A Nexus between Foreign Direct Investment & Pakistan s Economy (Co-Integration & Error Correction Approach)

Transcription

1 International Research Journal of Finance and Economics ISSN Issue 52 (2010) EuroJournals Publishing, Inc A Nexus between Foreign Direct Investment & Pakistan s Economy (Co-Integration & Error Correction Approach) Muhammad Zahid Awan Corresponding & Submitting Author Assistant Professor Department of Business Administration Gomal University, D. I. Khan, Pakistan zahidawan1967@gmail.com Tel: Bakhtiar Khan Chairman, Department of Business Administration Gomal University, D. I. Khan, Pakistan bkhan_ktk@yahoo.com Tel: Khair uz Zaman Chairman/Dean of sciences, Department of Economics Gomal University, D. I. Khan, Pakistan kzaman2001@yahoo.com Tel: Abstract Foreign Direct Investment (FDI) in Pakistan is considered as a vital source of external capital flows to meet saving-investment gap and export-import gap as well. This study examines the overall impact of FDI inflows into the economy of Pakistan, by using annual time series data for the period of To check the stationarity of the data Augmented Dickey Fuller (ADF) test has been applied. Co-integration and Error Correction Model (ECM) is used for data estimation. Results indicate that Gross Fixed Capital Formation (GFCF), Degree of Trade Openness (TO) and Inflation rate (INF) are statistically significant with positive signs, whereas Current Account Balance (CAB) is also found statically significant with negative sign. Our study also reveals that Debt servicing and Gross Domestic Product found statistically insignificant and it seems that these variables have no significant impact on FDI inflows into Pakistan. Keywords: FDI, Trade Openness, GFCF, Inflation Rate, Current Account Balance. JEL Classification Codes: B22, C01, C87, E31, F1, F21. I. Introduction Foreign capital comes in the form of FDI, Portfolio investment, Private Loans and other foreign assistance. In recent decades, developed and in particular, developing countries have given great importance to FDI as a largest external source of capital flow because FDI is considered as vital

2 International Research Journal of Finance and Economics - Issue 52 (2010) 18 growth-enhancing tool (Zeeshan et al. 2004). Likewise, FDI has also remained an imperative source of external capital to Pakistan in order to enhance economic development and growth. Although, impact of FDI on development of the economy of Pakistan could not be measured accurately. However, several studies have pointed out that FDI plays considerable role to elevate economic development and growth in the course of transferring modern and sophisticated technology, training and skill development, foreign trade and capital formation etc. In South Asia, Pakistan has exceptionally attractive environments for foreign investment, especially in agriculture, IT and telecommunication, power and Services sectors. In most cases, the industry sector has more attraction for foreign investors because in this sector, 100% equity investment is permissible. United States of America, United Kingdom and Middle-East countries are the major investors in Pakistan and each is contributing almost 25% of FDI (Kumar, 2003). As far as China is concerned, it has great presence in the Pakistan through infrastructural development and provides costeffective equipments as well. Pakistan has liberal investment policy and opened up its doors for foreign investors in almost all the sectors of the economy. Government of Pakistan (GOP) is offering tax exemptions and many other incentives to foreign investors enabling them 100% ownership for investment in many sectors. In new investment policy, GOP has provided equal investment opportunities for home and host countries. GOP has also entered an agreement with 39 countries, particularly with developed countries to evade Double Taxation on income generated through various sources in Pakistan. Pakistan has received $ Million of FDI during FY which is 5.27% higher than FY and % higher than FY In FY FDI inflow into Pakistan has dropped by 31.24% as compared to previous year due to adverse law and order situation. During the first eight months of FY (July-Fen 2010), $ million of FDI has been surged into Pakistan, despite of law and order situation. This reflects that still Pakistan has great potential for foreign investment in South Asia. Therefore FDI is considered as a effective weapon for sustainable economic development for Pakistan. (See Table 1 and figure-1 for further detail) Table 1: FDI Inflows into Pakistan ($ Million) Year Greenfield Investment Privatization Proceeds Total FDI 2001 $357 $128 $ jul-feb Source: Board of Investment (BOI), Government of Pakistan (2010) Figure 1: FOREIGN INVESTMENT INFLOWS IN PAKISTAN ($MILLION) FO REIG N CAPITAL INFLO W S ($ M IL L IO N ) $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $ jul-feb 2009 greenfield investment privat total fdi 2 per. Mov. Avg. (total fdi) YEAR

