CHAPTER-1

INTRODUCTION


The unprecedented growth of Foreign Direct Investment in the last two decades
has changed the underlying traditional economic relationships in the world
economy. The world stock of
Foreign Direct Investment reached more than
$
12 trillion in 2014. The rate of growth of worldwide outflows of FD1 since the mid
1980s has substantially exceeded that of world-wide gross
domestic product,
worldwide exports and domestic investments.
The number of transnational
corporations has also increased significantly, to more than 60,000 parent
companies (with
500,000 foreign affiliates). The
sales of these affiliates amounted
to about $ 19.4 trillion in 2013 compared to world exports of goods and non-factor
services of
$ 8 trillion, of which
approximately one third took the form of intra-firm
trade.

TABLE OF CONTENTS


Page No.
Certificate Abstract

Acknowledgment



CHAPTER 1
INTRODUCTION 1-8

1.1 Introduction
1

1.2 Objectives of the study
4

1.3 Hypothesis of the study 4

1.4 Significance of the study 5

1.5 Statement of problem
6

1.6 Organization of the study 7






CHAPTER 2 REVIEW OF LITERATURE
9-30

2.1 Introduction
9

2.2 Appraisal of Relevant Studies
9

2.3 Literature from Pakistan
24

2.4 Summary
29
CHAPTER:3 METHODOLOGY AND DATA SOURCES
31-45

3.1 Introduction 31

3.2 Model 31

3.3 Interpretation of variables 34

3.4 Data sources 42

3.5 Hypothesis testing of the parameters 43

3.6 Econometric Techniques for Estimation 44

3.7 Summary 45



CHAPTER 4 ANALYSIS AND ESTIMATIONS 47-59

4.1 Introduction 47

4.2 Basic Statistics
47

4.3 Cointegration Technique
48

4.4 Test of Stationarity
49

4.5 Cointegrating Regression Durbin Watson 53

Test

4.6 Error Correction Mechanism
54

4.7 Discussion of the results 56

4.8 Summary
59

CHAPTER:5 CONCLUSION AND POLICY
60
RECOMMENDATIONS
REFRENCES
63


LIST OF TABLES


TABLE DESCRIPTION
PAGE NO
NO
4.1 Basic Statistics
48

4.2
Results of Augmented Dicker Fuller 51
Test (ADF)



LIST OF FIGURES

FIGURE DESCRIPTION
PAGE NO
NO
3.1 Growth Rate of GDP in Pakistan
35
(1980-2006)
3.2 Labour force in millions in
37
Pakistan(19802006)
3.3 Domestic Capital Formation in 38
Pakistan (1980-2006)
3.4 Foreign Direct Investment in 40
Pakistan (1980-2006)
3.5 Exports of Goods and Services in 42
Pakistan(1980-2006)
LIST OF ABBREVIATIONS




F DI
Foreign Direct Investment
GLS Generalized Least Square
GMM Generalized Method of Moments
IFS International Financial Statistics
LDC Less Developed Countries
MNC
Multinational Corporation
OL S Ordinary Least Squares
TFP Total Factor Productivity
UNCTAD United Nations Conference on Trade and
Development
VECM
Vector Error Correction Model
WDI World Development Indicators
1



CHAPTER 1

INTRODUCTION





1.1 Introduction
Foreign direct investment has been recognized as the most captivating and interesting
topics among researchers in international business. The most distinct feature of the
emerging world economic system is the globalization of production, logistics and
consumption. The world has shrunk to become a global village, leading to greater
interdependence of economies. The concept of multinational investment has gained more
importance due to internationalized production.

FDI is an indicative of the changing feature of the emerging world economic system. It has
increased both in its pace and scope. The enormous increase in FDI flows across
countries is one of the clearest signs of the globalization of the world economy over the
past 20 years. The FDI flows increased from US $55 billion in 1985 to US $1,511 billion in
1990 according to World Bank Development Indicators (2005).
FDI is investment of foreign assets into domestic structures, equipment, and
organizations of the host country. It does not include foreign Investment in local equity
markets. According to UNCTAD (1992), FDI can be described as an investment involving a
long term relationship and reflecting a lasting interest and control of resident entity in
one economy in an enterprise resident in another economy other than that of the
foreign direct investor.

A firm undertakes FDI in a foreign market if it recognizes an ownership advantage over the
local competitors in the host country. The ownership of the foreign investment
usually remains in the investing (home) country. FDI represents the primary means of
transfer of private capital, technology, personnel and access to brand names and
marketing advantage FDI has been recognized as the most powerful and strategic means
for transforming a traditional economy into a modern economy by accelerating the pace of
growth and development. There are good examples wherein the FDI inflows have
transformed the traditional economies of several countries. For example, Chinese and
South Korean economies have attracted substantial FDI inflows and emerged as faster
growing economies in the world.

Developing countries face the problem of shortage of capital implying insufficient
savings or domestic sources to finance the two gaps i.e. the Import-Export gap and the
Savings-Investment gap. The alternative to domestic capital is the attraction of foreign
investment for accelerating the rate of internal capital formation. The foreign financial
flows to developing countries are broadly categorized as:
Private debt flows,
Official development finance,
Foreign direct investment,
Portfolio investment.
Loans and grants had historically created the problem of heavy external debt creating
balance of payment difficulties for developing countries. Official development
finance dried up since 1960's which left the other two sources; foreign direct
investment and portfolio investment as means for accelerating capital
formation. FDI is preferred to the above mentioned inflows as it imposes no
financial liability on the recipient country.
Financial development alternatively can be financed through export-led growth
to earn more foreign exchange through exports and finance its developmental
needs. Export-led growth requires resources namely investment, technology,
management and marketing techniques for the attainment of competitiveness in
global markets. FDI makes a positive contribution to the host economy's balance
of payment due to the export oriented investment which helps to earn the
much needed foreign exchange. Similarly for enhancing the export led growth,
the required inputs as mentioned above can also be secured from the FDI
inflows. Therefore, FDI could be regarded as a better measure for enhancing the
capital formation in a developing economy. A wide variety of benefits result
from FDI inflows. Some of these gains may occur in some instances but not in
others and the magnitudes of the gains vary from case to case. Several gains from
FDI as
discussed by Appleyard and Field
(1992) include; increase in output,
wages, employment, exports, tax revenues, realization of scale economies,
provision of managerial skills and weakening of power of domestic monopoly.

The commonly cited disadvantages to the host country arising from foreign
capital inflows include; adverse impact on the host country's commodity terms of
trade, decrease in domestic saving, decrease in domestic investment, instability in
the balance of payments, and loss of control over domestic policy. At present, the
consensus view seems to be that there is a positive association between FDI inflows and
growth provided; receiving countries have reached a minimum level of educational,
technological and infrastructure development.
Objectives of the Study
The objectives of the study are to:
Explore the effects of FDI inflows on the host economy in general, and Pakistan,
in particular.
Empirically assess the relationship between FDI inflows and economic growth.
Quantify the impact of FDI on the economy of Pakistan and suggest some policy
recommendations in order to improve the contribution of FDI in the economy of pakistan

1.3 Hypothesis of the Study
The study will focus on the exploration of the relationship between FDI and Pakistan's
economic growth. In this context, the main hypothesis to be tested is that whether there
exist a relationship between the FDI inflows and the economic growth (and its
components) in Pakistan.

1.4 Significance of the Study
A developing economy like Pakistan is characterized by capital deficiency, low level of
industrialization and a narrow industrial base, low capital-labour ratio, large disguised
unemployment, lack of technical and managerial skills, culture of inefficiency and
overwhelming reliance on export of primary goods. FD1 can be an important instrument for
overcoming these structural weaknesses necessary for transition towards development

Pakistan like other South Asians countries has been following a very liberal policy
towards attracting FDI since 1980. It consists of large number of provision for foreign
producers including an extensive set of fiscal incentives and allowances. These
provisions consist of tax concessions, permission to negotiate the terms and conditions of
payment of royalty and technical fees suited to foreign investors for transferring
technology, liberalization of foreign exchange regime, and permission of remittances of
principal and dividends from FDI. As a result of these measures FDI inflows increased in
Pakistan from $
63.6 millions in 1980 to $ 1.71 billion for 2007. (World development
indicators 2008).



The present study will attempt to explore the effects of FDI on the Pakistan economy, as
advanced by the proponents of globalization in the shape of increased FDI at world level. An
attempt will be made to quantify the effects of FDI on economic growth. It is hoped that
the results, will be helpful for the government and policy makers as well to review their
policies regarding FDI and its impact on the economy.
1.5 Statement of the problem
Foreign Direct Investment is considered an important vehicle for development,
and Pakistan, like most developing countries, has been keen to attract more of it.
The virtues that are associated with FDI are many. The present study will try to
explore the effects of FDI on Pakistan's economy to establish that the proposed
virtues of FDI hold for Pakistan or otherwise. The study will also highlight the
level of contributions of FDI in Pakistan economy over the years under study.



