Trade and Development

(Syed Turab Hussain)

Determinants of FDI in Pakistan

Mahnoor Bilal (2017-02-0412)
Zahid Ali (2017-02-0442)
Abstract:

Foreign Direct Investment (FDI) is an investment in which investor from some other

country invest in an enterprise of a different economy and the purpose of investment is to serve

the business interests of the investor in that economy. Overseas investors always inclined

towards those countries which assist them in terms of both infrastructure and encouraging

policies for investments. Solid policies from the host country also circulate foreign investment

into accurate areas where they are excessively desirable.

The reason we are interested in foreign direct investment (FDI) for our study is because

FDI has grown at a phenomenal rate since the early 1980s, and the world market for it has

become more competitive. Developing countries are becoming increasingly attractive investment

destinations, in part because they can offer investors a range of "created" assets. (Padma

Mallampally and Karl P. Sauvant). Developing countries have turned to FDI as a source of the

capital, technology, managerial skills, sustained economic growth and development. This

resulted in greater deregulation of economic activity and greater reliance on market forces. Total

capital flows in 1996 amounted to $ 349.2 billion, rising from $ 203.8 billion in 1990, thereby

registering an average annual growth rate of 11%. (Ashfaque H. Khan and Nasir M. Khilji).

In recent years, economic activity has been eminent by a notable increase in the global

scope of trade. One of the reasons of FDI flows from developed countries to developing

countries is their comparatively young and inexpensive men-power. After reaching at highest

peak in 2000, global FDI flows declined dramatically in subsequent years. In 2003, the United

Nations Conference on Trade and Development (UNCTAD) report showed terrible decrease in

FDI inflow by a further 17.5% than the previous year. In value terms, global FDI inflows in 2003

were about USD 560 billion, 40 percent of the USD 1,388 billion recorded in 2000. However,
due to further cross border Mergers and Acquisitions (MandAs), higher economic growth

worldwide and improved profitability among companies, the FDI situation in 2004 had shown

prominent improvements and in 2006 and 2007, made new heights of 1411 and 1833 Billion $

(UNCTAD, 2008).

World Investment Report (2004 and 2005) has shown the remarkable shift in FDI character

towards services. In 1970, for example, services FDI accounted for a quarter of global FDI stock.

In 1990, the share increased to about half, while in 2002, the share of services FDI to global

stock rose to about 60 per cent.

Literature Review:

Pakistan seems to follow more of the global trend of FDI inflow in developing countries. It is

among the first few countries in the region that opened up the markets in the early 90’s. Pakistan

does not have an enviable record of accomplishment of economic growth except in the 1960’s.

Adequate legal framework for foreign investment was provided in the form of Foreign Private

Investment (promotion and protection) Act, 1976 and the Protection of Economic Reforms Act,

1992. (Ashfaque H. Khan and Nasir M. Khilji).

Khan, H (1997) discussed the attitude of developing countries toward foreign direct

investment and tried to find out the reasons why Pakistan has not been able to attract FDI despite

liberalization measure. The polices for low inflow of foreign direct investment in Pakistan is

pointed i-e political stability, economic strength, law and order condition, government economics

polices, government bureaucracy, local business environment, infrastructure, labor force, quality

of life and welcoming attitude. All of these factors needed to be improved for more foreign direct

investment in Pakistan.
In developing country like Pakistan private investment is also playing crucial role. Khan and

khan (2001) attempted to analyze the determinants of private investment by using ARDL co

integration technique to check the existence of long run relationship as well as short run

dynamics of investment. The results supported the idea of providing suitable environment for

markets e.g. protection of policy rights, enforcement of contracts, and voluntary exchange at

market determined prices. Partial support for accelerator principle and crowding out hypothesis

is also findings in the case of Pakistan.