3 19 International Research Journal of Finance and Economics - Issue 52 (2010) Main purpose of this research paper is to conduct an econometric analysis of FDI inflows in Pakistan and to examine the overall impact of FDI on the economy of Pakistan as well. This study is organized as follows: Section II reviews the literature, section III describes research methodology and data sources, section IV discusses regression results and analysis, and section V deals with conclusion. II. Literature Review Various studies have been conducted by distinguished researchers to point out the importance of FDI such as Kindleberger, 1969; Zaman et al, 2006; and Yousaf et al, 2008, Kindleberger (1969) argued that foreign firms invest abroad with the intentions to take the explicit benefits including transfer of advance technology, sound financial position, efficient management, technical and marketing expertise. On the other hand Caves (1971) concluded that product differentiation is the key reason of investing abroad via FDI. Zaman et al (2006), study examined The Economic Determinants of FDI in Pakistan for the period running from They used FDI as a dependent variable and unit labor cost (ULBC), inflation (INF), market size (MS), service sector (SS) and trade balance (TB) as explanatory variables in their model. They found that TB, ULBC, INF, and MS have significant impact on FDI, on the other hand service sector did not reveal significant role in promoting FDI in Pakistan. Similarly, Shah and Ahmed (2004) carried out their research on The Determinants of FDI in Pakistan. They used time series data for the period running from Finally, they concluded that long term association have been existed between FDI flows and factors including political stability, market size, capital cost, transport and communication expenditures, in Pakistan. Agiomigianaks et al (2006) study investigated the determinants of FDI in 20 OECD countries ( ). This study found that educated and skilled labor force play active role in attracting FDI. Further, this study reveals that in OECD countries, GDP and trade openness are considerably associated with FDI in OECD countries. Several studies such as Shah and Ahmad (2003), Aqeel and Nishat (2004) have used Error- Correction techniques to examine the correlation between FDI and other variables. Yousaf et al (2008) conducted research on Economic Evaluation of FDI in Pakistan. They used time series data for the period of The variables which they used in their study are GDP deflator, real GDP, volume of exports and imports, unit value of exports and unit value of imports, FDI as a %age of GDP.D1 is used as dummy variable, 1 for military rule and 0 for democracy. This study used two models based on the model proposed by Khan and Kim (1999). Real Demand for Import Model Ln M = b0 + b1 Ln y + b2 Ln (Pm / Pg) + b3 Ln FDI ( 1) +b4 Ln rem + D1 + emt (1) Real Export Model Ln X = b0 + b1 Ln y + b2 Ln (Px / Pg) + b3 Ln FDI +b4 Ln rem + D1 + ext (2) Results indicate that in the case of import model, short and long run positive association exists between real demand of import and FDI. As far as export model is concerned, they found that in short run negative relationship exists between FDI and real exports but positive in long run. Tsai (1994) carried out study on Determinants of FDI and its impact on economic growth and pointed out that low labor cost induces the foreign investors and high labor cost discourages them. Majeed & Eatazaz (2009) conducted study to investigate the characteristics of those host countries which are essentials in taking decision regarding the location of MNEs in developing countries. They used panel data of 72 developing countries for the period of and used General Method of Moment (GMM) technique in this study. Results reveal that Gross Domestic Product, economic growth, per capita income, trade openness, remittances, and communication