CHAPTER 2

REVIEW OF LITERATURE

2.1 Introduction
This chapter examines studies conducted by various researchers. These studies
intended to find out the relationship between the foreign direct investment and
host country's economic growth. With growing importance of FDI in
mainstream economics, the literature on the topic is also wide. Different
aspects of FDI have been explored and evaluated in the past studies. The review
covers both the theoretical and particularly the empirical studies on the subject.
This chapter also includes the literature review of the studies on the FDI and
economic growth, with reference to Pakistan economy.
2.2 Appraisal of Relevant Studies
Within the framework of the neo-classical models as given by Solow (1956), the
impact of the FDI on the growth rate of output was inhibited due to the existence
of diminishing returns in the physical capital. Therefore, FDI could only exert a
level effect on the output per capita, but not a rate effect. In other words, it was
unable to change the growth rate of output in the long run. As a result FDI was
not considered seriously as a drive engine of growth by mainstream economics.
In contrast, the new theory of economic growth concludes that FDI may affect
not only the level of output but also its rate of growth. This literature has
developed various arguments that explain why FDI may potentially enhance the
growth rate of per capita income in the host country. The identified channels to
boost economic growth include increased capital accumulation in the recipient
economy, technological change, human capital augmentation and improved
exports. The domestic firms also show better efficiency due to their exposure to
fierce competition with foreign firms, and also due to the contract and
demonstration effects.
However, the extent to which FDI contributes to growth depends on the
economic and social condition or the quality of environment of the recipient
country (Buckley, et al. 2002). This quality of environment relates to the rate of
savings in the host country, the degree of openness and the level of technological
development. Host countries with high rate of savings, open trade regime and
high technological product would benefit from increase in FDI inflows to their
economies.


Many empirical works are available in the economic literature showing the
causal relationship between FDI and growth. At the firm level, several studies
provided evidence of technological spillover and improved plant productivity. At
the macro level, FDI inflows in developing countries tend to
-crowd in" other
investment and are
associated with an overall increase in total investment.
Most studies found that FDI inflows led to higher per capita GDP, increase
economic growth rate and higher productivity growth (like De Mello 1999,
Kumar and Siddharthan 1997, and Saggi 2000)
MI during 1960s and 1 970s was considered as growth retarding for the host
nations. The perceptions about the MNCs and their role in economic growth
were more ideological and historical rather than based on the rational economic
theory. The problem of low domestic savings can be improved by the MNCs
which help in capital formation of the host economy that raises the growth
performance of the poor host countries. However this optimism was not shared
by the contemporary theoretical thoughts of 1960s and 1970s . Singer (1950)
argued that the contribution of foreign investment in the growth process of a
developing country has been largely ineffective due to the following factors.
i) The foreign investment removed most of the secondary and cumulative effects
of the investment with respect to income, employment, capital, technical
knowledge and growth of external economies from the country in which
investment took place to the investing country.
ii) It promoted the specialization of LDCs along the lines of static
comparative advantages, offering less scope for technical progress, and without a
significant impact on the general level of education, acquisitions of new skills, and
way of life.
iii) The benefits of the foreign investment in LDCs led mostly to the export
specialization in food and raw materials which was further deteriorated by the
adverse term of trade for the LDCs. A number of early studies generally reported an
insignificant effect of FDI on growth in the host countries. FDI may have negative effect on
the growth prospect of the recipient economy if they give rise to a substantial reverse
flows in the form of remittances of profits, particularly if resources are remitted
through transfer pricing and dividends and/or if the transnational corporations (MNCs)
obtain substantial or other concessions from the host country.

Singh. (1988) found FDI penetration variable to have a little or no consequences for
economic or industrial growth in a sample of 73 developing countries. In the same way
Flien, (1992) reported an insignificant effect of FDI inflows on medium term economic
growth of per capita income for a sample of 4ldeveloping countries. In contrast to the
1960's and 1970's. the 1980s and
1990s witnessed structural adjustment programmes
being introduced in the developing countries. These programmes were coupled with
competitive outward orientation, liberalization of trade and exchange rate regimes.
Introduction of fiscal reforms in LDCs attached with the above mentioned reforms
brought the MNCs as leading international market actors into the centre of economic
development (World Investment Report
1992). Moreover decreasing official financial
fl
ows
and the instability of the private portfolio investment also increased the importance
of the
FDI as a solution to the problem of resource gap and external finance (Trade and
development report 1999).
Fry (1992) examined the role of FDI in promoting growth by using the framework of a
macro-model for a pooled time series cross section data of 16 developing countries for
1966-88 periods. The countries included in the sample were Argentina, Brazil,
Chile, Egypt, India, Mexico, Nigeria, Pakistan, Sri Lanka, Turkey, Venezuela, and 5
Pacific basin countries viz. Indonesia, Korea, Malaysia, Philippines, Thailand. For his
sample as a whole he did not find MI to exert a significantly different effect from
domestically financed investment on the rate of economic growth.

According to the results of the study the coefficient of FDI after controlling for
gross investment rate was not significantly different from zero in statistical
terms. FDI had a significant negative effect on domestic investment suggesting that
it crowds-out domestic investment. Hence FDI appears to have been immiserizing
growth rater than enhancing it. However, this effect varied across countries and in
the Pacific basin countries FDI seem to have crowded-in domestic investment.

Blomstrom et al.
(1994) found that FDI inflows had a significant positive effect
on the
average growth rate of per capita income for a sample of 78 developing and
23 developed countries. However, when the sample of developing countries was
split between two groups based on level of per capita income, the effect of FDI on
growth of lower income developing countries was not statistically significant
although still with a positive sign. They argued that least developed countries learn
very little from MNCs because domestic enterprises were too far behind in their
technological levels to be either imitators or suppliers to MNEs.

Using the framework of new growth theory, the role of foreign direct investment
(FDI) in the growth process, was analyzed by Balasubramanyam et.al, (1996).
The study considered the developing countries characterized by differing trade
policy regimes. It tested (using cross-section data relating to a sample of forty-six
developing countries) the hypothesis advanced by Jagdish Bhagwati (1978).
According to hypothesis the beneficial effect of FDI, in terms of enhanced
economic growth, was stronger in those countries which pursued an outwardly
oriented trade policy than in those countries that adopted an inwardly oriented
policy. They found the effect of FDI on average growth rate positive for the period
1970-85. Particularly for the countries that were deemed to pursue export
oriented
strategy to be positive and positive but not significant and some times negative
for the sub-set of countries that pursued inward-oriented strategy.

FDI is an important vehicle for the transfer of technology, contributing relatively
more to growth than domestic investment. This effect of FDI on economic growth
was tested by Borensztein, et al.
(1998) in a cross-country regression framework
utilizing data for FDI
inflows of 69 developing countries. The coefficient of FDI
was marginally significant, and it indicated that for each percentage point of
increase in the FDI-to-GDP ratio, the rate of growth of the host economy increased
by 0.8 percentage points.

The results of the study showed that, the higher productivity of FDI holds only
when the host country had a minimum threshold stock of human capital. They
also showed that FDI had the effect of increasing total investment in the economy
more than one for one, it indicates the predominance of complementarity effects
with domestic firms in other
words FDI crowds in domestic investment. Similarly Olofsdotter (1998) found that an
increase in the stock of FDI was positively related to growth, and the effect was stronger for
host countries with a higher level of institutional capability as measured by the degree of
property rights protection and bureaucratic efficiency in the host country.

FDI is believed to transfer technology, promote learning by doing, train labour and in
general, it results in spill-overs of human skills and technology. For all this to hold in a
given economy several prerequisites are required. Balasubramanyam et al.
(1999)
attempted to analyze the mechanisms by which FDI promotes economic growth, and by
identifying the preconditions necessary for the effective utilization of FDI. The
preconditions include presence of a liberal trade regime, a threshold level of endowments of
human capital, an adequate domestic market for the goods produced, and effective
competition from locally owned firms through both investments in R&D and domestic
production.





Their results indicate that the coefficient of the FDI to GDP ratio in the growth was
positive and significantly greater for the export oriented countries than for those countries
which pursued an import substituting trade policy. The proxy used for the human capital
was the manufacturing real wage, which showed the positive value. The estimated
coefficient for the FDI- human capital interaction term was found to be positive. It proves
that a certain threshold of human capital endowments was necessary before the
interaction effects begin to make their presence felt.
Similarly De Mello (1999) also conducted time series as well as panel data
estimation. He included a sample of 15 developed and
17 developing countries for
the period 1970-
90. The study found strong relationship between :MI, capital accumulation,
output and productivity growth. The time series estimations suggest that effect of
FDI on growth or on capital accumulation and total factor productivity (TFP)
varied greatly across the countries. The panel data estimation indicated a positive
impact of FDI on output growth for developed and developing country sub-samples.
However, the effect of FDI on capital accumulation and TFP growth varied across
developed (technological leaders) and developing countries (technological
followers).

