© Kamla-Raj 2010 J Economics, 1 (2): 99-104 (2010)

Economic Determinants of Foreign Direct Investment in Pakistan

Rana Ejaz Ali Khan and Muhammad Atif Nawaz*

Department of Economics, The Islamia University of Bahawalpur. Bahawalpur, PakistanTelephone: +92 062 9255456-64 ext. 433 (O), Mobile: +92 0345 8724744

E-mail: ranaejazalikhan@iub.edu.pk*Telephone: +92 063 9240298 (O), *Mobile: +92 0314 6864997,

*E-mail: atifnawaz_iub@yahoo.com

JEL Classification: F21, F31, E22, E31, H2.

KEYWORDS Capital Inflow. Exports. National Income. Tariff

ABSTRACT Pakistan aims to increase the investment GDP ratio by attracting foreign direct investment (FDI). Theforeign investors mostly from the developed dynamic centers are enhancing international production by investing inresource abundant economies. Having an overview of the influx of cross border investments, this paper empiricallyattempted to investigate the determinants of foreign direct investment in Pakistan. The analysis enabled identification ofsome economic determinants of FDI in Pakistan, like GDP growth rate, volume of exports, human population, tariff onimports, and price index. Volume of exports has been emerged the most powerful determinant of FDI. The governmentshould make a paradigm shift in its investment policy to attract FDI. It should focus on export-oriented industries insteadof encouraging FDI for domestic consumption.

1. INTRODUCTION

Economic development of a country involvesutilization of resources for increasing productivecapacity. In many developing countries such asPakistan, utilization of resources is renderedimpossible by the scarcity of domestic capital.Lizondo (1991) acknowledged a better choiceby developing countries of foreign direct invest-ment (FDI) rather than to depend on bank loansand bonds. These countries could promote theireconomic growth, by receiving FDI (China is aclassic example, where in 1997, FDI contributedabout 15 percent of domestic investment, 41 per-cent of total exports, 19 percent of industrialoutput, 13 percent of tax revenue and 18 millionemployment). First, FDI transfer financial re-sources to recipients or host countries whichcould be used to expand production facilities inthe host countries. Second, technology and mana-gerial know-how, which play crucial roles in pro-moting economic growth, may be transferred tothe host countries to participate in various net-works such as sales and procurement networksof foreign investors. Using international net-works, host countries could not only expand ex-ports, which in turn would improve productivityin the host countries. On the other hand, the crit-ics of FDI claim that foreign investors monopo-lize resources, supplant domestic enterprise, in-troduce inappropriate products and technology,and aggravate the balance of payments problem

through high remittances. They often use trans-fer pricing to minimize their tax liabilities. Theymay also come to wield considerable politicalinfluence, distort the path of development, exac-erbate income inequality, and exploit the weakenvironmental standards in developing countries.

Being a capital-deficit country, Pakistan needsFDI. Since late 1990s the Government of Paki-stan has initiated a number of policy and regula-tory measures to attract FDI. For example, therequirement of Government approval for foreigninvestment has been removed and 100 percentof ownership by foreigners is permitted, withexception of few projects. Foreign investment isprohibted in the area of agricultural land, for-estry, irrigation, real estate, insurance, health andrelated services. In the petroleum sector, thegovernment has enacted a new petroleum policywhich is significantly conducive for foreign in-vestment. One of the most important measuresto attract FDI is liberalization of the foreign ex-change regime. Resident and non-resident Paki-stanis and foreigners are now allowed to bringin, possess and take out foreign currency, openaccounts and hold certificates in foreign currency.Export incentives have been broadened. The 55percent income tax rebates for exports of highvalue-added products, and a 50 percent rebatefor all other products is implemented. Importpolicy has been liberalized to attract FDI. Im-port of machinery not manufactured locally isfully or partially exempted from import duties,

depending on whether a project is located in arural area, underdeveloped area, or industrialestate. A variety of other fiscal and monetary in-centives have also been offered for projects inselected industries like electronics, tourism, phar-maceutical, dairy-farming, mining, engineering,fertilizer and cement.