4 International Research Journal of Finance and Economics - Issue 52 (2010) 20 facilities all are significant and have positive impact on FDI. Moreover, they explore that inflation and balance of payment have negative influence on FDI, and military expenditure is significant with negative sign. Similarly, results also show that effect of domestic investment on FDI is significant with negative sign. Finally, this study also points out that affect of real exchange rate is also significant with negative sign. Loree and Guisinger (1995) studied on the The determinants of FDI by USA for the period and found that all the variables in developing countries are highly significant relating to host countries policy subject to availability of well established infrastructure in these countries. Rubio & Simon (1994) carried out study on An Econometric Analysis of Foreign Direct Investment in Spain They used annual data for the period of to examine the growth of FDI in Spanish economy and used co-integration techniques in this study. They found that long run association exists between FDI, real GDP, inflation rate, trade barriers and foreign capital stock. Further, they found that main determinants of FDI in manufacturing and Non-manufacturing sectors are almost same rather in total FDI. Moosa and Cardack (2006) examined The Determinants of FDI. They used cross-sectional data in this study and applied extreme bound analysis of 136 countries for the period of The variables included in this study are real GDP, growth rate of GDP (CGD), export as a %age of GDP (EXP), telephone lines (TEL), commercial energy use (ENG), domestic gross fixed capital formation (DIG), students in tertiary education as a %age of total population (TER) and country risk (CRK). They concluded that countries having large economies, high degree of trade openness, and low country risk can attract ore FDI. Further, they argued that real GDP, growth rate, energy consumption, domestic gross fixed capital formation etc are insignificant to robust FDI. Sandy (2003) studied on FDI to developing countries in the globalised world. He argued that developing countries can attract large share of FDI if they pay more attention to improve investment environment for the foreign investors as well as to facilitate them. The measures which lead to increase the interest of MNEs to make investment are investment-friendly domestic policies and regulatory framework such as open trade regime, persistent privatization program, large market size (in terms of GDP), favorable and attractive economic climate (in terms of economic growth. Another important study carried out by Getinet and Assefa (2005) on Determinants of FDI in Ethiopia by using annual time series data for the period of Results indicate that that market size (RGDPG) and trade openness (Exp) are significant with positive signs to FDI inflows in Ethiopia. Inflation (Inf) is also significant with negative sign. Whereas, infrastructure (GFCF) is insignificant to FDI inflows with negative sign. III. Research Methodology and Sources of Data This work is based upon the model of Zaman et al (2006) who studied the economic determinants of FDI in Pakistan. Here it is used in modified form. For this study time series data have been taken for the period from The functional equation is based on theoretical formulation. The equation is given in linear form as: FDI = δ 0 + δ 1 DS + δ 2 TO + δ 3 CAB + δ 4 GFCF + δ 5 INF + δ 6 GDPFC + ut Where FDI DS TO CAB GFCF INF GDPFC = Foreign Direct Investment Inflows in Pakistan = Debt Servicing as a %age of GDP = Trade Openness = Current Account Balance = Gross Fixed Capital Formation = Inflation Rate (Used Consumer Price Index) = Gross Domestic Product at Factor Cost.

5 21 International Research Journal of Finance and Economics - Issue 52 (2010) ut = Error term It is hypothesized that FDI / δ 1 DS > 0 FDI / δ 4 GFCF > 0 FDI / δ 2 TO > 0 FDI / δ 5 INF > 0 FDI / δ 3 CAB < 0 FDI / δ 6 GDPFC > 0 Specification of Variables Foreign Direct Investment inflows (FDI) is used as dependent variable. Data for FDI inflows in Pakistan has been collected from various issues of Economic Survey of Pakistan, Statistical Year Book 2005 and BOI. Independent variables are constructed as follows: Debt Service (DS): Trade Openness (TO): Current Account Balance (CAB): Gross Fixed Capital Formation (GFCF) Inflation Rate (INF): Gross Domestic Product at Factor cost (GDP): A Debt service is measured as a %age of GNP of Pakistan. Data for debt servicing repayment as a %age of GDP has been taken from various issues of Economic Survey of Pakistan. Trade Openness is taken as sum of export and import of Pakistan covering the period of Data for Export and Import has been taken from various issues of Economic Survey of Pakistan, Statistical Year Book 2005 and BOI. Is the new variable that was not considered earlier by any researcher as per our studies. Data for current account balance has been taken from various issues of Economic Survey of Pakistan. Is very important factor. Data of GFCF has been taken from various issues of Economic Survey of Pakistan. Consumer price index is used to measure the inflation rate of Pakistan. Various issues of Economic Survey of Pakistan are the major source of data for consumer price index which represents the overall price index for entire consumer baskets of goods. Various issues of Economic Survey of Pakistan and Statistical Year Book 2005 are used to gather the data for Gross Domestic Product at factor cost. To investigate the determinants of FDI in Pakistan, annual time series dataset has been used consisting of The study largely depends on secondary data sources originally compiled by various organizations. All dataset have been collected from World Development Indicators (WDI), World Investment Reports (WIR), various issues of Economic Surveys of Pakistan ( , , , , , , , , , , , and ), Board of Investment (BOI), Statistical Year Book 2005, Various issues of Statistical Bulletin of State Bank of Pakistan and International Financial Statistics (IFS). This facilitated the study s process of data collection. For the analysis of data we used Software Micro Fit #4.0. (Interactive Econometric Analysis). Since this study is based on time series data on Pakistan, we have used ADF test to check the stationarity of the data. The standard techniques to estimate such data are Co-integration approach and Error Correction Model. As we have analyzed various case studies in literature review, which are carried out by distinguished researchers. These studies have used different variables in their research studies like market size, trade openness, growth rate, inflation, gross fixed capital formation, unit labor cost, service sector, trade balance, balance of payment, per capita, exchange rate, foreign reserves etc. This study includes the impact of six important variables like gross fixed capital formation, debt servicing, trade openness, current account balance, Inflation Rate, and gross domestic product at factor cost on FDI of Pakistan.

