EFFECTS OF ECONOMIC FACTORS ON FOREIGN DIRECT INVESTMENT INFLOW: EVIDENCE FROM PAKISTAN ( )

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1 Sarhad J. Agric. Vol.25, No.1, 2009 EFFECTS OF ECONOMIC FACTORS ON FOREIGN DIRECT INVESTMENT INFLOW: EVIDENCE FROM PAKISTAN ( ) MUHAMMAD AZAM KHAN* and NAEEM-UR-REHMAN KHATTAK** * Department of Economics, University of Peshawar, Pakistan ** Faculty of Social Sciences, University of Peshawar, Pakistan ABSTRACT The objective of this research paper is to examine the effects of various economic factors on Foreign Direct Investment (FDI) inflow into Pakistan. For econometric analysis secondary data ranging from 1971 to 2005 have been used. Log linear regression model and the method of Least Square were used as an analytical tool for the empirical estimation. In addition, for time series data analysis Augmented Dickey Fuller test and Error Correction Model have also been used. This study found the market size (i.e., measured by gross domestic product), domestic investment, trade openness, and return on investment statistically significant with positive sign. Moreover, external debt and taxes have been found statistically significant with negative signs. To enhance desirable amount of FDI into Pakistan, the least square estimates suggests that the government make sure constant economic environment, provide a well-established infrastructure, encourage domestic investment, minimizing external debt burden, provide fiscal and financial incentives, and consistency in the government policy. Key Words: Economic Factors of FDI, Time series data, Pakistan Citation: Azam, K. M. and Naeem-ur-Rehman Khattak Effect of economic factors on foreign direct investment inflow: Evidence from Pakistan ( ). Sarhad J. Agric. 25(1): INTRODUCTION The word investment refers to the accumulation of some kind of assets in hope of getting a future return from it. In the broadest sense, investment provides the mechanism needed to finance the growth and development of an economy. Investment can be categorized into foreign direct investment and portfolio investment. Foreign direct investment (FDI) is real investment and can be defined, as medium to long-term investment aimed at obtaining direct managerial controlling power over the use of the capital. A Direct Foreign Investment is the amount invested by resident of a country in a foreign enterprise over which they have effective control (Ragazzi, 1973). IMF (2003) defined direct investment is a long-term commitment to engage in economic activities in the host country and has been proven to be less volatile compared to other forms of international capital flows. Also foreign investors are not reacting as drastically to changes in the investment climate as others do. They usually aim at long-term profit and are unlikely to withdraw investment in short period due to high transaction costs. Generally, FDI made by large multinational corporations (MNCs) through a merger and acquisition, or through the construction of a new facility. Numerous theoretical and empirical studies have been conducted regarding the forces that determine FDI. Though literature in this regard is not only extensive but also confusing. Most of the studies utilise multiple numbers of theories or hypotheses in order to investigate the empirical linkage between FDI and variety of economic, social and political variables. However, Shamsuddin (1994), studied the economic determinants of FDI using 1983 cross-section data on 36 Less Developed Countries (LDCs). The study observed that the most important factors in attracting FDI are the per capita GDP in the host country, wage cost, investment climate represented by as per capita debt, per capita inflow of public aid, volatility of prices, and the availability of energy in the recipient country. Tsai (1994) found real gross domestic product (GDP) per capita to have a positive effect on FDI, while Edwards (1990) and Jaspersen, et al., (2000) found it have a negative effect. Khan and Yun (1999), evaluated theoretically the determinants of FDI and according to this study in Pakistan the requirements for foreign investment are such as infrastructure, local business environment; law and order, quality of labour force, economic strength, government economic policies, government bureaucracy, quality of life, welcoming attitude, and political stability. Akhtar (2000) analyzed the location wise determinants of FDI in Pakistan for the period and found