Results of the study showed that FDI had a positive effect on TFP growth in
developed countries but a negative effect in developing countries but the pattern
is reversed in case of effect on capital accumulation. De Mello inferred from these
findings that the extent to which FDI is growth-enhancing depends on the degree
of complementarily between FDI and domestic investment, in line with the eclectic
approach given by Dunning, (1981).

The complementarities and linkage effects of foreign and national investment were
proved by Agrawal (2000). The study provides empirical evidence on the impact of
FDI inflows on the investment by national investors and on GDP growth. He used
time series data from five main South Asian countries. He showed that impact of
FDI inflow on GDP growth rate to be negative prior to 1980, mildly positive
for early eighties and increasingly positive over the late eighties and early
nineties. The reasons could be that Most of the South Asian countries followed
the import substitution policies and had high



import tariffs in the
1960s and 1970s, these policies changed over the 1980s and
1990s in
favor of more open international trade and generally market oriented
policies. Their results also prove that FDI inflows contributed more to investment
and to GDP growth in South Asia than an equal amount of foreign borrowing.
Marino
(2000) investigated if the trade policy regime followed by host
countries
influences significantly both the amount of inward FDI received by
recipient countries and the impact of foreign direct investment on growth.
Different indicators were used in order to measure the degree of openness of an
economy. Countries were sorted according to a given variable and then qualified
as "open" or "closed" according to a procedure similar to the regression tree
methods used in recent growth empirics. It turned out that: Inward FDI was
positively correlated to the degree of "openness". The impact of foreign
investment was significantly positive in "open" countries and significantly
negative in "closed" countries. Contrary to some other recent contributions, the
present study showed no evidence that a minimum human capital threshold
level has to be reached for the impact of FDI to be positive.

Agosin and Mayer, (2000) analyzed the effect of lagged values of FDI inflows
on investment rates in host countries to examine whether FDI crowds-in or
crowds-out domestic investment over the
1970-95 period. They conclude that
FDI crowds-in
domestic investment in Asian countries crowds-out in Latin
American countries while in Africa their relationship is neutral (or one-to-one
between FDI and total investment). Therefore, they conclude that effects of FDI
have by no means always favourable, and
simplistic policies are unlikely to be optimal. These regional patterns tend to
corroborate the findings of Fry
(1992) who also reported East Asian
countries to have a
complementarity between FDI and total investment.

Xu (2000) examines the effect of US MNCs on TFP for a sample of 20 developed and
20 developing countries for the period
1966-94. The growth rate of TFP is
regressed on
MNC presence, technology transfer intensity, a technology gap
variable, human capital, and an interaction term between M.NC presence and
technology transfer intensity. Xu measured MNC presence as the share of MNC
gross product as a percentage of GDP in the host country. Technology transfer
intensity was defined as the spending by US manufacturing MNCs on royalty and
license fee as a percentage of their gross product. It was hypothesized that a
higher degree of royalty and license fee spending leads to a greater level of
technology diffusion in the host country. The interaction term between these
two variables represents MNE spending on royalty and license fee as a percentage
of host country GDP.

The study by Xu estimates the equations with two-staged least squares where
lagged values of the independent variables were used as instruments. The findings
show that the technology gap variable to be significant and negative indicating the
existence of a catch up effect. In addition, the results showed strong support for
the transfer of technology leading to spillovers in developed countries, but weak
evidence for LDCs. Finally, human capital had a positive impact on TFP for the
sample for both developing and developed nations. Findings of Xu also support
the findings of De Mello that technology transfer
from FDI contributes to productivity growth in developed countries but not in
developing countries, which he attributes to lack of adequate human capital
in the countries concerned.

The two-way link between foreign direct investment and growth for India was
explored by Chakraborty and Basu (2001). The study used a structural
cointegration model with vector error correction mechanism. The existence of
two Cointegrating vectors between GDP, FDI, the unit labour cost and the share
of import duty in tax revenue was found, which captured the long run
relationship between FDI and GDP. A parsimonious vector error correction model
(VECM) was estimated to the short run dynamics of FDI and growth. The VECM
model revealed three important features: (a) GDP in India is not Granger caused
by FDI; the causality runs more from GDP to FDI; (b) trade liberalization policy of the
Indian government had some positive short run impact on the FDI flows and
(c) FDI tends to lower the unit labour cost suggesting that FDI in India is
labour displacing.

Accordingly, Calvo and Robles (2001) used the model of endogenous growth in
which the driving force is the technological diffusion entailed by the presence
of FDI in developing economies. They performed dynamic panel data estimation
by GMM on a sample of 18 countries belonging to the Latin-American region
over the period 1972-
1997. Their results indicate a significant and positive impact of FDI in the
economic growth, provided that a minimum of threshold of development exists.
Those countries in
which the stock of human capital is small, markets are heavily distorted and
economic and social stability is scarce, the benefits entailed by the external flows
will be less.

Lensink and Morrissey (2001) contributed to the literature on FDI and economic
growth. There study deviated froM previous studies by the introduction of
measures of the volatility of FDI Inflows. As introduced into the model, these
were predicted to have a negative effect on growth. The study estimated the
standard model using cross-section, panel data and instrumental variable
techniques. Whilst all results were not entirely robust, there was a consistent
finding that FDI had a positive effect on growth whereas volatility of FDI had a
negative impact. The evidence for a positive effect of FDI was not sensitive to
which other explanatory variables were included. In particular, it was not
conditional on the level of human capital (as found in some previous studies).
There was a suggestion that it was not the volatility of FDI per se that retarded
growth but that such volatility captured the growth-retarding effects of unobserved
variables.

FDI effect output growth through a host of direct and indirect channels. Nagesh
and Pardhan (2002) in a study analyzed the relationships between FDI, growth and
domestic investment for a sample of 107 developing countries. They argued that
the effect of FDI on growth could of a dynamic nature. That there may be two
rounds of effects of FDI viz. a competition effect for domestic enterprises in an
industry with foreign entrant that is generally negative, and a subsequent round
could include a usually favourable externality on domestic investment because of
backward linkages. The net weight of these effects depends on the nature of FDI
projects or the quality of the FDI which is known to vary
greatly for different types of investments. Panel data in a production function
framework suggest a positive effect of FDI on growth. The test of causality find
that in majority of cases the direction of causation is not pronounced however in
a substantial number of cases the direction of causation actually runs from
growth to FDI. The estimations add proof to the dynamic nature of the FDI effects.

A study conducted by Marwah and Tavakoli (2004) measured and analyzed the
impact of FDI and imports on the economic growth and productivity of four
individual countries. These four countries are Indonesia, Malaysia, the Philippines,
and Thailand. After briefly reviewing their economic patterns, the study
estimated, for each of the four countries, a separate production functions by
using foreign capital and imports as two distinct factors among the factors of
production. The analysis is based on time series annual data from early 1970s to
1998. The estimated production elasticities of foreign capital range from
0.044 for Thailand to 0.086 for Malaysia. About one-fifth to one-fourth
of the productivity of total capital stock is generated by growth in FDI: 24.5% in
Indonesia,
25.8% in Malaysia, 21.4% in the Philippines, and 20.3% in Thailand. Similarly,
the production elasticities of imports range from 0.226 for Indonesia to 0.428 for
Thailand.

Akinlo (2004) investigated the impact of FDI on economic growth in Nigeria for
the period1970-2001.The Error Correction Mechanism (ECM) results showed
that both private capital and lagged foreign capital have small, and not a
statistically significant effect, on the economic growth. The results of the study
seem to support the argument that extractive FDI might not be growth
enhancing as much as manufacturing FDI. The
20

results also showed that exports, labour force and human capital have significant
positive effect on growth.

Makki and Somwaru (2004) in a study used the endogenous growth theory frame
work to analyze the role of FDI and trade in economic growth of developing
countries. Their results, for a sample of sixty-six developing countries over three
decades, showed that FDI and trade contribute towards advancing economic
growth in developing countries. There is also strong positive interaction between
FDI and trade. FDI is often the main channel through which advanced technology is
transferred to developing countries. Their results imply that the benefits from such
investments would be greatly enhanced if the host country has better stock of
human capital. The results also showed that FDI stimulates domestic
investment. However the sound macroeconomic policies and institutional stability are
necessary preconditions for FDI-driven growth to materialize.