The rate of return on FDI is highest for Paki-stan among the major host countries of Asia. Theaverage rate of return of world is 5.5, develop-ing countries 4.2, China 5.8, Indonesia 5.4 andPakistan 7.0 (UNCTAD 2003). Despite thesefacts Pakistan has been able to get FDI ofUS$632.5 million in 2004-05, that is much lessthan China, India, Korea, Malaysia and HongKong.

The biggest foreign investor in Pakistan isSwitzerland having 31.9 percent of total FDI in2004-05. Then comes the USA and UK with 27.9percent and 12 percent share of FDI in Pakistan(SBP 2005). In a developing country like Paki-stan having abundant of natural resources, higherreturn is obtained in resource-oriented industriesresulting the inflow of capital into these indus-tries. Financial sector of Pakistan has absorbedthe maximum of the FDI, after that oil and gas,and petroleum refining has obtained 23.9 and 8.6percent of FDI. Textile is the largest manufac-turing sector of the country, attracting 4.2 per-cent of FDI that has more absorbing capacity.The construction industry is passing through theboom for the last many years. It has also taken asmall slice of 3.3 percent of FDI (SBP 2005).

The classical theory of international capitalflow stated that FDI is a function of internationaldifferences in the rates of return on capital. Em-pirical analysis of FDI from UK and Canada intothe US during 1950-1970 by Blais (1975) sup-ported the hypothesis. Contrary to this Weintraub(1976) observed no significant relationship be-tween the US capital flow and the relative ratesof return.

The traditional factor endowment theory as-sumes that factors are internationally immobile.This is an unrealistic assumption as there are fac-tors, which are relatively freely mobile. There-fore, it is necessary to distinguish between thosefactors, which are mobile, and those, which arenot. To this extent, the traditional theory requiresto be modified as it has considerable impact onthe decision to locate investment in a region andthereby influencing the movement of mobile fac-tors.

In the last three decades the FDI has changedthe form and structure of the contemporary glo-bal economy. Grossman and Helpman (1991)have concluded that small-developed countriessuch as Sweden and Switzerland are more likelyto invest abroad suggesting an inverse relation-ship between FDI and donor GDP. The supplyand demand determinants of FDI have been ex-plained theoretically along with empirical evi-dences. The work by Lucas (1993 for East andSouth Asia) and Jun and Singh (1996 for devel-oping economies) have focused on the businessenvironment, trade integration, labor costs andthe form of the privatization process. Shamsuddin(1994) has investigated the effects of per capitaincome, GDP in host country, wage rate, percapita debt, per-capita inflow of public aid, va-lidity of prices and the availability of energy inthe recipient country on FDI for 36 developingcountries by using cross section data (for theyears 1971-81) through single equation econo-metric model. Garribaldi et al. (1999) andResmini (2000) have focused on market access,along with other variables. These studies con-cluded that political and economic factors, theform and timing of the privatization process andthe need to secure market access are the primarydeterminants of the allocation of FDI. For theCentral and Easter Europe, Bevan and Estrin(2000) have found that FDI inflows are signifi-cantly influenced by risk, unit labor cost, hostmarket size and gravity factors. At the secondstage of analysis, they have identified that pri-vate sector development, industrial development,government balance, gross reserves and corrup-tion are significant determinants of risk. Urataand Kawai (2000) examined the factors in thehost countries that attract FDI by Japanese smalland medium-sized enterprises. Supply side fac-tors include abundance of low-wages labor avail-ability of well-developed infrastructure, and goodgovernance of the local government, while animportant demand side factor included is pres-ence of sizable local market. Asiedu (2002)focused on policy reforms in developing coun-tries as determinants of FDI inflows. The studyfound that corporate tax rates and degree of open-ness to foreign direct investment are significantdeterminants of FDI. Bolingen (2005) has giventhe review of empirical evidences of FDI crosscountries and suggested further research in thisdirection.

The literature on determinants of FDI in

100 RANA EJAZ ALI KHAN AND MUHAMMAD ATIF NAWAZ

Pakistan is still young enough that most theo-retical hypotheses are still grab up. That is whyChakra-barti (2001) concluded that most deter-minants of cross-country FDI are fairly fragilestatistically. Khan (1997) analyzed the factors re-sponsible for lower level of FDI in Pakistan. Thestudy identified a number of factors, i.e. lack ofpolitical stability, law and order situation, eco-nomic strength, government’s policies, govern-ment bureaucracy, local business environment,infrastructure, quality of labor force, quality oflife and welcome attitude.