2 Muhammad Azam Khan and Naeem-ur-Rehman Khattak. Effect of economic factors on foreign 136 market size, relative interest rates and exchange rates are the major determinants of FDI in Pakistan and market growth and political instability were found consistently insignificant in the analysis. Asiedu (2005) suggested that the macroeconomic instability, investment restrictions, corruption and political instability have a negative impact on foreign direct investment. FDI inflow in the year has reached US$ 1524 million as the highest if compared with FDI during in Pakistan. Hence total FDI inflows into Pakistan from to stands at US$ 9089 million, which come to US$ million per year. The data shows that a few sectors have comparatively attracted more foreign direct investment during last five years. The total inflows of FDI into textile sector in the last five years were US$ million, and this sector attracted US$ 39.3 million during , as the amount was US$ 35.4 million during Though less increase occurred in the inflow of FDI into the oil exploration sector but the inflow has highly increased in the power sector as it was in US$ 14.3 million in and in it is US$ 73.3 million but during last five years this sectors has enhanced considerable amount of FDI inflow of amount US$ million. Similarly communication (IT and Telecom) is on the top on the basis of more attracted FDI in this sector and such as the inflow was US$ during but in it is US$ million. The inflows also increased into the financial business sector to US$ million in , as it was US$ million during and the total FDI inflow is US$ million in the last five years as well. About 70 percent of FDI has come into oil and gas, telecom sector; chemicals, textile, power sector and banking and finance. Almost 60 percent of FDI has come from USA, UK, Switzerland, Japan, UAE and Netherlands as shown in the Table I. Table I. Shares of FDI inflow from various countries to pakistan (percentage) Years U.S.A U.K. U.A.E Germany France Hong Kong Italy Japan S.Arabia Canada Netherlands Others Sources: State Bank of Pakistan ( 1995, 1980, 1996, 2001, ) Pakistan Economic Survey (1975,1980,1990,2000, ) The aim of this present paper is to evaluate empirically the effect of different demand side determinants on the inflow of FDI into Pakistan during the period from Though there are various qualitative and quantitative factors determining the inflow of FDI but this study considers only economic factors such as market size of the host country, domestic investment, openness, inflation rate, return on investment, government consumption, taxes and external debt.

3 Sarhad J. Agric. Vol.25, No.1, MATERIALS AND METHODS Analytical Framework In the light of previously conducted studies based on various FDI theories, this research paper proposing the following linear regression model for the determination of FDI, which has also been used by Dunning (1980), Ioannatos, (2003), and Aseidu, (2005). The model of FDI as following; lnfdi= α 0 1 ln(mktz) +α 2 ln(debt) 3 ln(inf) 4 ln(di) 5 ln(ri) 6 ln(tpt)+ α 7 ln(tax) 8 ln(x + M/GDP) 9 ln(gc)+ µ (1) The above Equation 1 states that FDI is a positive function of the market size measured by GDP, domestic investment, return on investment, trade openness, and infrastructure facilities. Similarly the effect of external debt burden, inflation, government consumption, and taxes will negative on FDI respectively. Where, FDI= Foreign Direct Investment, MKTZ = Market size proxy used Gross Domestic Product, DI = Domestic Investment, DEBT= External Debt, TO = Trade Openness (X+ M/GDP), GC=Government Consumption, TPT=Expenditure on Electricity, Gas, Transport and Communication, Tax = Indirect Taxes, INF= Inflation, RI= Return on investment measured by 1/GDP per capita, and µ= Error term The explanatory variables and error term (µ) will follow the least square assumptions. For the econometric analysis of selected economic factors determining FDI inflows in Pakistan secondary data ranging from have been used taken from various sources such as Federal Bureau of Statistics volumes 1980, 1990, 2000, 2006 and Pakistan Economic Survey 1975, 1985, 1999, The Ordinary Least Square (OLS) method was used as an analytical technique for empirical estimation. In addition, Augmented Dickey Fuller (ADF) test and Error Correction Model (ECM) have been used. Due to non-linearity of the data log linear regression model was used. Statistical software (E. View) was used for deriving the results. RESULTS AND DISCUSSION The empirical results are reported in the Table II. The details of Augmented Dickey Fuller test are given in the Table III, and the results of Cointegration and Estimation of an Error Correction Model (ECM) are given in the Table IV. The estimated regression equation of FDI is; FDI = MKTZ DEBT TPT IDT DI TO RI INF GC (2) Table II. OLS Estimates of economic determinants of FDI Dependent Variable: FDI Method: Least Squares Sample: Observations: 35 Explanatory Variables Coefficient Std. Error t-statistic Prob. Constant MKTZ * DEBT * DI * TPT * IDT ** INF TO * RI ** GC R-squared Mean dependent var Adjusted R-squared S.D. dependent var S.E. of regression Akaike info criterion Sum squared resid Schwarz criterion Log likelihood F-statistic Durbin-Watson statistic Prob(F-statistic) Note: The asterisks *, **, *** shows that estimates are significant at 1%, 5%, and 10 % level of significance respectively.

