government have gradually liberalized its trade and investment regime by providing generous trade and fiscal incentives to foreign investors through number of tax concessions, credit facilities, and tariff reduction and have also eased foreign exchange controls (Khan, 1999). In the 1990s, the government further liberalized the policy and opened the sectors of agriculture, telecommunications, energy and insurance to FDI. But, due to rapid political changes and inconsistency in policies the level of FDI remained low compared to other developing countries.

Returns on foreign direct investment (FDI), taking the form of profits, expansion of business, market development and innovations, are linked to social, economic, political, financial and cultural factors in the host economy. A transitional economy often looks outward in order to find the Opportunity for rapid growth. Inward FDI helps them acquire the Technology of the developed world and apply this more advanced technology to their industries. Transition economies may expect other benefits too. Since foreign firms increase competition, their presence may encourage greater efficiency in domestic firms. Even foreign Investment may help increase workers incomes, if it creates higher paying jobs in the host country. Because foreign investment offers many potential benefits to host countries, policy makers are naturally interested

- ii -

process of economic development in host countries. Many policy makers and academics struggle that foreign direct investment (FDI) can have important positive effects on a host countrys development effort (Alfaro, 2003).It is not exaggerated to say that FDI plays essential role in the encouragement of national economic development, bringing innovative technology, up to date management and marketing techniques .When domestic resources are short to finance the development requirements.

To enhance more FDI into Pakistan, the management authorities of each respective country needs to ensure stable economic and political environment, provision of physical quality infrastructure, maintaining inflation rate, encourage domestic investment, curtail external debt, financial incentives, reduce duties, peace and security, law & order situation and consistency in the government policy because these all are the key factors for potential investors in making investment choices.

FDI is one of the most important forms of international capital flows. Particularly for DevelopingCountries like Pakistan, India and Bangladesh, FDI has been the most important source of foreign Investment and an important source of technological spillovers.

- iii -

2. LITERATURE REVIEW: Systematic review of literature is highly important for research activity because it gives relatively inclusive information concerning the problem and provides an improved understanding to make objectives of the research study. Though several empirical studies have been conducted concerning the factors determining FDI. Most of the studies utilize multiple numbers of theories or hypotheses in order to investigate the empirical linkage between FDI and variety of economic, social and political variables.

Economic development of a country involves utilization of resources for increasing productive capacity. In many developing countries such as Pakistan, utilization of resources is rendered impossible by the scarcity of domestic capital. (Lizondo, 1991) acknowledged a better choice by developing countries of foreign direct investment (FDI) rather than to depend on bank loans and bonds.

The literature on determinants of FDI in Pakistan is still young enough that most theoretical hypotheses are still grab up. That is why (Chakra-barti, 2001) concluded that most determinants of cross-country FDI are fairly fragile statistically. (Khan, 1997) analyzed the factors responsible for lower level of FDI in Pakistan. The study identified a number of factors, i.e. lack of political stability, law and order situation, economic strength, governments policies, government bureaucracy, local business environment, infrastructure, quality of labor force, quality of life and welcome attitude.

The determinants of FDI in Pakistan are estimated by (Shah and Ahmed, 2003) taking market size; cost factor, political and social factors as determining variables. For South Asia, determinants and trend of FDI are probed by (Sahoor, 2006). The study explored that sharp rise in private capital flows to developing countries come despite uncertainties caused by high oil prices, rising global interest rate and growing global payment imbalances. The rise in capital flows to developing economies was basically driven by abundant global liquidity, steady improvements in the credit quality of developing countries, lower yield in rich countries, and the expansion of investors interest in emerging market assets.

Extensive empirical literature on determinants of inward FDI emphasizes the economic conditions or fundamentals of the host countries relative to the home countries of FDI as determinants of FDI flows. This literature is in line with (Dunnings eclectic paradigm, - iv -

1993) which suggests that it is the locational advantages of the host countries e.g., market size and income levels, skills, infrastructure and political and macroeconomic stability that determines cross-country pattern of FDI. Following this approach (Nishat and Anjum, 1998) have estimated that political stability, peaceful law and order situation, level of technical labor force and mineral resources and liberal policies of the government attracted foreign investors in Pakistan.

A high level of economic growth is a strong indication of market opportunities. The growth of the host market is deemed to be significantfor expansionary direct investment (Clegg and Scott-Green, 1998). Marketsize exhibits existing demand in an economy while growth represents the future potential. Growth is also important because higher rates of economic growth are usually associated with an increase in the profitability of corporations (Gold, 1989, p. 213). There exists relatively little support in the existing literature for this determinant of FDI as compared to the market size variable (Goldberg, 1972; Scaperlanda and Balough, 1983; Culem, 1988 and Clegg 1995).

As confirmed by various studies from (Veugelers, 1991), (Grosse and Trevino, 1996) there is a positive effect of host countrys economic growth on FDI. In fact growth rates are positively related to foreign capital stocks, FDI flows to countries with increasing GDP and it leads to an increase in economic activity in the recipient country.