Shah and Ahmad (2002) concluded that fis-cal policy and high return from the investmenthave played a significant role in attracting FDIin Pakistan. From a data set of 1960-1999, thestudy concluded that cost of capital has strongimpact on investment. The study proposed tominimize the cost and maximize the returns ofFDI to attract FDI in Pakistan.

The determinants of FDI in Pakistan are esti-mated by Shah and Ahmad (2003) taking marketsize, cost factor, political and social factors asdetermining variables. They applied OLS andCointegration and Error Correction Method(ECM) on the data for the time period of 1980-1999. The model is a supply side model whiledemand side aspects are ignored.

However, Ahmed et al. (2003) have appliedGranger’s concept of causality on the data forthe time period of 1972-2000, to examine theeffect of export, production, domestic output,foreign income and exchange rate on inflow ofFDI in Pakistan. They concluded that domesticoutput is the most powerful determinant of FDI.The domestic output is a micro-level concept,therefore Pakistan should stress on micro eco-nomic approach, which would increase domes-tic output of international standard. Aqeel andNishat (2004) have identified the determinant ofFDI in Pakistan focusing on tariff, exchange rate,price index, wage rate (proxy of demand for la-bor) and GDP by using ECM on the data for theperiod 1960-61 to 2003-04.

For South Asia, determinants and trend of FDIare probed by Sahoor (2006). The study exploredthat sharp rise in private capital flows to devel-oping countries come despite uncertaintiescaused by high oil prices, rising global interestrate and growing global payment imbalances. Therise in capital flows to developing economies wasbasically driven by abundant global liquidity,steady improvements in the credit quality of de-veloping countries, lower yield in rich countries,

and the expansion of investors interest in emerg-ing market assets.

The empirical literature pertaining to Pakistanindicated several determinants of FDI. They aremainly concerned with political and businessenvironment, and macro-economic variables. Wewill analyze the economic determinants of FDIwith a new data-set of recent 35 years.

2. MATERIAL AND METHODS

FDI linkage can be analyzed in different waysby the type of FDI, the strategy of transnationalcorporations, sector of economic activity, and bygroup of countries and their level of develop-ment. There may be a number of variables, whichmay determine FDI in Pakistan and other devel-oping countries such as exports of goods andservices, wage rate per day, energy imported,energy price, per capita debt, per capita publicaid, foreign income, exchange rate, human popu-lation, quality of labor force, inflation rate, tar-iff, degree of openness to FDI, privatization,growth rate of GDP, political condition of thecountry, political relationship among countries,credit rating of the countries (as measure of eco-nomic, political and institutional performance),infrastructure, welcome attitude, returns to FDI,GDP of the domestic country, and GDP of thedonor country. We have included annual growthrate of GDP (as a measure of market size), an-nual average exchange rate, whole sale price in-dex, custom duty on imports, and export of goodsas explanatory variables affecting FDI in Paki-stan.

The data-sets for the years 1970-71 to 2004-05 have been taken from a number of sources,i.e. the amount of FDI, GDP growth rate, andcustom duty has taken from the Fifty Years ofPakistan in Statistics by Federal Bureau of Sta-tistics (FBS) and International Financial Statis-tics by International Finance Commission, ex-change rate and exports from Economic Surveysby State Bank of Pakistan (SBP), and whole saleprice index from Statistical Year Book of Paki-stan by FBS. Our analysis is based on time se-ries data so stationary properties of the variableswould be taken into account. A regression of onenon-stationary series on another non-stationaryseries can generate the so-called spurious regres-sion and lead to incorrect statistical inference.An important indicator of spurious regression isthat Durban Watson statistics remain less than

FOREIGN DIRECT INVESTMENT 101

coefficient of determination. If such problemdoes not arise in our model, we will be comfort-able to use OLS model, rather than co-integra-tion technique.

In OLS regression, we use linear combina-tions of predictor (independent) variables to com-pute values of the response (dependent) variable.

