Determinants of FDI (Foreign direct investment) and its capacity as an economic growth of Pakistan

Submited by: Shaikh Umair Saleem

Registration :1735132 (MBA Ev 36 E)
Submited to: Dr.Manzoor Ali Isran
Table of Contents

Chapter 1: Introduction ................................................................................................................... 0

1.0 Background ...................................................................................................................... 2

1.2 The Problem Statement ......................................................................................................... 3

1.3 Research Questions ............................................................................................................... 4

1.4 Research Objective ........................................................................................................... 4

1.5 Significance ........................................................................................................................... 4

1.6 Limitations ............................................................................................................................ 4

1.7 Scope ..................................................................................................................................... 5

1.8 Model/Framework to be used ................................................................................................ 5

1.9 Definition of Key Terms ....................................................................................................... 6

Chapter 2: Research Methodology.................................................................................................. 7

2.1 Research Design .................................................................................................................... 7

2.2 Procedure ............................................................................................................................... 7

2.3 Sample and Sampling Method .............................................................................................. 8

2.4 Data Collection Method & Instrument .................................................................................. 8

2.5Econometric model specification and variable

2.6 Statistical Tests to be used ....................................................................................................... 9

2.7 Software Employed ............................................................................................................... 9

References ....................................................................................................................................... 9
Chapter 1: Introduction
1.0 Background
Foreign Direct Investment could be distinct as “The investment created by an organization or
individual for the aim of productivity or to increase their business in any focused country. FDI
could be distinct as “The investment that is created in any foreign country in form of transfer of
technology, services or any tangible asset to achieve more and more profit.” (Wikipedia, 2009).
In another word foreign direct investment attribute to plough back the profit achieved through
investment in any business. From the last few periods, foreign direct investment flow changed
from developed to developing countries. FDI is distinct as the root of acquirement of the
managerial handle by a business enterprise of a guest country over business activities in a
landlord country (Graham, 1982). The primitive benefit of the FDI is the prospects they produce
to precipitate economic growth. (Collins et. al, 1999). Today FDI accounts for more than 60% of
the private capital flows to the developing countries (World Bank, 2006). Foreign direct
investment is an essential element for the country’s growth. Especially, those economies where
financial restraints are greater for local firms that impede their fertility.
(FDI) is one of the utmost prominent kind of investment in the world and its effect on economic
growth is optimistic. Thomas et al., (2008) objected that FDI performs an important function to
increase technology, product and make local firms more innovative. That is one of the major
purposes that why developing countries like Pakistan captivate FDI. Many developing countries
tackle the problem of saving gap and investment and this gap can be filled by FDI. FDI enhance
fertility in a developing country and make the competition. (Kobrin, 2005; Le and Ataullah
2006). These benefits have encouraged making easy and flexible policies regarding FDI in
developing countries. Many researchers figure out a mixed view of the effect of FDI on growth.
From the last decade, foreign direct investment has increased at least twice as rapidly as trade
(Meyer, 2003). As there is a shortage of capital in the developing countries, which need capital
for their development process, the marginal productivity of capital is higher in these countries.
On the other hand, investors in the developed world seek high returns for their capital. Hence
there is a mutual benefit in the international movement of capital.
During the early 1980s, the government in Pakistan has commenced market-based economic
amend policies. Those amend commenced to take over in 1988, and since the government had
liberalized its investment regime and trade by supplying bountiful fiscal incentives and trade to
international investors through a number of tariff discount, credit facilities, and tax concessions
and also relieved foreign exchange controls (see Khan, 1999). In the 1990s, the policy was more
liberalized by the government and opened the sector of insurance, energy, telecommunications,
and agriculture to FDI. But, owing to swift inconsistency in policies and political changes the
level of FDI remained low as compared to other developing countries. From the last two
decades, Pakistan’s FDI patterns have looked at mixed trends. During '90s Pakistan obtained a
minor amount of FDI due to its reliance on debt. (Hukro and Ghumro, 2007).
Even after liberalization and incentives for the investor to attract FDI performance was lackluster
in this regard (Khan and Kim, 1999). But this drift turned after 1999 and the FDI from
322million in 2000-2001 rose to 3.52billion in 2005-2006. In spite of the remarkable increase in
FDI during the last decade, Pakistan FDI floe remains feeble when compared with other
developing countries. During 2007 capital inflows to developing countries express 7.5% of GDP
but in context of Pakistan that share represented only 4%. In 2009 Pakistan again faced a decline
in FDI stock solely get to 3.72 billion from 5.4 billion in the previous twelve months
(Bloomberg). Nishat and Anjum (1998), evaluated that liberal policies of the government,
mineral resources, level of the technical labor force, peaceful law and order situation and
political stability captivated foreign investors in Pakistan. The government of Pakistan has also
opened its gate for FDI, but it has not grabbed more FDI and their applicable utilization to rising
economic growth. Unlike China and India successfully acquired consistent foreign direct inflows
(Le and Ataullah, 2006). FDI is still low in Pakistan. For economic growth, structure
composition is also very necessary (Chakraborty and Nunnenkamp, 2008).
FDI fetches the most desired global links, capital fund, advanced production technique,
advertising and marketing expertise, snobbish managerial skills, and the controversial
phenomenon of “transfer pricing”. Pakistan is the world’s 7th most populated country with 140
million people, a relatively high growth rate of GDP (averaging around 6 percent), with a
consequential a variety of investment provisions and stock of natural resources has remained
unpretentious for foreign private investment, grants, Foreign loans, and FDI inflows are the main
external sources of funds to meet developmental goals and the obligations of external resource
gaps in Pakistan.
The ongoing process of integration of the world economy and liberalization of the economies in
many developing countries have led to a fierce competition for inward FDI in these countries.
The controls and restrictions over the entry and operations of foreign firms in these countries are
now being replaced by selective policies aimed at FDI inflows, like incentives, both fiscal and in
kind. The selective policies not only improve the fundamentals of the economy, but they aim at
attracting more foreign investments in the country. However, it has been argued that the location-
specific advantages sought by foreign investors are changing in the globalized more open
economies of today. Accordingly, in his path-breaking work, Dunning (2002) finds out that FDI
from more advanced industrialized countries depends on government policies, transparent
governance and supportive infrastructure of the host country. However, very few studies exist
that have empirically estimated the impact of selective government policies aimed at FDI.