Prabirj it (2007) examined the relationship between economic growth and FDI (relative to
gross capital formation). The study analyzed panel (1981-2002) and time-series (1970-
2002) data for 51 Less Developed Countries (LDCs). The panel data analysis observed a
rising relationship between growth and FDI (relative to Gross Capital Formation), only
for the group of 16 countries having high GDP per capita and high trade-dependence.
Time-series analysis of individual country concludes that only for ten countries the share of
FDI in their gross capital formation had a long-term positive relationship with the
growth of per capita income. There were also four cases of negative relationship.
In the majority of country cases no long-term relationship between FDI share and
growth was
observed. These results were independent of whether these countries were closed
or open (as measured by the share of trade in their GDP) and poor or rich (as
measured by their GDP per capita) compared to the countries experiencing
a positive long-term relationship.

Ghatak and Halicioglu (2007) produced empirical evidence on the relation
between FDI and economic growth obtained from single equation and
simultaneous equation estimates for 140 countries using macroeconomic variables
for the period of 1991-2001.The results indicate a positive and statistically
significant estimate of coefficient of FDI. The results also showed that correlation
coefficient between exports-GDP ratio and percentage FDI
was insignificant.


Foreign direct investment has been an important source of economic
growth for Malaysia, bringing in capital investment, technology and management
knowledge needed for economic growth. A research done by Mun, et al. (2008)
studied the relationship between FDI and economic growth in Malaysia for the
period
1970-2005 using time
series data. OLS regressions and the empirical
analysis were conducted by using annual data on FDI and economy growth in
Malaysia over the 1970-2005 periods. The study used annual data from IMF
International Financial Statistics tables, published by International Monetary
Fund to find out the relationship between FDI and economic growth in
Malaysia. There evidence showed that there was significant relationship
between economic growth and foreign direct investment inflows in Malaysia.
FDI had
direct positive impact on real growth rate of GDP. Furthermore, FDI also has direct
positive impact on real gross national income.



2.3 Literature from Pakistan
Since 1980s developing countries had increasingly turned to :foreign direct investment
as a source of the capital, technology, managerial skills, and market access needed
for sustained economic growth and development. The move towards more open FDI
regimes has been accompanied by a shift in many countries towards greater
deregulation of economic activity and greater reliance on market forces. And Pakistan is no
exception.

The growing balance of payment difficulties as well as decline in concessional aid has
forced developing countries including Pakistan to reassess their stances on
FDI. Therefore most of the developing countries have taken substantial unilateral
steps to liberalize their inward FDI regimes. The Liberalization included tempering or
removal of obstacles to foreign investors, the establishment of standards for their
treatment, increased use of incentives to attract FDI. Most of the developing countries
including Pakistan have also adopted or agreed to general standards of treatment
and provided specific guarantees in key areas such as the transfer of funds,
expropriation and dispute settlement. In this scenario the need for better assessing
the motivating factors behind the FDI and effects of FDI on Pakistan economy have become
more important. A few studies have attempted to analyze the motivating factors of FDI, the
determinants of FDI in Pakistan, and the link between FDI and economic growth.
23
Shah and Ahmed (2003). and Ahmed and Hamdani (2003). A study conducted by
Shabir and Mahmood, (1992) analyzed the relationship between foreign private
investment and economic growth in Pakistan. The study used the data for 1959-60
to
1987-88. The study
explored the answers to the propositions that net foreign
private investment promotes economic growth and foreign private investment
displaces savings of a country. The study used the Simultaneous equation
model. The study concluded that net foreign private investment and
disbursements of grants and external loans had a positive impact on the rate of
growth of real GNP. The results showed that foreign inflows may discourage
domestic public and/or private savings.

Shah (2003) analyzed the attractiveness of FDI in Pakistan with special emphasis
on the cost of capital element in effecting the rate of return and the internal
cash flow for investment of the investing firms. Using the Jorgenson's Neo-
classical Investment Model. the cost of capital was computed after considering
the taxation policy and the treatment of invested capital. The study
elaborated fiscal provisions and their implications on the investment
environment specifically available to foreign investors in Pakistan.

The computed results showed consistent and influencing impact of the cost of
capital on FDI inflows. The objective of the study was to explore the realistic
and in depth investigation of the tax concessions and the response of investors.
The paper argued that fi
scal incentives were more appropriate in attracting FDI as
these had no direct drain over

public resources and the after tax return were increased by availing the tax
holidays and depreciation allowances.

Ahmed et al.
(2003) in a study examined the causal relationship between FDI,
exports
and output by employing Granger non-causality procedure developed
by Toda and Yamamoto (1995) over the period 1972 to 2001 in Pakistan. They
found significant effect from EDI to domestic output. The results of the study
derived from the Granger (1969) concept of causality, established the long run
relation between foreign direct investment, export and domestic growth for
Pakistan economy over the period 1972-2001. The results support the export-led
hypothesis but also the existence of FDI-growth nexus. In other words, the
study found significant spillovers effect from FDI to domestic output.
Furthermore, the findings do not suggest a kind of FDI-led export growth linkage.
This would confirm that most of the multinational investment in Pakistan is in
services sector rather than in exports oriented industries.


The impact of FDI on Economic growth under foreign trade regimes in Pakistan
was studied in a research study by Atique et al. (2004). The study investigated
the effect of Trade policy regime in Pakistan, on the amount of inward FDI
received and economic growth. As over the decades the trade policy of
Pakistan has swung between import substitution and export promotion. In early
1970's, Pakistan went for Nationalization that made the government biggest
player in the economy. While during 1980's Pakistan followed denationalization
policy, opened its economy and changed its stance and allowed foreign and
private investments to flow in. Using the Engle-Granger and Hansen
technique for estimation for long run relation between the variables of the study the
results showed that coefficient of FDI is negative but positive for the less the interaction
term of FDI and Openness of trade, therefore the overall effect of FDI on growth was
positive for Pakistan economy. Therefore, the study concluded that the trade policy
regime followed by Pakistan has influenced significantly both the amount of the inward
FDI received and economic growth, using data from 1970-2001.

Yasmin (2005) analyzed the effect of foreign capital inflows on the growth performance of
Pakistan. As the growth rate and foreign capital inflows were expected to affect each
other simultaneously, the Simultaneous Equation Model was applied on the aggregate
time series data for the years 1970-71 to 2000-2001 for foreign capital inflows, GNP and
Savings. A positive and statistically significant relationship appeared between foreign
capital inflows and growth. Further, it could be seen that FDI in foreign capital inflows
was highly significant and had contributed positively in the country's economic
growth. The optimal policy which followed from these results was to bring changes
in the composition of foreign capital inflows and preferably to encourage FPI in
order to enhance economic growth.

A study undertaken by Khan (2007) examined the link between FDI and economic
growth by including the role of domestic financial sector. The study covered the time
period from 1972-2005. It intended to examine the long run relationship between
variables i.e. growth rate of real GDP, ratio of FDI to real GDP, financial sector
development, labour, and physical capital. The study used Bound testing approach to
co-
integration within the framework of Autoregressive Distributes Lag(ARDL)
developed by Pesaran, et al.(2001). The findings of the study suggest that
Pakistan will effectively transform benefits embodied in FDI inflows, if the
evolution of the domestic financial sector has aimed at a certain development
level. The interaction term between FDI and financial development indicator is
positive, while the coefficient of FDI is negative in the case of Pakistan. This
suggests that FDI will have a positive impact on growth performance only if
the domestic financial sector is well developed and functioning efficiently.

A study by Mohey-ud-din (2008) analyzed the impact of foreign capital inflows
on economic growth from
1975-2004. According to the study there are many
forms of the
Foreign Capital Inflows that include grants, loans, foreign direct
investment, foreign portfolio investment, export credit, project and non
project assistance, Technical assistance and emergency relief etc. The study uses
the two main types of foreign capital inflows i.e. Private Foreign Investment
(includes Foreign Direct Investment and Foreign Portfolio Investment) and Public
and Official Development Assistance.

The study proved, using the regression analysis that foreign capital inflow had a
positive effect on GDP in Pakistan for the years 1975-2004. The study also showed
that according to the values of regression coefficients, the FPI had more
powerful and strong positive impact on the GDP growth in Pakistan than the
official development assistance. Therefore FPI has more positive impact on the
GDP in Pakistan.

Yousaf, et al
(2008) in a study empirically analyzed the impact of FDI on Pakistan's
exports and imports through time series data. The study based on data for Pakistan
exports, imports and FDI inflows, covered the time period from
1973-1985. The
paper
used two techniques for testing for cointegration i.e. Engle and Granger (1987)
and the Johansen's Full Information Maximum Likelihood approach proposed by
Johansen (1998) and ;Johansen and Juselius (1990). The results of the study
showed that FDI positively impacted real demand for imports in the short run and
long run, and the FDI has negative relation with real exports in the short run and
positive relation in the long run.