μ = E(y|X) = ΣXjβj = XβThese expected values are conditional on the

independent variables. The full model for OLSincludes both the structural or systematic com-ponent, Óxâ, and a random component, å.

y = ΣXjβj + åi = Xβ + åi

We proposed the following empirical modelfor determinants of FDI in Pakistan.FDI = ß1 + ß2GDP + ß3EXR + ß4EXP + ß5AR+

ß6WPI+ UI ……….............................…(1)WhereFDI = Annual Foreign Direct Invest-

ment in DollarsGDP = Annual growth rate of GDPEXR = Annual average exchange rate

as Rupees/DollarEXP = Exports of good and services

from PakistanTAR = Custom duty on imports in the

countryWPI = General wholesale price

index of the countryThe foreign investors move a part of their pro-

duction to the country where market is large toabsorb a substantial part of their production. Toinvestigate such type of effect we included GDPgrowth rate as proxy for market size (The othermeasures for market size may be GDP per capitaand size of the middle income group). We hy-pothesized that the coefficient of GDP growthrate should be positive because foreign inves-tors are interested where there is larger marketfor their production.

Until 1996 the common wisdom was thatchange in the level of exchange rate did not alterthe decision by a donor country to invest in aforeign country. In rough terms, while an appre-ciation of home country’s currency would lowerthe cost of assets, the (expected) nominal returngoes down as well in the home currency, leadingthe rate of return identical. Froot and Stein (1991)presented an imperfect capital market story forwhy a currency appreciation may actually in-crease foreign investment by a firm. Imperfectcapital market means that the internal cost of

capital is lower than borrowing from externalsources. Thus, an appreciation of the currencyleads to increased firm wealth and provides thefirm with greater low-cost funds to invest rela-tive to the counterpart firms in the foreign coun-try that experience the devaluation of theircurrency. Another case may be that firms areinterested in export production. The deprecia-tion of the currency of a host country increasesthe attractiveness of that country as a host to FDI,because depreciation tends to improve exportcompetitiveness of the products produced inthat country. In this case the exchange rate wouldhave positive coefficient. We hypothesized thatcoefficient of exchange rate for Pakistan wouldbe negative, i.e. foreign investors are interestedin high returns on their investment.

In the theory there may be two possibilitiesfor the foreign investors to choose the host coun-try depending upon the trade policy of the hostcountry. The two broader categories of the policyrepresents the export promotion regime andimport promotion regime. In export promotionregime, the foreign investors use lower laborcosts and low price availability of raw material.On the other hand, in import promotion regime,the host country has no advantage leading toextra profit ands rent seeking activities. Tradeopenness generally positively influences theexport-oriented FDI into an economy. That iswhy the investors like to invest in countries,which have regional trade integration and wherethere are greater investment provisions in theirtrade agreements. The coefficient of exportshould be positive for Pakistan, i.e. county’sinvestment policy is export-oriented and foreigninvestors make investment where there is highpotential of exports.

The link between FDI and trade protection inthe form of tariff is seen fairly clear by most tradeeconomists, that is higher trade protection shouldmake firms more likely to substitute by produc-ing in foreign country for domestic consumptionto avoid the cost of trade protection. This iscommonly termed tariff-jumping FDI. It ishypothesized that if foreign investors are inter-ested of goods for domestic use then there shouldbe a positive relationship between tariff onimports and FDI. It has been observed generallythat foreign investors in Pakistan are investingin small units to meet the domestic demand. Theexamples are automobile industry, chemicalindustry and home-appliance industry. Therelationship may be positive.

RANA EJAZ ALI KHAN AND MUHAMMAD ATIF NAWAZ102

The sign of wholesale price index would bepositive as it stands to represent the movementof the economy towards boom, along with in-creased demand for goods and services. The for-eign investors are concerned with the hot invest-ment climate of the country.

3. RESULTS AND DISCUSSION

For the model, the estimated results are en-couraging and show theoretically correct signsof the coefficients. Since D>R2 for the model sowe used OLS model though, in the previous lit-erature, Shah and Ahmed (2003) and Aqeel andNishat (2004) have used co-integration and er-ror-correction technique. The Durbin-Watsonvalues reject the existence of auto-correlation inthe model. They fall in area of no-autocorrelationthat support the model specifications. The econo-metric results are shown in table 1. The value ofR2 shows that 91 percent of the variation in FDIinflows to Pakistan is due to variation in GDPgrowth rate, exchange rate, whole sale price in-dex, tariff rate and exports. The T-value is sig-nificant. All variable coefficients bear expectedtheoretical signs.

Table 1: Regression Results of OLS model (Coefficientsa)

We have found the co-efficient of GDP growthrate positive, confirming the purchasing powerhypothesis, i.e. higher growth rate as a proxy forpurchasing power of nation is associated withgreater inflow of FDI. The evidence suggestedthat foreign investors invest in search of newmarket opportunities. It explains that the purposeof foreign investors is to tap the domestic mar-ket, and thus domestic market size matter fordomestic oriented foreign investment. A largemarket size provides more opportunities for saleand profit. The growth prospects symbolized by

GDP growth rate take the greater inflows of FDIthan volatile economies (see also, Dasgupta andRath 2000 and Durham 2002). Wei (2000) con-cluded that growth impart differ under differentconditions of the economy. On the other hand,Asiedu (2002) narrated that economic growth hasno impact on FDI.

The coefficient of exchange rate is negativeas expected. One percent decrease in Pakistan’sexchange rate is associated with 0.41 percent-age point increase in FDI annually. The depre-ciation of the country’s currency would encour-age the inflow of FDI. It also confirms the hy-pothesis that foreign investors are much inter-ested in high returns on their investment.

Pakistan’s trade policy focuses on boostingthe exports that is connected with export-ledgrowth policy of the country. We have found thatFDI is positively related with volume of exportsfrom the country. The results support the hypoth-esis that gains from FDI are higher in the exportpromotion regime than the import promotion re-gime. In the export promotion regime FDI useslow labor costs and available raw material forexport promotion. It further explains that inves-tors have incentives for investment, where thereis higher potential of exports. Initially, firms tradein the foreign market, and after learning moreabout the economic, social and ruling conditionsof their trading partners they may establish a sub-sidiary in the host country or they may embarkon joint ventures with local enterprise. This im-plies FDI inflows, and after some period, thesefirms start to export. Pakistan is at the point whereforeign exports is connected with additional capi-tal, new technology and better management andmarketing strategies that they bring with them.

There may be two possible bidirectional linksbetween FDI and imports. First, if imports areevidence that a market exists for a commodity,FDI might be attracted to the host country to pro-duce that product locally. In other words, a risein imports in the host justifies investment andproduction by foreign investors, thus importsstimulate FDI inflows. Second, as soon as for-eign investors establish in the host country, theyimport certain types of supplies (basic compo-nents and intermediate goods produced by theheadquarters) to satisfy the quality standards re-quired by the international market, therefore, FDIinflows increase the imports. Our results haveshown that tariff on imports are effecting theFDI positively. It confirms the hypothesis that

FOREIGN DIRECT INVESTMENT

Model Standardized coefficients t-ValuesBeta

Constant 2.055GDP .095 1.523 **EXR -.415 -1.923 *EXP 1.163 3.109 *TAR .991 5.777 *WPI .076 1.159 **a. Dependent Variable: FDIR2 = 0.914Number of observations = 35* and ** represents the level of significance at 5 and 10percent respectively.

103

Pakistan is absorbing tariff-jumping FDI. Theforeign investors are investing in the sector wheredomestic demand is met by domestic productioninstead of imports.

The whole sale price index stands proxy forrecovery of the economy from recession alongwith high demand for goods and services. Wehave found that FDI in Pakistan is positivelyrelated with whole sale price index.

4. CONCLUSION AND POLICYPROPOSALS

Our results may provide an opportunity toframe some policy implications. The regressionresults confirmed that an increase in GDP growthrate has positive effect on inflow of FDI in Paki-stan. Hence the authorities should positively con-centrate on maximum utilization of resources toincrease GDP growth rate.

The important finding of the study is that ex-port demand that is shown by the bulk of exportsis major determinant of FDI in Pakistan. Thenational trade policy should focus on exports byincreasing export processing zones, global mar-ket orientation and adjusting fiscal policies.

A co-efficient of import tariff suggested animportant role of the government in promotingthe foreign investment in the country. It needseffective and encouraging import policies fromthe public sector to restore the confidence of theinvestors.

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