DETERMINANTS OF FDI. Studying Determinants of FDI in Pakistan. Mushtaq Ur Rehman. Mohammad Ali Jinnah University, Islamabad.

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1 Determinants of FDI 1 DETERMINANTS OF FDI Studying Determinants of FDI in Pakistan Mushtaq Ur Rehman Mohammad Ali Jinnah University, Islamabad Arshad University of Lahore, Islamabad Shafiq Ur Rehman University of Malakand, Dir Muhammad Ilyas Mohammad Ali Jinnah University, Islamabad

2 Determinants of FDI 2 1. Introduction Last few decades marked the change in the flow of foreign direct investment from developed to developing countries. FDI is defined as the source of acquisition of managerial control by a business enterprise of a foreign country over a business activity in a host country. (Graham, 1982). The primary benefit of the FDI is the opportunities they provide to accelerate 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).Patterns of FDI to Pakistan have seen mixed trends over the last two decades. During 90's it received little amount as FDI because of its dependence on debt. (Hukro and Ghumro, 2007).Even after liberalization and incentives for the investor to attract FDI performance was lacklustre in this regard (Khan and Kim,1999).But that trend changed after 1999 and the FDI from 322million in rose to 3.52billion in Despite the impressive rise in FDI during the last decade Pakistan FDI inflow remain meagre when compared with other developing countries. In 2007 the capital inflow to developing countries represent a 7.5% of GDP but in the case of Pakistan that share was only 4%.The country is again facing a decrease in FDI stock merely reaching 3.72billion in 2009 from 5.4 billion in the previous twelve months (Bloomberg).This fall can be contributed to various factors ranging from unstable political environment to conflict between investors and the government. The recent wave of terrorism could be another significant factor towards this fall. The association of FDI with the social, economic, political and financial factors of the host country make them significant determinants of the FDI flow to the host country (Hanif, 2001).It must be kept in mind the list of the determinants of FDI is long and vague and tends

3 Determinants of FDI 3 to change over time (Encyclopaedia of developing countries).but the literature suggest that these factors are divided into three broad categories. These are 1) The cost related factors such as the availability of the labour or the low wage rate 2) Investment environment improving factors such as the foreign debt or the balance of payment situation 3) Market factor such as the size and the growth of the GDP of the host country (Dunning, 1973).Furthermore the political instability in the host country cannot be ignored as it erodes the investors' confidence and make the investment risky. Political factors reflect how stable the government of the host country is and how consistent its policies are over a period of time (Shah and Ahmed, 2003).In case of political instability it will erode investor's confidence no matter how open and liberalized your economy is. Pakistan is a main economic power in Asia but the political instability in the country poses a serious threat to not only its economic growth but also on the investment in the country. Over the years the country has faced military rules, assassinations of the leaders as well as the sublime law and order situation. According to the institute of peace and conflict studies Pakistan economic growth is associated with the political stability in the country at the national level. 2. Objective of the Study The purpose of the study is to empirically investigate the determinants that are responsible of the meagre FDI inflow to Pakistan. Through this study we want to test how important political stability and energy availability is in attracting FDI beside other determinants. It will contribute to the literature because we have not seen any study in Pakistan in which the effect of political instability on FDI was measured through an index. All the studies that we have gone through have used a dummy variable for political instability which resulted in an

4 Determinants of FDI 4 insignificant relationship. So for the first time in case of Pakistan this relationship will be studied through an index and for a time period that is Rest of the paper is organized as; Section II is Literature review followed by Section III Data and Methodology, Section IV results and discussion and Section V is the conclusion. 3. Literature Review Shamusddin (1994) used Dunning model for his study and classified the FDI in three groups. These are the 1) Market factors 2) Cost factors 3) Investment climate. The study ignored the political factors and focuses on the economic factors by using a single equation econometric model for 36 LDC for the year 1983.According to the study the market size which was measured by the per capita GDP is the most important determinant of FDI. Other significant factor in the study was the cost factor which was measured as the wage cost and the investment climate which was measured by per capita debt was affecting the flow of FDI. The FDI flow in Pakistan remained discouraging despite liberalization program initiated since early 90's (Khan, 1997).He attempts to point out the reasons behind the low FDIs in Pakistan. The determinants that he believes are behind this discouraging trend of FDI are political instability, law and order situation and economic weakness of the country. He divides the determinants into four broader categories. These are concessions, cost, convenience and capability. Except for the concessions everything else is lacking in Pakistan. Shah and Ahmed (2003) have classified the determinants of FDI into four broader categories namely market size factors, Cost factors, political and social factors. Time series data of Pakistan for the period of to is used. Hypothesis was tested by using co integration technique advanced by Johansen and Juselius (1990).The regression result of the study showed that the market size has a positive effect on the inward FDI flow. A highly

5 Determinants of FDI 5 significant co-efficient of cost of capital, tariffs and cost of capital points toward the important role that the government can play toward attracting the FDI flow in Pakistan. Hukro and Ghumro(2007) studied the factors that are responsible for the recent rise in FDI in Pakistan. The study takes in account the period of liberalization and studied all the variables of cost, investment macro-economic and risk and stability factors in the short as well as in the long run. VAR was used and the result suggested that the economic factors followed by the cost factors are the most important factors in determining the FDI. Recently, a few researchers have also studied the impact of liberalization policies on FDI in the host countries. These variables include openness of economy which is measured through import and exports of the host country, tariff, taxes and exchange rate. Gastanaga, Nugent, and Pashamova (1998) focus on policy reforms in developing countries as determinants of foreign direct investment inflows. They found that the economy openness and corporate tax rates were the significant determinant of the FDI inflow to Pakistan. Ozturk et al (2007) pointed towards the deterioration of BOP when the profits are repatriated back. He argues that there is no universal positive association between the FDI flows and the economic growth. In case of LDC positive relationship exists but in case of DC no growth benefit was found. The relationship was studied by using Engle Granger co integration and causality test for the period the result suggest that in case of Pakistan it is the GDP which is the main determinant of FDI. Collins et. al (1999) suggested that the capital inflows to a country are normally influenced by the domestic economic condition of the host country. The motives for FDI are different for different type of FDIs. The motive could be market seeking and efficiency seeking (Hanif, 2001).The study is about the locational determinants of the FDI in Pakistan. The findings of

6 Determinants of FDI 6 the regression analysis suggested that the economic factors are more significant determinants of the FDI than the political factors. The importance of exchange rate in the determination of FDI flows to a country is a well studied topic in literature. (Froot and Stein, 1991 and Klein and Rosenger,1994) emphasized that when currency of a country devalue it will result in the reduction of the production cost, when measured in the foreign currency which will result in increase inflow of FDI as it will cause the wealth of foreign investors to grow. Feng YI (2001) studied the effect of democracy and various characteristics of political institutions on the flow of investment in a country. The determinants that he tested through regression analysis are political freedom, political instability and policy uncertainty. The findings of the study show that political freedom help in promoting investment while the political instability which was measured by the variance in the political freedom negatively effect the investment flow into a country. 4. Empirical Specification of the Model The variables used in the study are among those which are identified by Khan(1997).the variables that we will use in our research are FDI growth rate, GDP Growth rate, Energy imports, Political instability and Real exchange rate. The following model is proposed for the regression analysis. FDI% = B0 + B1(GDP%) + B2(REER) + B3(POLITY) + B4(ENERGY) + error

7 Determinants of FDI 7 5. Specification of Variables and Data Description 5.1 Endogenous Variable The foreign direct investment to Pakistan is taken as dependent variable. The FDI include the purchases of fixed capital asset, imports of capital equipment and foreign exchange for other businesses transactions (Shah and Ahmed, 2003). 5.2 Exogenous Variables Due to unavailability, questionable quality of data and degree of freedom issue only those variables are included that were available from the published sources. In order to test the economic strength of our country GDP growth is taken as an explanatory variable, as the investors are unwilling to invest in an economy where the economic fundamentals are weak. Real effective exchange rate will measure the effect of our exchange rate on the inflow of FDI and will test whether the devaluation of our Rs has a positive impact on FDI or not? Polity variable will measure the political instability in our country. The variable is taken from polity IV data set(marshall and Jaggers, 2000).This widely used data set provides a picture of political situation of a country on an annual basis from The variable is obtained by the difference between the democracy and the autocracy index. The democratic characteristics of a country are given by 10 points and the autocratic characteristics are given by -10. The availability and the reliability of the infrastructure facilities like power and telecommunication provide conducive environment for FDI (Khan, 1997).To measure this determinant energy imports are used to measure the availability of energy in our country and its effect on the flow of FDIs. So the variables used in the model are