Most of the empirical studies i.e. Fry (1992), Bloomstrom (1994), Xu (2000) covered in
the literature review have been carried out are either cross section or panel data
analysis. The cross section analysis usually suffers from the problems such as countries of
the data set differing in the size, openness, factor endowment, and infrastructure.
Therefore the results may not be generalized results for all the countries. The focus of
the most of the studies conducted for Pakistan economy has been the FDI and trade
(exports and imports) i.e. Ahmed (2003) or the FDI and trade regimes i.e. Atique (2004).
The study conducted by Shabir and Mahmood (1992) analyzed the relationship between
FPI and economic growth in Pakistan. The study however did not treat FDI as a separate
variable i.e. the study treated FDI as a part of the foreign private investment (FPI) on
whole. Thus the results could not be explained in terms of FDI effecting the economic
growth. The proposed study will be different than studies already conducted as it
will test for the relationship between FDI and economic growth, by treating the FDI
as a separate variable and taking the time series analysis from 1980-2006.


2.4 Summary
Keeping in view that FDI has become the very important for most of the
developing countries, this chapter has reviewed some empirical and theoretical
work done on the subject. The findings of the relationship between FDI and
economic growth are mixed, with some studies supporting it and others not.
However, a point of consensus that all studies make is preconditions which are
necessary for the FDI to have a positive effect on economic growth. And these
preconditions include infrastructure, economic stability, law and order, and
developed capital markets. The present study will try to explore the FDI growth
nexus.



CHAPTER 3
METHODOLOGY AND DATA SOURCES



3.1 Introduction
This chapter explains the methodology that has been used to explore the effects of
FDI on economic growth. The methodology consists of the selection of main
variables as well as the data collection sources. It also introduces the model used
for the estimation process. The chapter also throws light on the techniques that
have been used for getting empirical results for this study.



3.2 Model
In order to test the hypothesis, endogenous growth theory model
developed by Borensztein et al.,
(1998) and Kumar & Pardhan (2002) has been
used in this study with
sonic modifications. The basic assumption of the model
is that FDI contributes to economic growth directly through new technologies and
other inputs as well as indirectly through improving human capital,
infrastructure, and institutions. And the level of a country's productivity depends
on the FDI, trade and domestic investment. The variable A captures the total
factor productivity effect on growth in output and it is assumed that the effect of
FDI on growth in output operates through variable A, and the effect of FDI on A
also depends on the human capital. For testing the effects of FDI on economic
growth empirically, the model used can be specified as: the capital stock
assumed to
30
comprise of two components viz. domestic and foreign owned capital stock. So,
we can specify the model as under:


Kt Kdi
Ktt
An augmented Solow production function that makes output a function of
stocks of capital; labor and productivity will be adopted in this study (see
Mankiw et al 1992; Benhabib and Spiegel
1994, among others). However, this study
has specified domestic
and foreign owned capital stock separately in a Cobb-
Douglas type production function.


Yt = At Kadt 1(Xft 1-13t
(1)

Where signs in equations represents

Y = flow of output,

Kd = domestic capital,

Kt.= foreign owned capital,

L =labor,

While a represent the output elasticity of domestic capital stock.,

represents the output elasticity of foreign capital stock,

13 represents the output elasticity of labor force,

A is total factor productivity that explains the output growth that is not accounted
for by the growth in factors of production specified and t represents time. Taking
logs and differentiating equation
(1) with respect to time, following familiar
growth equation is


obtained

Yt = -Fakcit kkft
t
(2)

Where lower case letters yt, knit, krt, and It represent the growth rates of output,
domestic capital, foreign capital, and labour force respectively. While, a represent
the output

elasticity of domestic capital,

represents the output elasticity of foreign
capital,
13

represents the output elasticity of labor force, and t stands for time.

In a world of perfect competition and constant returns to scale these elasticity
coefficients can be interpreted as respective factor shares in total output.
Equation (2) is the fundamental growth accounting equation, which decomposes
the growth rate of output into growth rate of total factor productivity plus a
weighted sum of the growth rates of
capital stocks and the growth rate of labor.
Theoretically, a and
13 were expected to be positive while the sign of 2, is expected
to be positive depending on the relative strength of competition and linkage
effects and other externalities that FDI generates in the development process.
The main purpose of the study is to assess/quantify the impact of FDI on economic
growth.

In order to achieve the desired objective, other independent variables which are
assumed typically to influence the economic growth has been be included in the
model (such aslabour, domestic capital, and exports). It is expected that this
inclusion will reduce or eliminate the specification error. Exports have been
included in the traditional growth equation as there are many studies that have
reported the positive and significant relation between exports and economic
growth in Pakistan (see Ahmed 2003, and Yousaf 2008). For the purpose of
estimation the equation to be tested was obtained by taking the log on both sides,
equation (2) that could be rewritten as follows
( see Kumar and Pardhan
2002).



lnGDP, = b0 +
+1321nL, +b31nFDIt +b41nXi
(3)

Where variable on the left side is dependent variable and variables on the
right side are the exogenous variables. In equation 3 the variable, InGDPt is the
natural log of gross domestic
product GDP in time period t, which is the endogenous variable. And
exogenous Variables are Inicit is the natural logarithm of the domestic capital,
InLt is the natural logarithm of local labour force, InFDIt is the natural logarithm of
foreign capital, InXt is the natural logarithm of exports of the host economy and
[it is the error term. The
coefficients b,, b2, b3, b4 are the elasticities of domestic capital, labour, foreign
capital, and exports respectively, and t represents time.



3.3 Interpretation of Variables
For the purpose of exploring the relationship between the economic growth and
FDI, the variables specified by the equation no 3 and used in the study are
interpreted as under: Gross Domestic Product (GDP):
In most of the empirical studies like Akinlo
(2004), De Mello(1 998), Ramirez
(2006)
GDP is used to measure the national income showing the economic
growth. As the GDP represent the domestic product that has been produced
during the whole year by using domestic resources on market values. The
present study will use the secondary data of GDP at market prices measured in
millions of current
$ US, derived from the World
Development Indicators 2008.



Figure 3.1: Growth rate of
GDP in Pakistan:



12

10 \

8

6

4






Source: World Development Indicators 2008

The data on GDP of Pakistan show that the GDP growth has not been consistent over
the entire sample period. Figure 3.1 reveals highly fluctuating trend in the growth
rate of GDP over the years. With the highest growth rate witnessed in 1980, the
growth rate of
GDP has been declining ever since. The years 1993 and 1998 witnessed a very low
level of GDP growth rate that could be attributed to the economic sanctions Pakistan
had to face in the aftermaths of nuclear blasts in 1998, and adverse balance of payment
situation. A noticeable feature in figure 3.1 is the upward trend in the growth rate of
GDP since 2002 with highest growth rate 7.6 witnessed in 2005. This increase in GDP
growth rate has been due to widely introduced regulatory and economic reforms.
Privatization of state owned units and deregulation coupled with strong
macroeconomic policy led to increase in GDP in year 2005.



Labour Force:
Labour force is taken as all the people who supply labor for the production of goods
and services during a specified period. It includes both the employed and the
unemployed. While national practices vary in the treatment of such groups like the
armed forces and seasonal or part-time workers. In general, the labor force includes
the armed forces, the unemployed, and first-time job-seekers, but excludes
homemakers and other unpaid caregivers and workers in the informal sector.
Therefore, the present study uses the labour force data for Pakistan for a period
from 1980-2006, obtained from World Development Indicators 2008.

The data for Labour force for Pakistan for the sample period 1980-2006 shows
that the total labour force of Pakistan has been increasing steadily. The increase in
labour force is governed by two factors, population growth rate and employment
opportunities. The constant increase in labour force in Pakistan has been due to the
high population growthrates. With a sharp decline in mortality since 1950s without a
corresponding reduction in

fertility, the population growth rate increased from about 2 percent in 1950s to 3 percent

until 1980s. The population growth rate declined form 2.6 percent from 1981-1998, and

further to

Source: World
Development
Indicators
2008

Figure 3.2
shows a
constant
upward trend
in the labour
force,
particularly
since 2002
there is sharp
increase in
labour force.
This increase in
labour force
could be
ascribed to the
fact that
economic
activity picked
up pace in
2002 with
privatization
and liberal
monetary and
fiscal reforms.
With the
provision of
greater
employment
opportunities,
labour force
also increased.
Domestic
Capital:
The domestic
capital is
measured by
the Gross
fixed capital
formation
that is
defined as
Gross capital
formation. It
consists of
outlays on
additions to the
fixed assets of
the economy
plus net
changes in the
level of
inventories.
Fixed assets
include land
improvements,
plant machinery,
and equipment
purchases; and
the construction
of roads, railways,
and the like,
including schools,
offices, hospitals,
private residential
dwellings, and
commercial and
industrial
buildings.
Inventories are
stocks of goods
held by firms to
meet temporary
or unexpected
fluctuations in
production or
sales, and "work
in progress." The
present study
will use Gross
fixed capital
formation to
represent the
domestic capital
measured in
millions of
current $ US in
Pakistan for time
period 1980-
2006.