4 Muhammad Azam Khan and Naeem-ur-Rehman Khattak. Effect of economic factors on foreign 138 Table II shows that market size (MKTZ) is positively significant at one percent level of significance. The coefficient size is 5.00, it indicates that one unit change in the GDP will bring 5.00 unit change in the FDI inflow. The effect of external debt has been found highly significant with at one percent level of significance. The coefficient size is -2.92, which indicates one unit change in the external debt will bring unit changes in the total FDI inflow. The effect of infrastructure has been found positively significant at one percent level of significance. The coefficient size of this determinant found is 0.91, which indicates that one unit changes in this variable will bring 0.91 unit changes in the total FDI inflow. Trade openness found highly significant with positive sign at one percent level of significance. The coefficient size 3.48 indicates that one unit change in the trade openness will bring 3.48 unit changes in the FDI inflow. Domestic investment has been found found highly significant with positive sign at one percent level of significance. The coefficient size 4.82 indicates that one unit change in the domestic investment will bring 4.82 unit increases in the total inflow of FDI. The effect of indirect tax on FDI has found significant with negative sign at five percent level of significance. The coefficient size is that demonstrate that one unit change will bring unit changes in the total FDI inflow. Similarly return on investment has been found statistically significant with positive sign at five percent level of significance. However, inflation rate have found insignificant while government consumption has been found insignificant with expected negative sign. But it does not mean that these variables have no effect on FDI but they are equally important in the determination of FDI inflow. Regression Results and Cointegration This empirical investigation on the determinants of FDI in Pakistan uses the time series data over the period ranging from 1971 to Augmented Dickey Fuller (ADF) test for units root has used to find out that variables are concluded to be integrated of the same order. Time series data has the property of non-stationary in levels. Unit Root Tests are performed for the stationarity in the levels and in first difference of the variables. Results of ADF test for FDI model are presented in the Table III in detail. Table III. Results of augmented dickey fuller test (FDI Model) Variables Level/Difference Without Trend (Intercept) With Trend (Intercept & trend) FDI Level First Difference DEBT Level First Difference TPT Level First Difference GC Level First Difference DI Level First Difference MKTZ Level First Difference IDT Level First Difference INF Level First Difference TO Level First Difference RI Level Conclusion 5% Critical Value (without trend) 5% Critical Value (with trend) First Difference Also 95% critical value for ADF statistics for all variables i.e., (without trend) and 3.56 (with trend). ADF Test demonstrates that almost all variables have sationarity in the levels of 95% critical values with trend and without trend. From the Unit Root Tests it has been concluded that all of the variables are integrated of order I.

5 Sarhad J. Agric. Vol.25, No.1, Estimation of an Error Correction Model (ECM) An Error Correction Model can be established to determine the short run dynamics of the regression model. The following ECM is found to be the most appropriate and fits the data best. FDI = α 0 1 MKTZ 2 DEBT 3 INF 4 DI 5 Rl + X + M (3) α 6 TPT 7 Tax 8 9 GC + β10 R( 1) GDP Where R (-1) is an error correcting term. Table IV shows the results obtained by the Error Correction Model (ECM). Table IV. Estimates of economic determinants of FDI ( ) Dependent Variable: FDI Method: Ordinary Least Squares (OLS) Explanatory Variables Coefficients (t-statistics) CONSTANT 0.17 (0.44) MKTZ 5.10 (3.21)* DEBT (-5.54)* INF 1.28 (0.47) GC (-0.63) TPT 0.99 (2.65)** IDT (-3.14)* DI 6.41 (5.50)* TO 3.72 (3.63)* RI 5.68 (2.36)** R (-1) 1.04 (4.81)* R-squared (R 2 ) 0.92 Adjusted R-squared 0.88 S.E. of regression 0.49 Akaike info criterion 1.69 Schwarz criterion 2.17 F-statistic Durbin Watson statistics 1.86 Note: (i). The asterisks *, **, *** shows that estimates are significant at 1%, 5%, and 10 % level of significance respectively. (ii). The figures in parenthesis are t-statistics. Results showed that infrastructure (TPT), trade openness (TO) and return on investment (RI) almost the same level of significance and with the same signs as obtained in the Table II. However level of significance declined in case of taxes (IDT) with the same sign as obtained in the Table II, while the remaining variables show improvement. R (Residual) also found significant with positive sign. CONCLUSION The present research paper was conducted with the aim to find out those factors, which are important in determining the location decision of multinational corporations in Pakistan. Secondary data over the period from 1971 to 2005 has been used for econometric analysis and the method of least square was used for empirical estimation. Augmented Dickey Fuller test and Error Correction Model have also been used t check stationarity in the level of data. Although, through estimation some variables have been found highly statistically significant, some lower significant and some insignificant for the attraction of FDI into Pakistan. The lower and insignificant does not mean that these variables have little or no effect on the determination of FDI. This study has been found the effect of market size, domestic investment, trade openness, infrastructure and return on investment on FDI inflow positively statistically significant. Also found the effect of external debt, and indirect tax on FDI inflow negatively statistically significant. While, inflation rate have found insignificant and government consumption has been found insignificant with expected negative sign. But it does not mean that these variables have no effect on FDI but they are equally important in the determination of FDI inflow.