8 Determinants of FDI 8 FDI% = FDI growth rate GDP % = GDP growth rate for REER = Real effective exchange rate i-e 1$=Rs POLITY = Political index taken from Polity IV ENERGY = energy imports as a percentage of total merchandise exports from Time series data will be used for a period of In our further study we added another variable in our model i.e. openness of economy and tried to study its relationship with the FDI. This variable is computed from the imports plus the exports of the country divided by the GDP of that year. This variable will measure the government policies towards the FDI inflow. To test the variable two regressions separately will be done one for pre liberalization period and the other for the post liberalization period to check the exact impact of the liberalization efforts. OPEN = Openness of an economy measured as imports + exports/gdp current 6. Expected Results The expected signs of the parameters are: B 1 >0, B 2 >0, B 3 <0, B 4 >0,

9 Determinants of FDI 9 7. Regression Results Table I Model Summary Adjusted R Std. Error of the Model R R Square Square Estimate a a. Predictors: (Constant), Poli, Exchangerate, GDP, Energyimport Table II ANOVA b Sum of Model Squares df Mean Square F Sig. 1 Regression a Residual Total a. Predictors: (Constant), Poli, Exchangerate, GDP, Energyimport b. Dependent Variable: ChangeinFDI

10 Determinants of FDI 10 Table III Coefficients a Unstandardized Coefficients Standardized Coefficients Model B Std. Error Beta t Sig. 1 (Constant) GDP Energyimport Exchangerate Poli a. Dependent Variable: ChangeinFDI The estimated results of regression are given in the tables I, II and III.The dependent variable is the growth rate of foreign direct investment. The time period of the analysis is The results of regression show a positive relation between the FDI growth and the GDP growth rate which is contradicting with the results of (Shamusddin, 1994). His findings were that GDP growth rate was found insignificant with FDI. Real exchange rate was found positively related but not significant against the FDIs, Which confirm that the devaluation of currency have a positive impact on the flow of FDI. The positive relationship is because when the currency of a country depreciates it reduces the country s wages and the production cost as compared to the foreign countries so it result in enhanced locational advantage for receiving productive capacity investments (Goldberg.S.Linda, 2007).

11 Determinants of FDI 11 The regression results show a significant negative result for polity variable. The beta was found to be This result conflict with other researches the reason could be the expansion of the time frame as well as the use of index instead of dummy variable for the political instability. Situmeang (1978) found no statistically significant impact of political instability on the inflow of FDI. Shamusddin (1994) concluded that political factors have little importance towards the determination of FDI flow. Our results contradict with this research and our result point out towards the importance of political factors in attracting FDI to our country. This factor is essential to attract FDI because it creates confidence in foreign investors (Khan, 1997). The energy variable was found having a negative relationship with the growth of foreign direct investment over the years. This negative relationship indicates that as the availability of energy decreases over the years which result in increase in its imports. This increase in imports is causing a negative impact on the FDI growth over the years. But the result was not found significant. It relates with the result of Shamussddin (1994) in which the energy imports were negatively affecting the FDI but the result was not found significant statistically. In our further study we tried to find the relationship of economy openness with FDI. The sample period was divided into two phases a phase which was before liberalization and the phase after the liberalization. It was found that before the liberalization the variable was found significant and negative with a beta value of Thus it was pointing towards the negative impact that our economy was having on the flow of FDI when it was closed. The success of a country in attracting FDI crucially depend upon the environment it creates for the investors (Khan, 1997).The second phase which is pro liberalization the FDI was found