Figure 3.3 shows
the gradual
upward trend of
domestic fixed
capital formation
in

Pakistan for

1980-2006.
The upward trend
of gross fixed
capital formation
is also
characterized by
some episodes of
fluctuations
witnessed in
1992-1994
and 1998-2000.
The decline in
capital
formation could
be traced in a
badly
deteriorating
overall
macroeconomic
situation in Pakistan
as reflected by
decline in GDP
during the same
time periods. The
upward trend in
capital formation
from 2000 is
reflected in the
Figure 4.3. This
increase in Capital
formation during
2001-2006 was
due to more
increased
investments both
by the public
sector as well as
by the private
sector.


Foreign Capital:
Foreign capital is measured
as the foreign direct
investment, net inflows.
The Foreign Direct
Investment, Net Inflows
according to World
development indicators
2008 are defined as the
net inflows of investment
to acquire a lasting
management interest in
an enterprise operating in
an economy other than that
of the investor. It is the sum
of equity capital,
reinvestment of earnings,
long-term, and short-term
capital as shown in the
balance of payments.
Therefore, the data for
foreign direct investment
net inflows, as reflected
in the Pakistan's BOP,
given by World
development indicators
2008 will be used for this
study.

The present study will use
foreign direct investment
net inflows measured in
millions of current $ US
Figure 3.4 shows the
foreign direct investment
inflows in Pakistan
graphically. As the Figure
3.4 shows the amount of
FDI inflows increased
modestly during 1980-1984,
while the era of 1984-1996
witnessed a faster pace of
FDI inflows
Figure 3.4: Foreign Direct
Investment Inflows in
Pakistan: 1980-2006










Source: World development indicators 2008

This increase in FDI inflows was due to the implementation of a more liberal
foreign investment policy as part of the overall economic reform programme in
late l 980s. A new industrial policy package was introduced in 1989, under this
package virtually all industrial sectors of Pakistan were opened up for the
foreign investment (with the exception of few industries). The average FDI inflow
as the percentage of GDP for the decade of 1980s was just about 0.38, while it
increased to 0.98 in the decade of 1990s. It is evident from the figure that Since
1997 FDI started declining in Pakistan. It was due to the row between the
government and the Independent power producers that severely affected the
foreign investor's confidence in Pakistan. FDI was further reduced in 1998 due to
the economic sanctions imposed by the developed countries due to the nuclear
blasts. The flow of foreign capital remained under immense pressure because of
political instability, low internal and external demand, disarrayed relations with the
International Financial Institutions, freezing of foreign currency accounts in May 1998, low
level of foreign exchange reserves and threat of default on external payments obligations
played an important role in keeping foreign investors away. The figure 3.4 reflects the fact
that the EDI inflows increased dramatically since 2002. It was mainly due to the adoption of a
liberal trade and exchange regime of the government followed after 2000 intensely under
the umbrella of WTO trade liberalization regime. The government also succeeded in
removing various irritants which affected business and investment climate including the
issue of independent power producers. The average FD1 inflows as a percentage of GDP also
increased from 0.98 in 1990-2000, to 1.8 in 2000-2005.



Exports:
Exports of goods and services are defined as comprising of all transactions between
residents of a country and the rest of the world. It involves a change of ownership from
residents to nonresidents of general merchandise, goods sent for processing and repairs,
nonmonetary gold, and services. Therefore, the study will use the data for the exports of
goods and services of Pakistan measured in millions of current $ US. The data has been
obtained from world development indicators 2008.

Figure 3.5 shows the increase in exports over the sample period, however the table
reveals negative growth rate of exports for few years as well. The decade of 1990 is
characterized by a high growth rate in initial years and then falling growth rate in
later half of the decade.


Fluctuating world demand for the exports, domestic political instability, and the
impact of occasional droughts on its agriculture production have all contributed
to low growth of exports. Substantial macroeconomic reforms since 2000,
renewed access to global markets, and increased foreign investment helped to
increase the exports.



3.4 Data Sources
The study will rely mainly on the use of Secondary data obtained from various
sources. The study intends to estimate the relationship to be found between
foreign direct investment and economic growth for Pakistan for a period of
around 26 years i.e., 1980-

2006. The data set used in the study is derived from a number of sources which
include World Development Indicators (WDI) 2008 developed by the World Bank.
International Financial Statistics (IFS), published by the International Monetary
Fund, and the Handbook of Statistics on Pakistan Economy 2005, issued by the
State Bank of Pakistan. The data for all the variables is measured in Millions of
$
US at current prices for
particular years under study.



3.5 Hypotheses Testing of the Parameters
In order to test the hypothesis regarding the relationship between GDP and
other regressors, t test statistics has been applied. The hypotheses that have been
tested by the study regarding the regressors' relationship are as follow:


1) Null hypothesis Ho: b1= 0 Alternate hypothesis Hi: b1 > 0

(Domestic capital affects the GDP positively)

2)
Null hypothesis Ho: b2 = 0 Alternate hypothesis HI: b2 > 0

(Labour Force response positively to GDP)

3) Null hypothesis Ho: b3 = 0 Alternate hypothesis Hi: b3 > 0

(Foreign Direct Investment effects GDP positively)

4) Null hypothesis Ho: b4 = 0 Alternate hypothesis Hi:
b4 >

(Exports affect the GDP positively)


3.6 Econometric Technique for Estimation
The empirical estimation of relationship between economic growth and FDI, has been
carried out by many economists using different econometric techniques like generalized

method of moments (Carkovic & Levine 2002), ordinary least square (Olofosdotter

1998), vector autoregressive regression (Zhao1995), cointegration analysis (Akinlo
2004), and instrumental variable technique (Makki and Somwaru 2004). However, the
present study will adopt the method of cointegration to test the long run relationship
between the FD1 and economic growth. The cointegration analysis will also be used due to
the fact that the time series data often show the property of non-stationarity in levels. The
estimates thus obtained from the estimations based on OLS on non-stationary data,
usually provide spurious results that are meaningless.

The cointegration analysis consists of first checking the stationarity of the data in levels of
all the variables. The test for the order of integration of all the variables is important
because only variables of the same order of integration exhibit a stable long run
relationship and they are cointegrated. If the variables are not cointegrated, this implies
that the error term is non-stationary and OLS estimates are not reliable. Unit root test is
used to check the stationarity of a series. The most widely used unit root test is as
proposed by Dickey and Fuller (1981). The study will test stationarity of the series of
GDP, L, K, FDI, and X using the Augmented Dickey Fuller test (ADF).


The DF Unit root test is based on the following three regression forms

I) Without constant and trend
AYt = Wt-1 +


2) With constant
AYt = a + 6)(1-1 + [It


3)
With constant and trend AYt = a + 13T +



The hypothesis that is tested is:

Ho: 6 = 0 (Unit root exists)

HI: 0


The decision rule is: if the calculated t* > ADF critical value, not reject the
null
hypothesis i.e., unit root exists. And if the calculated t* < ADF critical value,
reject the null hypothesis i.e., unit root does not exist. The estimation of
Error correction mechanism (ECM) will follow the cointegration analysis, which
tests for the short run
behaviour of the variables.



3.7 Summary
This chapter gives a complete picture of the methodology adopted for empirically testing
the relationship between economic growth and FDI, domestic capital, labour and exports.
The model that is used to analyze the relationship between the economic growth and
FDI is based on the endogenous growth theory. The main data source is the
World Development Indicators 2008. The estimation technique being adopted by the
study is the cointegration analysis that tests the relationship of variables of the system in
long run and
44
estimation of Error correction mechanism, which explains that how the short
run fluctuations affects the relationship of variables.

CHAPTER 4

ANALYSIS AND ESTIMATION



4.1 Introduction
This chapter presents the analysis and estimation of the results. It includes the
application of econometric techniques that have been used to derive the results
regarding the FDI and economic growth. Augmented Dickey Fuller (ADF) test is
applied on the series of the variables for checking their stationarity. ADF has
been applied on level and on 1s
t difference level. After checking the order of integration of the variables at level
form the, method of co-integration is applied to find the existence of long run equilibrium of the series. The study has used the
cointegration technique as given by Engle and Granger method and as given by cointegration regression Durbin-Watson test
CDRW. The short run relationship between variables is estimated by Error Correcti on Mechanism.