6 Muhammad Azam Khan and Naeem-ur-Rehman Khattak. Effect of economic factors on foreign 140 However, to attract more FDI into Pakistan, the government should ensure stable economic environment, promote a well-established infrastructure including good quality telecommunication and information technology etc, maintaining inflation rate, encourage domestic investment, minimizing external debt, remove barriers and other restrictions on imports and exports to favour trade openness, fiscal and financial incentives, and consistency in the government policy. REFERENCES Akhtar, M. H The determinants of foreign direct investment in Pakistan: An econometric analysis. The Lahore J. Econ. 5 (1):1-22 Asiedu, E Foreign direct investment in Africa: The role of natural resources, market size, government policy, institutions and political instability. Res. paper No. 2005/24, UNU-WIDER, World Inst. for Dev. Econ. Res. asiedu@ku.edu Dunning, J.H Multinational enterprises and the global economy. Reading, Addison-Wesley Publ. Co. New York. Dunning, J. H Towards an eclectic of international production: Some empirical tests. J. Int. Business Studies. 30(1): Dunning, J.H Trade, location of economic activity and MNE: A search for an eclectic approach. International allocation of economic activity: Proc. Nobel Symp. Stockholm London: Macmillan, pp Engle, R. and C. Granger Long-run economic relationships: Oxford, Oxford Univ. Press. Federal Bureau of Statistics. (1980, 1990, 2000, 2006). Statistics Division, Ministry of Economic Affairs and Statistics, Govt. of Pakistan, 5-SLIC Building, F-6/4, Blue Area, Islamabad, Pakistan. Foreign Liabilities & Assets and Foreign Investment in Pakistan (various issues), State Bank of Pakistan. Greene, W. H Econometric analysis. 5 th Ed. New York, Published by Pearson Edu. (Singapore) International Monetary Fund Effects of financial globalization on developing countries: Some empirical evidence, Int. Monetary Fund, Washington, D.C. Ioannatos, P. E The demand determinants of foreign direct investment: Evidence from nonnested hypothesis. The asymetrical economy: Growth, investment and public policy. Studies in economic transformation and public policy. pp Jaspersen, F. and A. Knox The effects of risk on private investment: Africa compared with other developing areas. P. Collier & C. Pattillo (Eds.), Investment and Risk in Africa, New York: Stmartin s Press. pp Khan, A. H. and Yun-Hwan Kim Foreign direct investment in Pakistan: Policy issues and operational implications. EDRC Report Series No.066 Nnadozie, E What determines US direct investment in African countries?" Truman State Univ. Kirksville, MO, Pakistan Economic Survey. (1975,1980,1990,2000, ). Govt. of Pakistan, Econ. Advisor s Wing, Finance Div. Islamabad, Pakistan. Ragazzi, G Theories of the determinants of direct foreign investment. Int. Monetary Fund Staff Papers. 20(2): Schneider, F. and Bruno Economic and political foreign direct investment. World Dev. 13(2): Shamsuddin, A. F.M Economic determinants of foreign direct investment in less developing countries. The Pakistan Dev. Rev. 33 (1): Tsai, P Determinants of foreign investment and its impact on economic growth. J. Econ. Dev.19: