FACTORS INFLUENCING FOREIGN DIRECT INVESTMENT (The Case of Pakistan)

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1 FACTORS INFLUENCING FOREIGN DIRECT INVESTMENT (The Case of Pakistan) Sajid Gul (Corresponding Author) Faculty of Administrative Sciences Air University Islamabad, Pakistan Mardan KPK, Pakistan Muhammad Sajid Faculty of Administrative Sciences Air University Islamabad, Pakistan Farman Afzal Lecturer Institute of Business and Management, UET Lahore, Pakistan Muhammad Bilal Khan MS Scholar Air University Islamabad, Pakistan Sumra Mughal MS Scholar Air University Islamabad, Pakistan ABSTRACT In this research article we have analyzed the role of Foreign Direct Investment and trade on growth of Pakistan economy by estimating the simple least square method. The variables included in this study are; GDP growth rate, GNP growth rate, FDI, trade of goods and services, employment, exchange rate, consumer price index, openness factor, BOP, GDP deflator, and GNP deflator. The data used in this paper is secondary, since it relates economic indicators; it is easily gathered from state bank of Pakistan, Pakistan economic survey and board of investment. The time period used in this research article is from and all the data are on annual basis. Foreign direct investment and growth of economy have strong positive association, which is the most important finding of the study. Further we found that FDI and GDP have a strong positive association. The relationship between FDI and inflation is positive; however this association is not very strong. Keywords: Foreign Direct Investment, GDP, Inflation, Economic Growth. 1. INTRODUCTION It is recognized worldwide that growing inflow of foreign direct investment can provide potential benefits and promote the economic development of the poor countries. Foreign direct investment also plays a very significant role in accelerating growth of economy and transformation. There are two ways through which FDI takes place firstly, it can take place when foreign companies make direct entry and secondly, it can take place through the acquisition of existing domestic companies. It can also increase growth in two ways first, when investment increases in the country it creates more opportunities for employment, the income level of the people also increases, secondly as a result people will demand more goods, due to which production of goods will increase. FDI for developing nations become an important source of private external finance, because such nations always look for investments due to which their development projects will speed up. Most of the studies show that those countries are in a better position to attract FDI successfully, which offer secure and profitable investment opportunities. It has been observed that many developing countries are now opening up their economies to attract FDI from developed countries and experiencing rapid growth. Such policies create a favorable climate for attracting FDI inflow, which bring new production, marketing and managerial technologies all of which are necessary for increasing the efficiency and productivity of firms at a national level. In Pakistan foreign direct investment is also being considered as an important vehicle for growth of economy. To increase domestic savings and investment, Pakistan seeks to enhance the inflow of FDI so that the economy will get benefit from these financial resources. In this way the growth of economy, employment opportunities and living standard of people will also increases. The aim of the study is to analyze the pattern and role of foreign direct investment on 21

2 growth of Pakistan economy and to identify the policies and factors that attract more foreign investors in order to strengthen the economy of Pakistan. 2. LITERATURE REVIEW The relationship between FDI inflows and growth of economy has been investigated in many studies. Azhar (2001) has analyzed the impact of trade policy regime on FDI contribution to growth of economy over the period of 1970 to The study found that the growth impact of FDI tends to be greater under an export promotion trade regime compared to an import-substitution regime. In short, these finding suggest that Pakistan s capacity to progress on economic development will depend on her performance in attracting FDI. William (2002) has examined the efforts of many developing countries to promote their economies as sites for foreign direct investment over the period of 1995 to The results suggest that most of the variables have shown a positive sign like per capita income, literacy interest rates and promotion, where as the current account deficit do not determined FDI. The per capita growth had an inverse relationship with per capita FDI. The results also found that the growth rates of per capita income were negatively correlated with inflow of FDI. Levine (2005) has analyzed foreign direct investment to accelerate growth of economy and also determined the relationship between FDI and growth of economy over the period of 1960 to This study provides conflicting predictions concerning the growth effects of FDI. The macroeconomic studies found a positive link between FDI and growth of economy not only contributed that FDI inflow exert an independent influence on growth of economy but also sound economic policies increase both FDI and growth. Arshad (2007) has examined the link between FDI, domestic financial sector, and growth of economy for Pakistan over the period The results found that the presence of FDI inflows does not necessarily improve the technology level of host country through positive spillover efficiency. Findings also suggest that FDI plays an important role in contributing to growth of economy. However, domestic financial sector development is crucial for positive effects. Falki (2008) has assessed the impact of FDI on growth of economy in Pakistan for the period of The expected results of the study have a positive and statistically significant relation between the real per-capita GDP and FDI. Tanna (2009) has examined the association between inward foreign direct investment (FDI) and bank level productivity changes covering the period The results indicate that inward FDI has a negative short-term level effect but a positive long-term rate effect on TFP change. 2.1 FDI inflow in Pakistan Through liberalization of trade, investment policies and offering financial and trade incentives the level of foreign capital inflows can be increased. Host country should promote investment in export sectors, and follow active liberalization policies to overcome trade deficit. The decision of foreign investment is influenced by the policies of the host country. To increase the level of FDI, the host country should increase the confidence of foreign investors and accept investor friendly policies. Over the past two decades, Pakistan FDI has increased dramatically because of the environment which is business friendly and also because of good investment policies. Pakistan FDI inflows can be explained in terms of direct and portfolio investment. Until 1991, FDI inflow was not significant due to its inconsistent economic policies. The inflow of foreign direct investment in Pakistan increased 65% during the period to , and reached to $ million in the period Table 1: FDI Inflows in Pakistan (in Million US$) Years Direct investment Total Investment

3 Source: Economic Survey, Government of Pakistan, Finance Division The inflow of foreign investment in Pakistan during was almost equal to total debt services of external debt. The FDI inflow increased from only $246 million in to a record high level of million in The share of FDI in total foreign investment was highest in , which has gradually declined in 1990s due to rising share of portfolio investment. The capital inflow has been increased dramatically since In 2005, foreign direct investment has reached to $1.5 billion. Foreign investment inflow has remained submissive in rising markets in fiscal year 2008 however the case of Pakistan was more sensitive because of the political instability. Pakistan has become an attractive destination for foreign investors and even during the crises managed to get $3.6 billion worth of foreign investment. Pakistan has also witnessed a decline in inflows of foreign direct investment in in line with all other developing countries. 2.3 Hypothesis H1: The association between foreign direct investment and growth of economy is positive. H2: The association between growth of economy and trade is positive. 3. RESEARCH METHODOLOGY AND EMPIRICAL DATA 3.1 Methodology There are two main approaches, which have been used in this research; one is Error Correction Method (ECM) and the other is Co integration analysis. The ECM explains the immediate short-term changes in dependent variable. The common approach is to reformulate the short run relationship by including lagged values of first differences in the relevant variables. As well as co-integration analysis is concerned, we first verify that either all the variables are expected to be co-integrated with growth of economy or not after confirming the long run relationship among the variables. 3.2 Variables Selection Following the article by Falki (2008), following variables are included in this research; GDP growth rate, GNP growth rate, FDI, trade of goods and services, employment, exchange rate, consumer price index, balance of payment, GDP deflator, GNP deflator and openness factor. 3.3 Data Collection The importance of the data in economic research is an integral part of the building blocks of the research. Various sources of data that provide information on foreign direct investment and economic variables have been used. The data used for this study was secondary. Since it relates economic indicators, it was easily gathered from stat bank of Pakistan, Pakistan economic survey and board of investment. The time period used in this study is from and all the data are on annual basis. 4. THE MODEL We have used simple least square method to study the relationship between growth of economy and FDI. The present study has therefore analyzed the role of trade and foreign direct investment on growth of Pakistan economy by estimating the simple least square model of these variables on the basis of available time series secondary data. The model can be specified as follows: RGDP 1 RFDI RER RFD IMP EXP GNP( def ) 2 Where, Dependent variable is= RGDP Explanatory variables are; RFDI= Ratio of FDI to GDP RER= Real exchange rate RFD= Ratio of financial sector development IMP= Imports EXP= Exports