Therefore there is a positive sign between GDP and FDI.The interest rate is the rate which is charged or paid for the use of money or more precisely the cost of borrowing. According to (Gross and Trevino, 1996) a relatively high interest rate in a host country has a positive impact on inward FDI. However the direction of the impact could be in a reverse if the foreign investors depend on host countries capital market for raising FDI fund. The researcher has used prime lending rates because investors are lenders and borrowers.

Higher Interest Rates implies more costly investment and, therefore, the higher the interest rate, the more it is likely to defer FDI and the relationship between FDI and the interest rate is expected to be negative. (Love and Lage-Hidalgo, 2000) and (Erdal and Tatoglu, 2000) amongst others, find that an increase in the interest rate leads to a decrease in FDI.

-v-

According to (Akinboade , 2006) low inflation is taken to be a sign of internal economic stability in the host country. Any form of instability introduces a form of uncertainty that distort investor perception of the future profitability in the country. (Wint and Williams, 1994) show that a stable economy attracts more FDI thus a low inflation environment is desired in countries that promote FDI as a source of capital flow. Therefore the study expects a negative relationship in the regression analysis.

Regarding empirical evidence on macroeconomic policy and reforms,(Schneider and Frey, 1985) find inflation and high balance of payments deficit negatively affecting FDI. Likewise (Apergis and Katrakilidis, 1998) find that inflation and inflation uncertainty adversely affect FDI. (Hasen and Gianluigi, 2009) also find that measurement of government mismanagement such as inflation and high fiscal deficit act as disincentives for FDI to Arab Maghreb Union (AMU) countries.

(Yartey and Adjasi, 2007) and (Asiedu, 2002) find a negative significant effect of inflation on FDI inflows. In sharp contrast to aforementioned studies, (Alfaro et al, 2009) demonstrates that increased domestic inflation rate increases foreign investment via changes in the intertemporal consumption pattern of the agent.

It is argued that FDI boosts economic growth indirectly where the direct transfer of technology augments the stock of knowledge in the recipient country through new management practices and organizational arrangements as well as labor training and skill acquisition, (De Mello, 1999). In the theoretical context of either endogenous growth models or neo-classical there is a difference in the effect of FDI on the economic growth of the receiving country from their conventional equivalent. The counterpart theory states growth in the framework of an open in contrast to a closed economy and the emergence of externality based growth models. For instance, a study showed that the positive growth effects of FDI have been more likely when FDI is drawn into competitive markets, while negative effects on growth have been more possible when FDI is drawn into heavily protected industries (Encarnation and Wells, 1986). (Alfaro et al, 2007) proposed that FDI had a positive effect in countries with adequate developed financial economies, while, (Carkovic and Levine, 2002) argued this view was not accurate, since FDI did not exert an exogenous impact on growth in financially developed markets.

- vi -

3 .OBJECTIVE OF THE STUDY: The main objectives of this study are mentioned below: 1. To investigate the factors which affect Foreign Direct Investment. 2. The effects of Foreign Direct Investment upon Pakistan Financial situation. 3. Providing a clear picture to potential investors before they decide on using their investment in such country. 4. To identify the risks if which the foreign investors bear while investing in Pakistan.

From this study we would be able to see which specific government policy is attracting or distracting FDI in Pakistan. This study would be of interest to policy makers in many developing countries where structural reforms are being implemented. The broad objectives of this study are to analyze those factors which discourage and encourage FDI to Pakistanduring the study period. Moreover, to know about the trends and importance of FDI in Pakistan

3. HYPOTHESIS: Hypothesis plays significant role in the research which helps to solve problem in research model. The hypothesis of the study is stated as under: H1= interest rate has significant impact on FDI H2=GDP has significant impact on FDI H3= inflation rate has significant impact on FDI H4= Political Situations have significant impact on FDI

4. RESEARCH METHODOLOGY:

According to (Azam and Luqman, 2008) the Foreigner Investor may be attracted to come in the host country to invest their capital. The main objective of the host country is to gain returns on these investments. There is no single theory suggesting explaining the FDI. Numerous researchers put forward a number of variables to explaining the inflow of FDI. They use the Model of their study the linear Regression Model. (Hashim, Munir, & Khan, 2008) in their study on telecom sector of Pakistan .They elaborate in their study that telecom sector started in 1990 and it will growth in the 2000.