4.2 Basic Statistics
Some basic statistics have been used to analyze the data and its changes over
the time span. The table
4.1 shows the Mean, Median, Maximum, Minimum
values for all the
variables i.e. GDP, K, L, FDI, and X. The correlation coefficient
shows the degree of association between the GDP and all the other variables
respectively.
46



Table 4.1 Basic Statistics



variables Mean Median Maximum Minimum


LNG 10.82718 10.84892 11.75065 10.0728

LNK 12.33599 12.45456 14.24071 10.62971

LNL 3.655296 3.61265 4.087495 3.313349

LNF 14.12038 14.10297 15.84285 12.36533

LNX 5.717705 5.818538 8.360071 3.382932

Source: Calculated by author using E-views




4.3 Cointegration Engle-Granger Method


Correlation
coefficient




0.991036

0.986225

0.986211

0.932013

The study is going to use (macro) time series since 1980 for analyzing FDI
influence on economic growth in Pakistan. It is well established that
(macro) time
series tend to
exhibit either a deterministic or stochastic time trend.
Therefore such data is non stationary: that is the variables in question have
means, variances and covariances that are not time invariant. According to Engle
and Granger (1987) the direct application of Ordinary Least Square (OLS) or
Generalised Least Square (GLS) to nonstationary data produces regression results
that are misspecified or spurious in nature.

These regressions tend to produce performance statistics that are inflated in
nature, such as high R2 and t-statistics. which often lead investigators to commit a
high frequency of Type I errors as shown by Granger and Newbold (1974). The
study has used the
cointegration technique as given by Engle and Granger method. The concept of
the Cointegration as introduced by Engle and Granger(1987) states that for two
variables that are nonstationary or integrated of order 41), if there exists a linear
combination of these non stationary variables that is stationary then such variables
are said to be Cointegrated and the system is said to be in long run equilibrium.
The short run behaviour of the variables is tested by the estimation of Error
Correction Mechanism.

The proposed analysis proceeds with first testing the stationarity of the
variables, and then applying the Ordinary Least Squares (OLS) Method to estimate
the coefficients of the regression equation and then checking the residuals of the
regression for stationarity. If the residuals are stationary at level, then the variables
are cointegrated or in a long run equilibrium and the estimated coefficients are
regarded as the long term elasticities.


4.4 Test of Stationarity
The first stage in the application of the Cointegration analysis is to check the
stationarity of the time series data involved. As the non stationarity of a data
series strongly influences its behaviour and properties therefore to do any
meaningful analysis it is strongly recommended to check the stationarity of the
series. Among the several tests of stationarity that are available, the study has
used the graphical analysis and unit root test to check the stationarity of the data
series involved. 4.4.1 Graphical Analysis
Before pursuing any formal test like unit root test, the graphical analysis has been carried out
for all the five data series of the study. (Figure 3.1, 3.2, 3.3, 3.4, and 3.5, in section
3.3). The Figures show the graphical plots of growth rate of GDP, labour, domestic
capital. FD1, and exports respectively. A review of all these graphical plots reveals that over
the period of study the data series have been increasing, that is, they all show an upward
trend. As the mean of such series is changing, this suggests that all the five series are not
stationary.



4.4.2 Unit Root Test

Unit root test is used to check the stationarity of a series. The most widely used unit root
test is as proposed by Dickey and Fuller (1981). The study has tested stationarity of the
series of GDP, L, K, FDI, and X using the Augmented Dickey Fuller test. After taking the
natural logarithm of all the five variables i.e., GDP, L, K, FDI, and X, the Augmented
Dickey Fuller (ADF) test has been applied on the levels of the series. The test has
been carried out at lag 1 for all the variables (with trend and constant). The results have
been based on estimations of E-views 3.1, and are shown in table 4.1.
Table 4.1 shows that GDP, L, K, FD1, and X, all variables are nonstationary in levels. For GDP
the null hypothesis of unit root can not be rejected as the t*(-1.818) > ADF critical values at
1%, 5% and 10%. In other words the series of GDP is nonstationary at levels.

Table 4.1 Results of Augmented Dicker Fuller Test (ADF) on Level and
Difference (With Trend and Intercept)


Variable Level 1st Difference Conclusion
Ln GDP -1.81 -5.14 1 (1)
Ln L -0.81 -4.66 I(1)
Ln K -3.00 -4.39 I(1)
Ln FDI -2.92 -5.21 1 (1)
L Ln X -1.74 -4.28 1 (1)
Source: Results obtained from E-views.


1st

For the series of L the calculated t*(-0.817) > ADF critical values at 1%, 5% and 10%,
hence the series of L is also nonstationary at levels. Similarly the table also reveals that
the K series is also nonstationary at levels as t*(-3.005) > ADF critical value at 1%,
the same holds for the other two variables FDI, and X, as for both the variables the
calculated t* > ADF critical values. I t is evident from the table that all the series do not
suffer from autocorrelation as the value of Durbin Watson statistic is close to 2 for all the
series.

The stationary of all the five variables is checked at first difference by applying the ADF Test
on first difference of the variables. Results obtained from the E-Views estimations is uiven
in table 4.1 shows that all the variables are stationary at first difference. Therefore,
taking the first difference or detrending the series generates the stationarity. It is
evident
from the examination of data presented in table 4.1 that for GDP, L, K, FD1 and X, the
calculated V' < ADF critical values at 1%, 5% and 10% level of significance. The null
hypothesis of unit root can be rejected leading to the acceptance of alternate hypothesis of
no unit roots. Thus data series of all of the five variables can be said to be stationary at
.first difference. After establishing that all the variables are stationary at first difference,
the second step in Engle Granger method is the estimation of long run equilibrium
relationship between the variables. To estimate the long run relationship between
variables OLS has been used to estimate equation 3. The results obtained, could be
written in regression equation form as given below:





LNGDP = 5.440 + 0.398'LNK + 0.674*LNL + 0.161*LNFDI + 0.049*LNX (4)

(16.58) (2.40) (2.39) (2.01) (1.89)

Adjusted R2 = 0.98 F Statistics = 451

Durbin Watson stat =1.42


The OLS estimation results illustrate the estimated coefficients of the variables K, L, FDI,
and X. The brackets present the t-statistics for all the variables. The estimated value of R2 is
0.98, and F-statistic is 451. The results show that the regression is overall good fitted and
as the F calculated (451) > F.01: 4,21, therefore the null hypothesis of all slope coefficients
simultaneously equal to zero can be rejected. This indicates that the regressors
have an overall impact on the dependent variable.

Based on the results the significance of the estimated coefficients has been
tested by usual t statistics. The t statistics (given in the parenthesis) show that the
parameters K, L are significant at 5% level of significance. The variable export is
positive and statistically significant at 10% level of significance. The variable of
interest i.e. FDI is positive and statistically significant at 5% level of significance.

According to the Engle-Granger method of Cointegration the long run
equilibrium between variables is verified if the residuals of the OLS regression
equation (applied at levels) are stationary, then the system is in long run
equilibrium. The residual series obtained from the regression equation no. 4 has
been tested for stationarity at levels by applying ADF test. The results illustrate
that the calculated t*(-3.725) < ADF 5% critical value, therefore the null
hypothesis can be rejected and the alternate hypothesis of stationarity of
residual series can be accepted. As the residuals are stationary or integrated of
order 1, according to Engle and Granger such a system is in long run equilibrium.

The results obtained for regression parameters
(see equation 4) could be
stated to have
the validity of long run trend. The coefficients obtained represent
the long run behaviour, or elasticity of the variables of the equation. The
coefficients show the responsiveness of economic growth (GDP) for a unit change
in exogenous variables included in the study (K. L, FDI, and X).

4.5 Cointegrating Regression Durbin-Watson Test.
The study further tested the cointegration of variables of the study by applying another
test namely Cointegrating Regression Durbin-Watson test (CRDW) whose critical
values were first provided by Sargan and Bhargava (1983). For the CRDW test the
value of Durbin-Watson obtained from the Cointegrating regression is used. The 1%, 5%,
and 10% critical values to test the hypothesis that the true d = 0 ( where "d" is the
DurbinWatson statistics obtained from the regression) are 0.511, 0.386, 0.322,
respectively. Thus if the computed value of d is less than, say 0.511, the null
hypothesis of cointegration at 1% is rejected. In our study, the value of d =1.42 (
equation 4 ) which is above the critical values stated above suggesting that the variables
are cointegrated, thus reinforcing findings on the basis of Engle Granger test.

The result based on the both the Engle and Granger, and CRDW Test is that the variables
GDP. K, L, FD1 and X are cointegrated. Although they individually exhibit random
walks, there exists a stable long run relationship between them.