6 International Research Journal of Finance and Economics - Issue 52 (2010) 22 IV. Data Analysis The econometric investigation of FDI in Pakistan uses annual time series data ( ). Various summary statistics, correlation among variables, results of ADF test, and regression results are given below in tables 1, 2, and 3: Table 2: Descriptive Statistics (Sample period: 1971 to 2008) Variable(s) FDI DS TO CAB GFCF INF GDPFC Maximum E+07 Minimum Mean Std. Deviation Coef of Variation Table 3: Estimated Correlation Between FDI and Other Variables Variables FDI DS TO CAB GFCF INF GDPFC FDI DS TO E CAB GFCF INF GDPFC Table 4: Results of ADF Test Variables Level/Difference Without trend With trend Order of Integration FDI Level Second Difference I(2) DS Level First Difference I(1) TO Level Second Difference I(2) CAB Level I(0) GFCF Level First Difference I(1) INF Level Second Difference I(2) GDPFC Level Second Difference I(2) 95% critical value for ADF Statistics for all variables: (without trend) and ( ) with trend. Table 2 indicates the summary statistics whereas table 3 shows correlation between FDI and independent variables. To check the order of integration of suggested variables and test the stationarity of the data in our model, we use unit root test. Augmented-Dickey Fuller (ADF) test is used for unit roots and found that presence of unit roots in some variables (FDI, DS, TO, GFCF, INF, and GDPFC) and, therefore existence of non stationarity. Only CAB is stationary at the level. DS is stationary at first difference and remaining four variables are stationary at second difference (see Table 4 for further detail)

7 23 International Research Journal of Finance and Economics - Issue 52 (2010) Table 5: Ordinary Least Squares Estimation Dependent Variable Total FDI (FDI) Regressor Coefficient t-statistics Probability Constant term Debt service (DS) Trade Openness (TO) ** Current Account Balance (CAB) * Gross Fixed Capital Formation (GFCF) *** Inflation (INF) * Gross Domestic Product (GDPFC) *** R² Adjusted R² Mean of dependent variable Residual Sum of Squares 8.65E+09 D.W No of Observations 38 ***. **, * indicate 10%, 5%, and 1% level of significance respectively. Figure 2: Regression result shows that degree of trade openness and current account balance are found statistically significant with positive and negative sign respectively at 10% level of significance, whereas gross fixed capital formation and inflation rate are also found statistically significant with positive sign respectively at 5% and 1% level of significance respectively. Results indicate that inflation rate is highly significant which attracts the foreign investors to invest in Pakistan with the intention to generate abnormal profit. Results also reveal that Current Account Balance (Deficit) is also found statistically significant with negative sign. Degree of trade openness is also found statistically significant with positive sign. Generally, trade openness reflects the extent of trade liberalizations. Our study found that positive association between FDI and trade openness is theoretically sound. Similarly, gross domestic product is also found statistically significant with positive size at 10% level of significance. On the other hand, debt servicing is found statistically insignificant with positive size. R-square and adjusted R- square is and respectively. But D.W value is , which indicates positive serial correlation (see table 5 for further detail).