1.2 The Problem Statement

Foreign Direct Investment is performing the main function in the improvement of any country's
economy, meanly in developing countries like Pakistan. and it is the main source of external
finance in Pakistan to trade policies, stable fiscal and financial. FDI performs an important
function to increase technology, product and make local firms more innovative. That is one of
the major purposes that why developing countries like Pakistan captivate FDI.
In this research, FDI behavior will be studied to assess statistically analyze the current
determinants of FDI inflow in Pakistan. We will also study which factor has more capacity to
increase growth.

1.3 Research Questions

 What are the signifier factors that affect FDI?

 What is the capacity of the relationship between FDI and its determinants?
 What are the effective policies that the government utilize for the reform period?

1.4Research Objective

 To analyze the main factors which affect FDI in Pakistan.

 To evaluate the impact of every determinant on FDI.
 To inspect the capacity of the relationship between FDI and its determinants.
 To figure out the effectiveness of these policies during the reform period.
 To figure out which specific government policy is attracting or distracting FDI in
Pakistan.

1.5Significance

Foreign direct investment is one of the economic theory that is observed as the component of
economic development of the countries in regard to the market economy. That is why it is
broadly regarded in a kind of economic studies. Foreign direct investment is an essential factor
for economic growth. In particular, for those economies where financial restrictions are greater
for local firms which impede their capability. The primitive benefit of the FDI is the prospects
they produce to precipitate economic growth. (Collins et. al, 1999). Today FDI accounts for
more than 60% of the private capital flows to the developing countries (World Bank, 2006).
Structure of FDI in Pakistan mixed trends has been observed over the last two decades.in
Pakistan. This study focuses that which factors have a high capacity to increase economic
growth. This study could be beneficial in finding out the factors and appropriate policy to the
reforms period.

1.6Limitations
Following are the limitations which needs be addressed in the future researches related to this
area of study.
 Due to limited time and resource constraint this research will be conducted
determinants of FDI and economic growth in Pakistan.
  This study will be covered by secondary data.
 There are ten variables which will be studied in this research.

1.7 Scope
The focus of this study will be on the determinants of FDI and its capacity as economic
growth in Pakistan. It will analyze which factors have a high capacity to enhance economic
growth. Previously in Pakistan, there was no such study conducted variable of political stability
that is also hinder to increase economic growth in Pakistan although Pakistan has good human
resources and another factor to attract FDI. This research study is conducted by macro-level
indicators of Pakistan.

1.7Model/Framework to be used

The preliminary conceptual framework, which is being studied empirically is illustrated.

It may be further refined based on the in-depth literature review.

Independent Variable

 GDP
 Infrastructure
 Political stability
 Price index
 Exchange rate
 Total credit
 Tax
 Wage
 Tariff
Dependent Variable