12 Determinants of FDI 12 positive but not significant with the openness of economy which explains the failure of Pakistan to attract sufficient FDIs even after opening its economy. 8. Conclusion The study has examined few of the determinants that were identified by Khan (1997).The main purpose was to identify the factors that were not letting the growth of our FDIs when compared with other developing countries even after liberalization. The most important and significant factor in this regard was found to be the political instability that was eroding the investors confidence in our country. It was found that the stability rather than the democracy was found more important in the choice of the investment decisions. It can be reconfirmed by the figures of FDI during the democratic government it is evident that the country is again facing the trauma of falling levels of FDI, though a democratic government is present in the country. So the conclusion is that the investor is more concerned with the stability rather than the nature of the government. The empirical results are supportive of all hypothesis although they are not significant, this points towards the fact that there are other factors that are more significantly affecting the FDI flow. Other than the political instability variable result all the results are consistent with the results of the previous researches. The study clearly emphasizes the importance of these variables in attracting FDI in the long run. The study also points toward the positive impact of the reforms adopted by the government. As it is a working paper so I would like to measure other variables as well that were mentioned in (Khan, 1997) like cost of doing business, terrorism and labour efficiency on our FDI flow.

13 Determinants of FDI 13 Sources of Data United Nation Statistical Year Book World Development Report, Various Issues. New York: Oxford University Press International Financial Statistics, Various Issues, Washington DC: IMF State Bank of Pakistan World Bank Data bank Pakistan institute of development economics Economic survey of Pakistan International monetary fund

14 Determinants of FDI 14 References: Gastanaga, V. M., J. B. Nugent, and B. Pashamova (1998) Host Country Reforms and FDI Inflows: How Much Difference Do They Make? World Development 26:7, Froot,k.A.,and J.C.Stein (1991).'Exchange rate and foreign direct investment: an imperfect capital market approach' Quarterly Journal of Economics,106(4): Klein,M.W.and R.Rosengren (1994),;The real exchange rate and the foreign direct investment in the United States: Relative wealth VS Relative wage effects' Journal of international economics 36: Feng YI (2001), ;Political freedom,political instability and political uncertainty:a study of political institutions and private investment in developing countries', international studies quarterly 45, Goldberg S. Linda (2007) 'Exchange rate and foreign direct investment' Princeton encyclopedia of the world economy. Abdul F. M. Sahmsuddin (1994) 'Economic Determinants of Foreign Direct Investment in Less Developed Countries' The Pakistan Development Review 33:1 Khan H. Ashfaque (1997) 'Foreign Direct Investment in Pakistan: Policies and Trends' The Pakistan Development Review 36:4 Collins M. Susan and Bosworth P. Barry (1999) 'capital Flows to Developing Economies : Implications for Savings and Investment' Brookings Paper on Economics 1:1999 Mughal, Mazhar (2008) 'Boon or Bane- Role of FDI in the Economic Growth of Pakistan' MPRA Paper No 16468

15 Determinants of FDI 15 Brune Nancy et.al (2001) 'The Political Economy of Political Account Liberalization' American Political science Association Ozturk, Ilhan and kalyoncu (2007) 'Foreign Direct Investment and Growth: An Empirical Investigation Based on Cross Country Comparison' Economia Internazionale 60:1 Akhtar H. Muhammad (2001) 'The determinants of Foreign Direct Investment in Pakistan: An Econometric Analysis' The Lahore Journal of Economics 5:1 Shah and Ahmed (2003) 'The Determinants of Foreign Direct Investment in Pakistan: an Empirical Investigation' The Pakistan Development Review 42:4 Dunning John H. (1973) 'The determinants of Economic Prediction' Oxford economic Papers 25:3 Harms Phillip 'International Investment, Political risk and growth' Development Economics pp Keefer Phillip, Loayza Norman 'Terrorism, Economic Development and Political Openness' Cambridge University Press pp Alberto Abadie and Javier Gardeazabal (2008) 'Terrorism and the World Economy' European Economic Review 52:1 Aqeel Anjum and Nishat Muhammad 'The Determinants of Foreign Direct investment in Pakistan' The Pakistan Development Review 43:4

16 Determinants of FDI 16 Appendix Table 1 GDP Energy REER Years FDI FDI G% Growth imports Polity (1US=Rs)

17 Determinants of FDI Valid Missing Mean Median