- vii -

The study utilizes the following model as per the above mention studies Y= 0+ 1GDP+ 2 INF+ 3 IR+ t According to the above equation FDI is the positive product of GDP, Inflation Rate, and Interest Rate. Where, FDI= Foreign Direct Investment GDP=Gross Domestic Product INF=Inflation Rate IR= Interest Rate = Error term The explanatory variables and error term () will follow the least square assumptions.To assist our research and to run Regression which has been applied as an analytical technique for investing the impacts of variables on the FDI we apply ANOVA test for variability. ANOVA provides a statistical test of whether or not the means of several groups are all equal, and therefore generalize t-test to more than two groups.Doing multiple two-sample t-tests would result in an increased chance of committing a type error. For this reason, ANOVAs are useful in comparing two, three or more means. Variability refers tothe extent to which these data points differ from each other. Thereare four commonly used measures of variability: range, mean,variance and standard deviation.

Furthermore, in this study we also check the effect of political situation on FDI, for this purpose we have introduce the dummy variable in the estimated equation; Y = 0+ 1GDP+ 2 INF+ 3 IR+4D +t D = 1, For Political Stability = 0, Otherwise (For Political Instability)

5. DATA COLLECTION:

Data collection is based on secondary data from official publications of each country. The model consists of Three variables i.e. Economic growth (GDP),Rate of inflation (INF),and Interest rate (IR) .Annual data of these variables for Pakistan over the period of 1990- 2010 will be used to estimate the equation. Thus a total of 20 observations are used

- viii -

for the test for the country. All tests are conducted over the full sample. All the data refer to the end of the year. Data were collected from the annual report of State Bank of Pakistan, Economic Survey of Pakistan, and other Publications of the State Bank of Pakistan. The data of FDI is collected from various issues of Assets, Liabilities and Foreign Investment published by State Bank of Pakistan. The exchange rate is extracted from the electronic data of International Financial Statistics. The data of all the other variables are from 50 Years of Pakistan and various issues of Pakistan Statistical Year Book published by Federal Bureau of Statistics, Government of Pakistan. 6. RESEARCH BODY: Acknowledgement Table of content Abstract Introduction Review of Literature Brief History of FDI in Pakistan Methodology Data Collection and Estimation Conclusion and Policy Recommendation References and Bibliography

7. REFERENCES: Dunning, J. H. (1993),Multinational Enterprises and the Global Economy. Harrow: Addison-Wesley. Khan. Ashfaque H. and Yun-Hwan Kim (1999) EDRC (Report Series No. 66.) Nishat, M., and A. Aqeel (1998), The Empirical Determinants of Foreign Direct Investment in Pakistan.Saving and Development. Vol 24 No. 4, P.P.47179. Billington, N. (1999), The Location of Foreign Direct Investment, An Empirical Analysis.Applied Economics 31, P.P. 6576.

- ix -

Alfaro, L. (2003), Foreign Direct Investment and Growth: Does the sector Matter? Harvard Business School, Morgan 263, Bostan, MA02163 Asiedu E., (2005) Foreign Direct Investment in Africa: The Role of Natural Resources, Market Size, Government Policy, Institutions and Political Instability. Research Paper No. 2005/24, UNU-WIDER, World Institute for Development Economics Research. Adinboade, (2006). The Location of Foreign Direct Investment: An Empirical Analysis. Applied Economics 31, 65-76. Gross., and Trvino., (1996). Determinants of Foreign Direct Investment., Journal of International Economics, Volume 45, p.p.115-135. Wint. and Williams., (1994). International Investment Location Decisions: The Case of US Firms, Journal of International Economics, Volume 33, P.P. 57-76. Clegg, Jeremy and Susan Scott-Green, (1998), The Determinants of Japanese Foreign Direct Investment Flows to the European Community, 1963-1990, in J.-L.Mucchielli, ed., Multinational Location Strategy, Vol. 6 in the series Research in Global Strategic Management edited by Rugman, A.M. (Greenwich, Conn.: JAI Press), pp. 29-49. Gold, D., (1989), Foreign Direct Investment, in A. P. Harvey, ed., International Corporate Finance. Culem, C., (1988), The Locational Determinants of Direct Investment Among Industrialized Countries, European Economic Review, 32, pp. 885-904. Schneider, F. and B. S. Frey (1985). Economic and Political Determinants of Foreign Direct Investment, World Development, 13, P.P. 161-175. Apergis, N. and C. Katrakilidis (1998). Does Inflation Uncertainty Matter in Foreign Direct Investment Decisions? : An Empirical Investigation for Portugal, Spain, and Greece, Rivista Internazionale Di Scienze Economiche E Commerciali, 45, P.P. 729-744. Hasen, B. T. and G. Gianluigi (2009). The Determinants of Foreign Direct Investment: A Panel Data Study on AMU Countries, Centre for International Banking Economics and Finance Working Paper (November)

-x-

Yartey, C. A. and C. K. Adjasi (2007). Stock Market Development in Sub Sahara Africa: Critical Issues and Challenges, IMF Working Paper WP/07/209 Shahzad .N and Zahid.M.(2000) The Determinants of FDI in Pakistan. Abasyn J4ournal of Social Sciences, Vol. 5 no. 1 P.P. 111-121.

- xi -