Foreign Direct Investment

1.8Definition of Key Terms

 Foreign Direct Investment (FDI) is an investment “made by a company or entity based

in one country, into a company or entity based in another country. The FDI differ
substantially from indirect investments such as portfolio flows, wherein overseas
institutions invest in equities listed on a nation's stock exchange”. It is taken as a
percentage of GDP.
 GDP is the most commonly mentioned. Larger markets (economies) will attract a larger
volume of FDI due to the influence of the economies of scale in the context of market-
seeking investments. In some cases, this factor may be the key determinant of foreign
investment (Sharma & Bandara, 2010). only a few studies obtained significant results:
Noorbakhsh & Paloni (2001), Kok & Ersoy (2009) and Pearson et al. (2012). All this
investigation emphasizes the positive influence of GDP growth on FDI. However,
considering empirical results, we cannot affirm the existence of a reliable relationship
between this factor and FDI.
 Tax The literature remains fairly indecisive regarding whether FDI may be sensitive to
tax incentives. Some studies have shown that host country corporate taxes have a
significant negative effect on FDI flows. Others have reported that taxes do not have a
significant effect on FDI. Hartman (1994), Grubert and Mutti (1991), Hines and Rice
(1994), Loree and Guisinger (1995), Cassou (1997) and Kemsley (1998) find that host
country corporate income taxes have a significant negative effect on attracting FDI flows.
 Infrastructure covers many dimensions ranging from roads, ports, railways and
telecommunication systems to institutional development (e.g. accounting, legal services,
etc.). According to ODI (1997), poor infrastructure can be seen, however, as both an
obstacle and an opportunity for foreign investment. For the majority of low-income
countries, it is often cited as one of the major constraints. But foreign investors also point
to the potential for attracting significant FDI if host governments permit more substantial
foreign participation in the infrastructure sector.
 Political stability the ranking of political risk among FDI determinants remains rather
unclear. According to ODI (1997), where the host country owns rich natural resources, no
further incentive may be required, as it is seen in politically unstable countries, such as
 Nigeria and Angola, where high returns in the extractive industries seem to compensate
for political instability. The empirical relationship between political instability and FDI
flows is unclear. For example, Jaspersen et al. (2000) and Hausmann and Fernandez-
Arias (2000) find no relationship between FDI flows and political risk while Schneider
and Frey (1985) find an inverse relationship between the two variables.
 Wage Labour costs reflected in the level of wages are often seen as one of the main
determinants of FDI inflows, low wages being regarded as an advantage in attracting
foreign firms, because of the diminution of production costs. However, the methodology
of the variable forming is dissimilar: Du et al. (2012) and Hayakawa et al. (2013) use the
average payment for manufacturing workers, Mateev (2009) utilizes the percentage
change in overall cost of labor, Khachoo & Khan (2012) apply the natural logarithm of
the wage rate, whereas Riedl (2010) uses real unit labor costs.
 Exchange Rate Exchange Rate is also considered to be an influential factor when
studying foreign investment. Arbatli (2011) proposes two variables to investigate it: Real
exchange rate and Exchange Rate Classification. The first one does not have any
statistically significant relationship with FDI. For Exchange Rate Classification the
author introduces dummy variables on the basis of IMF’s de facto classification of
exchange rate arrangements and obtains significant results, stating that the exchange rate
fixation or volatility affects foreign capital inflows.
 Tarif we expect a negative relationship between FDI and TARIF.
 Total credit as a credit to foreign investors is an investment incentive, we expect a
positive sign for the coefficient of CREDIT.
 Price index if the sign of INDEX is negative it indicates that the government pursues
policies to attract FDI when the capital market is sluggish. However, a positive sign for
INDEX suggests that the foreign investors are concerned with the investment climate of
the country.

Chapter 2: Research Methodology

2.1 Research Design

This is explanatory research and will be conducted through a quantitative method in which
secondary data will be gathered from different sources including National Highway Authority,
State Bank of Pakistan, Federal Bureau of Statistics and Global Terrorism database. Thus, data is
analyzed to figure out the significant element of FDI flows in Pakistan.

2.2 Procedure
 This study will be accomplished by using secondary data and conducting different
sources.

2.4 Sample and Sampling Method

We have selected the sample size of 35 years from FY 1980 to 2015. To analysis and find out the
significance of those determinants.

2.5 Data Collection Method & Instrument

The results for this research will be obtained through secondary data and the strategy will be data
sources. Time series analysis is used to figure out the major determinant element in current FDI
flows in Pakistan in the short run and long-run analysis.

2.6 Econometric model specification and variable

FDIt = f (GDPt, WAGEt,, TARIFt , TAXt, CREDITt , EXt, INDEXt, INFRSTt, PSt,)
where
FDI = Growth in FDI inflows (deflated by GDP deflator)
GDP = Log of GDP/Capita
WAGE = Log of Average Annual wages of factory workers in perennial industries(deflated by
GDP deflator)
TARIF = Ratio of custom duties to total value of imports
CREDIT = Share of credit of the private sector in total credit to public and private sectors
EX = Average Annual Exchange Rate as rupees / $
INDEX = Log of General Share Price Index
INFRST = Infrastructure proxy used Expenditure on Electricity, Gas, Transport and
Communication
Tax = Indirect Taxes
PS = political stability
2.7 Statistical Tests to be used

 Unit root test

 Cointegration techniques
 Error correction techniques

2.8 Software Employed

SPSS software will be used to analyze the data gathered through quantitative data
sources.

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