4 5. DISCUSSION OF RESULTS Table 2: Regression results Variables Coefficient Std. Error t- Statistic Prob. C GDP FDI(-1) ER INF AR(1) R-squared Mean dependent var Adjusted R-squared S.D. dependent var S.E. of regression Akaike info criterion Sum squared resid 4.41E+09 Schwarz criterion Log likelihood F-statistic Durbin-Watson stat Prob (F-statistic) 3.25E-15 Inverted AR Roots 0.38 R-square has a maximum value of 1, and it occurs when the regression line fits the observations exactly. The overall fit of the estimated regression equation to the actual data will be "better" if R-square is closer to 1. For time series data R-square is often in excess of.9 however.5 might be considered as a reasonable good fit for cross sectional data Baye (2005). In this research paper, total 95% variation in the dependent variable as shown in table 2 is explained by the explanatory variables. However, the rest of the variation is due to factors other than determinants studied in this research article. The validity of the model is represented in the value F- statistics. F-statistic is a measure of total explained variation divided by total unexplained variation. The higher the F-statistic, the better the overall fit of the regression line through the actual data. The correlation between FDI and GDP is positive because as FDI is increasing the GDP is also increasing; both the values are greater than 2 which show that they have a strong positive association but if the value of GDP is less than 2 than there is insignificant association because if FDI is decreasing the GDP will also decreasing. The small significant level indicates that FDI and GDP are significantly positively correlated. As a whole the R- squared test and Watson test are also showing positive signs. In our case the correlation coefficient for FDI and Inflation is positive but not close to 2 the value of inflation is far away from value 2 so there is a relationship but insignificant. If the value of inflation is greater than 2 than there is significant association between FDI and inflation but if the value is less than 2 than there is insignificant association between them but they are positively correlated. In our case the correlation coefficient for FDI and exchange rate is negative so there is inverse association between FDI and exchange rate. If FDI increases the exchange rate decreases. The main reason is that if exchange rates decreases, inflation will increase due to increase in inflation the purchasing power of people will decrease, also decrease the demand of goods and services it will also decrease the supply of goods and services and the resulting investment will also decease. 5.1 Conclusion In this research article we have analyzed the role of foreign direct investment and trade on growth of Pakistan economy by estimating the simple least square method. The variables included in this study are; GDP growth rate, GNP growth rate, FDI, trade of goods and services, employment, exchange rate, consumer price index, balance of payment, GDP deflator, GNP deflator and openness factor. The time period used in this research article is from and all the data are on annual basis. In this research article the most important finding 24

5 is the positive influence of FDI on growth of economy of the country. This result is based on the estimation of coefficient in the model as well as from the test made in the preceding chapter. We have found that foreign direct investment and GDP are positively correlated. We have also found positive but not a very strong association between FDI and inflation. The association between FDI and the growth of economy is positive. REFERENCES Sailesh Tanna (2009), The impact of foreign direct investment on total factor productivity growth, Managerial Finance Vol. 35 No. 3, pp Zeshan A. Mohsin H. Ahmad and Usman Azhar (2001), The impact of FDI on growth of economy under foreign trade regimes, Economics Department, University of Karachi. Carkovic, M. and R. Levine (2005), Does FDI Accelerate Economic Growth? In Theodore Moran, Edward Graham and Magnus Blomstorn (eds.) Does Foreign Direct Investment Promote Development? Washington, DC: Institute of International Economics, pp William Lyakurwa (2009), Prospects for economic governance resilient pro-poor growth, Economic research consortium, VOL. 11, NO. 4, pp Khan, M. A. (2007), Foreign Direct Investment and Economic Growth: The Role of Domestic Financial Sector, PIDE working Papers, 18. Islamabad: Pakistan Institute of Development Economics. 25