Before 1980’s, the economy of Pakistan was a highly regulated economy with public

ownership, industrial licensing, and price controls, inefficient financial sector with mostly public

ownership. Import licensing, bans, and high tariffs. However, following the global trend, FDI

inflow in Pakistan was $322 million in 2000-01 and increased to $3.52 billion in 2005-06 and

exceeded $8 billion dollars in 2006-07 (Ahmed Nawaz Hakro and Ikhtiar Ali Ghumro)

As the global FDI faced a downward shock due to Global Financial crises in 2008, the same

declining trend was observed in Pakistan after 2008. However, in addition to this global

recession, deteriorated law and order situation, political instability, energy crisis and weak

economic activity were found to be some of the reasons for Pakistan. (JAFFRI, ASGHAR, ALI

and ASJED)

The below figure shows the FDI inflow ups and downs in Pakistan:

Source: World Bank

Significant Factors affecting FDI in Pakistan:

FDI can be effected by either economic factors or socio-political factors. We have studied two

papers to analyze the determinants of FDI inflow in Pakistan. First paper talks about the

economic factors while the second paper talks about the social and political factors.

Syed Ali Mohiuddin and Muhammad Abdus Salam paper:

The research problem behind this study was to statistically analyze the current determinants of

FDI inflow in Pakistan. The objectives of the study are to empirically identify the current

determinants of FDI inflow in Pakistan to test their significance.

VARIABLES:

Following variables were analyzed contributing in FDI inflows which were identified through

literature survey.

a) Real GDP b) Interest Rate c) Exchange Rate d) Infrastructure e) Openness

Scope of the Study

The study covered data of macro level indicators during the period from FY 1975 to FY 2007-

08 which would help in identifying determinants of FDI inflows in Pakistan.

Research Methodology and Research Design:

The research was quantitative in nature and for that researcher collected secondary data from

different sources including State Bank of Pakistan, Federal Bureau of Statistics and National

Highway Authority. Hence data was analyzed to find out significant determinants of FDI inflows

in Pakistan.

Sample:

A sample of 35 years data from FY 1974-75 to FY 2007-08 was used to identify and analyze the

significance of these determinants.

Statistical Tools:

Time Series analysis was used to find major contributing factors in recent FDI inflows in

Pakistan through the software E-views.

Data Analysis and Findings

1. Unit Root Test 2. Estimation of a Cointegrating Vector 3. Vector Error Correction

Estimates.

Interpretation of Empirical Results

FDI = 4.571 RGDP + 0.109 OPEN - 0.00000375 IS + 0.105 IR + 0.048 EXR

Moreover, the coefficient of Real GDP are positive implying that when Real GDP

increases it means there are more economic activities and new markets so FDI increases as

investors see greater opportunities and expect high returns. The relationship between FDI and
Growth is bidirectional causal relationship i.e. FDI can also led to growth. However, assuming

that FDI does crowd out domestic investment, there can be negative impact of FDI on growth. In

this case, they have controlled for the bidirectional causal relation and only looked at the impact

of real GDP on FDI. (Herzer et al.92008: 794).

The resemblance of FDI and GDP in case of Pakistan is evident from below graphs i.e

downward shock in 1990’s and upward shock in 2006-07 and fall in 2008.

FDI inflow of Pakistan. Source: World Bank

GDP as annual percentage of growth in Pakistan. Source: World Bank

 Openness was positive and significant meaning that the more trade liberalization policies

will ensure greater inflow of FDI. Policies like lower taxes and tariffs would attract home

countries to Pakistan.

The results showed a positive relationship between FDI and Exchange Rate but

insignificant. The reason for this may be that an increase in Exchange Rate increases the relative

buying power of investors in the host country and also the labor wage and cost of production

decreases for the investors. However, stable exchange rates are significant for FDI because high

volatility of exchange rate makes it difficult to estimate the cost and profits on FDI. The

resemblance of trends of FDI and stability of exchange rates is evident from below graphs.

Source: World Bank

 Interest rate is return on investment, investor will channel their investments from low

interest rates to higher interest rate, and because it provides incentive to foreign investors looking

for higher returns therefore high interest rate can lead to increased more FDI.

Countries with good infrastructure are expected to attract more FDI. Infrastructure as

roads, airports etc provide facilities to industries and reduce cost which result in increased

profitability.

But in this case it was not significant because the relative infrastructural development in

Pakistan was not catching up with global investing demands of home countries. E.g in CPEC we

have to invest 10 billion dollars on infrastructure too as we don’t have that level of infrastructure

to cope with huge investing policies of regional level.

Second Model:

SOCIAL AND POLITICAL FACTORS EFFECTS ON FOREIGN DIRECT INVESTMENT IN

PAKISTAN (1971-2005)

This paper is by Muhammad Azam and Naeem-ur-Rehman Khattak. The former is faculty of

Department of Economics, University of Peshawar (N.W.F.P) Pakistan and the latter is Faculty

of Social Sciences, University of Peshawar (N.W.F.P) Pakistan

This paper empirically evaluates the effects of social and political factors on the inflow of

Foreign Direct Investment (FDI) in Pakistan

MATERIALS AND METHODS:

In analyzing the socio-political factors effects on FDI, secondary data have been used over the

period from 1971 to 2005. The data on human capital have been obtained from Federal Bureau

of Statistics.
A simple semi log linear regression model was used and the method of Least Square (OLS) was

used for estimation. Minitab statistical software was used for the analysis.

The purpose of the present research paper is to analyze the effects of social and political

factors i.e., human capital and political instability on FDI in Pakistan. Though there are several

factors determining FDI inflow such as economic, social and political factors but this study

focuses only on the social factor (i.e., human capital) and political factor (i.e., political

instability) of FDI in Pakistan.

The level of workers quality and quantity is an important factor to a firm that is locating in a host

country primarily to use their labor as a less expensive input than the labour in their home

country. They have used primary school enrollment as proxy for the level of human capital in

this study.

Jun and Singh (1996) argued that political instability is a qualitative phenomenon and the exact

measurement of which is a complicated issue in terms of what investors perceive as politically

risky and a constraint to their investment.

Econometric studies frequently fail to establish a relationship between political risk and FDI

flows (Cahse et al., 1998).

Lucas (1993) evaluated that due to political risk capital does not move from developed countries

to developing countries.

In literature political instability were measured by different variables that all are proxy variables

like number of strikes and riots, workdays lost, etc., have proved significant in some studies, but

these quantitative estimates can capture only some aspects of the qualitative nature of political

instability. However, due to the non-availability of appropriate data on political risk rating for
Pakistan, employing dummy variable for political risk and using one (1) and zero (0) for stability

and instability. In this study by political stability mean democracy in Pakistan and vice versa.

Econometric Model

Due to non-linearity of the data log linear model was used. The following simple linear equation

was used;

Ln (FDI) = β+β1 Ln (HK) + β2 (Prisk) + ε

The explanatory variables and error term (ε) followed the least square assumptions.

The above equation (1) states that human capital measured by primary school enrollment has

positive impact on FDI inflows and the impact of political instability on FDI inflow is negative.

The estimated regression equation is:

FDI = - 32.3657 + 4.4137HK - 0.5814Prisk

Dependent Variable: FDI

Independent Variables Coefficients (t-

statistics)

HK 4.413782

(12.26313)*

PRISK -0.581445

(-1.500336)

Constant -32.36572

(-9.808710)

R-squared (R2) 0.828884

 Adjusted R-squared 0.818190

S.E. of regression 1.140558

Observations (N) 35

The results indicate that human capital is positively significant at one percent level of

significance. The coefficient size found 4.413, which show that one unit change in human capital

will bring 4.413 unit changes in FDI inflow.

The estimated coefficient size of political instability found as –0.581 showing though an inverse

relationship with FDI inflow but statistically insignificant. When there is any political instability

foreign investors feel unwell to invest in that country.

Hence, in conclusion, the economic factors are significant for determining the inflow of FDI

while political factors like democracy and political risk are secondary and insignificant.
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