8 International Research Journal of Finance and Economics - Issue 52 (2010) 24 V. Estimation of Error Correction Model (ECM) An Error Correction Model (ECM) has been applied to find out the short run dynamics of this model. Now our model is estimated in the following equation: FDI = γ 0 + γ 1 DS+ γ 2 TO + γ 3 CAB + γ 4 GFCF + γ 5 INF + γ 6 GDPFC+ γ 7 r (-1) Where r (-1) represents error correcting term. The results of ECM of FDI in Pakistan are given in table 6. Table 6: ECM Results Variables Coefficient T-Statistics Probability Constant term DDS DDTO *** CAB *** DGFCF ** DD INF * DDGDPFC R(-1) * R² Adjusted R² Mean of Dependent Variable Residual Sum of squares 8.23E+09 D.W No of Observations 38 ***. **, * indicate 10%, 5%, and 1% level of significance respectively. Results indicate that after applying ECM, degree of trade openness (TO), current account balance (CAB), gross fixed capital formation (GFCF) and inflation rate (INF) are found statistically significant with required signs whereas gross domestic product (GDP) and debt servicing are found statistically insignificant but with positive sign. No serial correlation lies and residual also found significant.all results were obtained, as they were hypothesized so null hypothesis is rejected (see table 6 for further details). After applying ECM, all variables were significant with the required sign except trade openness. R 2 and adjusted R 2 are and respectively and D.W-statistics has improved upto (means no serial correlation). R (Residual) is also found statistically significant at the level of 1% with positive sign and speed of adjust is almost 70%. Figure 3(a):

9 25 International Research Journal of Finance and Economics - Issue 52 (2010) Figure 3(b): Tests for structural stability based on Brown et al (1975: cited in Pesaran and Pesaran, 1997) suggests that at 5% level of confidence, there is insufficient evidence to reject null hypothesis, that model is well specified (see figure 3 (a) and 3 (b)). This indicates that FDI inflows in Pakistan have greatly augmented with the increase in degree of trade openness, well-established infrastructure and improvement in current account balance. So this study indicates that degree of trade openness, current account balance, gross fixed capital formation and inflation rate have strong influence on the FDI inflows in of Pakistan. VI. Conclusion This paper has empirically investigated the focus of the study encircles around the Foreign Direct Investment (FDI) inflows into Pakistan covering the period of This study explored how different variables impact on FDI inflows into Pakistan. To examine this impact, Co-integration and Error Correction Model (ECM) is used. FDI inflows in Pakistan has been taken as a dependent variable while debt servicing as a %age of GDP (DS), Degree of Trade Openness (TO), Current Account Balance (CAB), Gross Fixed Capital Formation (GFCF), Inflation Rate (INF), and Gross Domestic Product at Factor Cost (GDPFC) are used as independent variables. Our study reveals that degree of trade openness (1.8732), Gross Fixed Capital formation (2.0332), and inflation rate (3.5920) are statistically significant with positive signs. This indicates that high degree of trade openness and investment friendly policies as well as well established infrastructure are key determinants to attract FDI inflows into Pakistan. To increase the FDI inflows, GOP should take solid steps to develop infrastructure and offer attractive benefits to foreign investors in terms of financial and fiscal incentives. Similarly, increase in inflation rate also induces foreign investors to invest in Pakistan because higher prices lead to increase the profit margin of foreign investors. On the other hand, Current Account Deficit ( ) is also found statistically significant but with negative sign which indicates that reduction in current account deficit improves Balance of Payment (BOP), reflecting macroeconomic stability in Pakistan. This situation encourages the foreign investors and increases the FDI inflows into Pakistan. So, Pakistan should take appropriate measure to improve BOP position to attract foreign investors.

10 International Research Journal of Finance and Economics - Issue 52 (2010) 26 This study has explored that degree of trade openness, Gross Fixed Capital formation; inflation rate and Current Account Deficit are crucial variables for FDI. In this way Pakistan can strengthen its economic situation and lift up economic development and growth as well. Finally, Government of Pakistan should initiate more Open-Door policy to attract massive FDI inflows into Pakistan. References [1] Agiomirgianakis, G., Asterious, D. and Papathoma, K. (2006), The Determinants of Foreign Direct Investment: A Panel Data Study for the OECD Countries, Discussion Paper Series, No. 03/06. [2] Aqeel, A., and Nishat, M. (2004), The Determinants of Foreign Direct Investment, The Pakistan Development Review, 43:4 Part II, pp [3] Astatike, G. and Assefa, H. (2005), Determinants of Foreign Direct Investment in Ethiopia: a Time series Analysis. Paper presented for the 4 th International Conference on the Ethiopian Economy, June [4] Atique.Z., Hasnain.M., and Azhar.U. (2004), The Impact of FDI on [5] Economic Growth under Foreign Trade Regime: A Case Study of Pakistan. The Pakistan Development Review 43:4, Part II, pp: [6] Board of Investment, (BOI), Government of Pakistan, 2010 [7] Brown R.L., Durbin J. and Evans J. M. (1975). Techniques for testing the Constancy of Regression Relations overtime (with discussion), Journal of the Royal Statistical Society B, vol. 37, pp: [8] Caves, R. 1971, International Corporations; the industrial economics of foreign investments, Economica, Vol. 38, pp [9] Khan, A.H., and Kim, Y.H. (1999), Foreign Direct Investment: Policy Issues and Operational Implications, EDRC Report series No. 66 [10] Kindleberger, C.P. (1969), American Business Abroad: Six Lectures on Direct Investment, Yale University Press, New Haven, CT. [11] Kumar, R. (2003), Changing Role of the Public Sector in the Promotion of FDI. Asia-Pacific Journal, Vol.10, No.2. [12] Kyaw, S. (2003), Foreign Direct Investment to Developing Countries in the Globalised World. Paper presented at the DSA conference 2003, University of Strathclyde, Glasgow September, [13] Loree., Guisinger, D.W. and Stephen, E. (1995), Policy and Non-policy determinants of US Equity Foreign Direct Investment. Journal of International Business Studies, vol 26, Issue 2: [14] Majeed, M.T. and Ahmad, E. (2009). An Analysis of Host Country Characteristics that Determine FDI in Developing Countries: Recent Panel Data Evidence. The Lahore Journal of Economics, 14:2 (Winter 2009): pp [15] Moosa, I.A. and Cardak, B.A. (2006), The Determinants of FDI: an extreme bound analysis. Journal of Multinational Financial Management 16 (2006) [16] Pesaran, M.H. and Pesaran. B (1997). Working with Microfit 4.0: Interactive Econometric Analysis, Oxford, Oxford University Press, And pp: 117. [17] Rubio, O.B. and Rivero, S.S. (1994), An Econometric Analysis of Foreign Direct Investment in Spain Southern Economic Journal, Vol. 61, No.1, [18] Shah, Z. and Ahmad, Q. (2004), Determinants of Foreign Direct Investment in Pakistan: An Empirical Investigation, 19 th Annual General Meeting and Conference, Pakistan Institute of Development Economics (PIDE), Islamabad, Pakistan. [19] Tsai, P. (1994), Determinants of Foreign Direct Investment and its impact on economic Growth. Journal of Economic Development, 19(19), [20] Statistical Year Book of Pakistan 2005

11 27 International Research Journal of Finance and Economics - Issue 52 (2010) [21] Various issues of Economic Survey of Pakistan from [22] World Investment Report, 2005, 2006, 2007, 2008, and [23] Yousaf, M.M., Hussain,Z. and Ahmad, N. (2008), Economic Evaluation of Foreign Direct Investment in Pakistan, Pakistan Economic and Social Review, Volume 46, No.1 (Summer 2008), pp [24] Zaman, K., Hashim, S. & Awan.Z. (2006), Economic Determinants of Foreign Direct Investment in Pakistan, Journal of Humanities and Social Sciences, University of Peshawar, Peshawar.