4.6 Error Correction Mechanism (ECM)
The error correction mechanism (ECM) was first used by Sargan (1983) and later used by
Engle and Granger as corrects for disequilibrium. The Engle representation theorem
states that if two variables are cointegrated, (i.e., if the null hypothesis of no cointegration
has been rejected), the residuals from the equilibrium regression can be used to estimate
the error correction model. In the short run the variables may be in
disequilibrium. The
error term obtained from equilibrium regression (see equation 4) can be treated as the
equilibrium error. This error term is used to tie the short run behaviour of variables to
their long run value. The ECM equation for our study can be stated in equation form as
Oven below:



AlnGDP, = ao + aiAlnKt + a7AlnL1 + a3A1nFDIt+ a4A1nX1 + a51-11-1
---(5)



In above equation A denotes the first difference operator, Et is a random error term,
and

equilibrium error term
= ( InGDPi_i - b0 - bilnKt_I - bAnLt_I - b31nFDIt_I -
)
that is one period lagged value of the error term from the cointegrating regression (see
equation 3).The ECM equation states that A1nGDP depends on AlnK, A1nL, A1nFDI. A1nX.
and also on the equilibrium error term. If the latter is nonzero, then the model is out of
equilibrium. The absolute value of a5 decides how quickly the equilibrium is

restored.



The study has applied OLS on equation no 5, to estimate the ECM, and the
resulting

equation can be given as below:



AlnGDPt = 0.119 + 0.211AlnKt + 1.390A1nLt + 0.084A1nFDIt + 0.0331nXt 0.0721.4.1--(6)

t = (2.976) (2.523) (1.966) (2.834) (1.823) (-4.387)

R'=0.78
The above equation shows that statistically the equilibrium term is zero
(0.072) that suggests that GDP adjusts to changes in all of the variables
involved in the study in the same period. The coefficients estimated can be
interpreted as short run elasticities. The above equation reveals that short run
changes in K, L, FDI, and X have a positive impact on the short run changes in GDP.
4.7 Discussion of Results
The results of the study are very interesting (equation 4 & 6), and in line with the
results obtained by other researchers on the relationship between economic
growth and the foreign direct investment inflows. Since the Cointegrating,
system is in long run equilibrium, the estimated coefficients of the
parameters can be interpreted as the elasticities of the respective variables.
The following section discuses the results of the test individually for the
exogenous variables of the study.
The coefficient of domestic capital is positive and significant and the value 0.398
can be treated as long run elasticity of domestic capital. For one unit change in
domestic capital the GDP increases by almost 40%.The short run elasticity as
calculated by ECM is about
0.21 This shows the positive contribution of domestic capital formation on
economic growth which has been positive, during the period under review i.e.,
1980-2006. These
results are in line with the results obtained by Atique et.al.
(2004).Their results for Pakistan economy for 1970-2001, show that the coefficient
of domestic capital is positive and significant with value of 0.51(near the value
obtained by this study). The result for
domestic capital is also in line with the results of Balasubramanyam et.al
(1999),

Agrawal (2000) and Ramirez (2000).

The coefficient of labour force is positive and significant, with value 0.67
that can be treated as long run elasticity. For one unit change in labour the
economic growth (GDP) increases by
67%. While the short run effect of labour on
GDP is also positive, as the
estimated coefficient obtained from ECM is 1.39.
This positive contribution of labour towards the economic growth is also in
accordance with the results of other studies. The study by Atique et.al., (2004)
obtained the value
1.96 showing highly significant effect of labour on economic growth. Similarly,
another study on Pakistan by Khan (2007) also documented the long run
coefficient of labour as

1.45 with a positive sign, thus reinforcing the results obtained by this study.

For the variable FDI, the variable of prime interest in this study, the coefficient of
FDI is positive and is also statistically significant. The long run elasticity is 0.16.
This value of FDI long run elasticity with is also somehow in line with the previous
research that had been conducted on the said topic. Study undertaken by
Blomstorm et al. (1994) also reported a significant and positive effect of FDI on
average growth rate of per capita income for a sample of 23 developed countries.
Results obtained by this study are also in line with Makki and Somwaru (2004),
Prabirjit
(2007) and Akinlo (2004). All these
studies report a positive and significant
effect of FDI on economic growth..
The short run effects as given by ECM (see equation 6) reveal a positive effect of
FDI on


economic growth (GDP). The coefficient of FDI is 0.80 that is statistically
significant at

5% level of significance. A one percent increase in the FDI leads to 8%
increase in the

GDP growth. The possible explanation for the positive short run effect can be
traced in


the fact that Pakistan started receiving major amount of FDI inflows only since 2000.

This clearly shows that the role of FDI in fostering growth is significant and
consistent with the study of Yasmin (2005), which analyzed the effect of foreign
capital inflows on the growth performance of Pakistan and vice versa. The study
also showed a positive and statistically significant relationship between foreign
capital inflows and economic growth. Further, it was observed that FDI
component in foreign capital inflows was highly significant and had contributed
positively in the country's economic growth.

The result showing positive effect of FDI on economic growth is also in line with
Kumar & Pardhan (2002) who analyzed the relationships between FDI, growth
and domestic investment for a sample of 107 developing countries for the 1980-
99 periods. Panel data estimations in a production function framework in that
study suggested a positive effect of FD1 on growth.
The result for the last variable of the study exports is positive and significant at 10%
level of significance, with value .04 treated as the long run elasticity (see table 4.7).
The results
could be justified on the ground that since Pakistan's export performance has not been
very impressive over the last two decades. So The Exports have failed to play a
significant role in economic growth. It is so, because the larger part of FDI inflows in
Pakistan have been in services sector rather than being in Industrial sector or large scale
manufacturing sector, thus the role of FDI in enhancing the exports has not been effective
Khan (2007).



4.8 Summary
The above chapter analyzes in detail the data used for testing the relationship between
FDI and Economic Growth. The stationarity of the data was tested by observing the
graphical plots of the series of K, L, FDI, X, and GDP. The results were further
verified by the application of the ADF test on the series. It was concluded that all the
variables are not stationary in levels but stationary at first difference. The cointegration
technique has been applied at levels and the residual errors were further tested for
stationarity. As the residual errors are stationary at levels hence the system is in long
run equilibrium. The variables K, L, FDI and X are found to be statistically significant and
positively effecting GDP. The ECM has been used to estimate the short run effects of
variables on economic growth. The variable FDI, K, L, and X seem to effect the economic
growth in short run statistically significantly and positively.
58


CHAPTER 5

Conclusion and Policy Recommendation


This chapter contains the summary of the results and conclusion of the whole research
exercise. Some policy implications are also drawn in this chapter that have been derived
from the study results discussed in detail in the preceding chapter.



5.1 Conclusions
Foreign direct investment is now considered in many developing countries as a key
source of much needed capital, advanced technology, and managerial skills. Keeping in
view its central importance to economic development, government of Pakistan has taken
wide ranging steps to liberalize inward FDI regime and have succeeded in attracting
substantial amount ofFDI in the last five years.
Pakistan however, lags behind considerably in attracting FDI compared with the other
major developing countries in Asia. Because of its central importance to the economic
development, this study was conducted to analyze the relationship of FDI and economic
growth of Pakistan. A statistical model was used in this study to estimate the impact of
FDI on economic growth. Cointegration technique was used to estimate the long run
relationship between the FDI and economic growth along with other variables that are
typically assumed to effect economic growth. An ECM was estimated to inquire about
the short run relationship between variables of the study. The other variables
included in the study which are assumed to effect the economic growth are
labour, domestic capital and exports.

The regression results showed that FDI affect the economic growth significantly
for the sample involved i.e.
1980-2006 in the long run, while other variables such
as domestic
capital, labour, and exports effected the economic growth
significantly. The results obtained for the short run show that FDI effected the
economic growth significantly and positively. The results were likewise for the
other variables in the short run.


5.2 Policy Implications
Important policy lessons can be drawn from the findings of this study. The
aggregate estimation results of the study indicate that FDI has contributed to the
economic growth in Pakistan for the time period
1980-2006, along with other
factors such as domestic
capital, labour, and exports. Therefore it is imperative
for the government to make a policy for attracting FDI in such a way that it should
be more growth enhancing.
FDI is believed to transfer technology, promote learning by doing, train labour
and in general, results in spill-overs of human skills and technology. For all this
to hold in a given economy several prerequisites are required. The preconditions
include presence of a liberal trade regime, a threshold level of endowments of
human capital, an adequate domestic market for the goods produced, and
effective competition from locally owned firms through both investments in R&D
and domestic production.
The results of the study show the effect of FDI on economic growth in the long
run. It seems that Pakistan has to fulfill the above mentioned
preconditions despite of government's liberal trade and investment policies. The
business environment in Pakistan with weak infrastructure, poor law and order
conditions, and low level of trained manpower, is still not conducive for
attracting foreign investment.
It is, hereby, proposed that the government should ensure maximum business
friendly policies, particularly creating an attractive environment for the FDI.
Furthermore there is need to regulate the FDI and direct it to investment in
various other sectors, most importantly in large scale manufacturing sector,
other than the services sector. More Greenfield investment should be
encouraged along with investment in large scale manufacturing that can
improve the exports of the Pakistan as well as the strongest argument for FDI is
that it stimulates exports for the host country.