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Growing foreign direct investment

INTRODUCTION

It has been increasingly recognized that growing foreign direct investment (FDI) inflows can contribute to economic development and promise a variety of potential benefits to poor country recipients. Due to the potential role foreign direct investment can play in accelerating growth and economic transformation, many developing countries seek such investment to accelerate their development efforts. Consequently, foreign direct investment has become an important source of private external finance for developing countries.

The foreign direct investment can take place in two ways, either through the direct entry of foreign firms or the acquisition of existing domestic firms. It can also increase growth in two ways. The investment increases total investment by attracting higher levels of domestic investment. Also, through interaction of the more advanced technology with the host country’s human capital, foreign direct investment is more productive than domestic investment.

Foreign Direct Investment (FDI):

FDI is defined as a cross-border investment -in which a resident in one economy (the direct investor) acquires a lasting interest in an enterprise in another economy (the direct investment enterprise). The lasting interest implies a long-term relationship between the direct investor and the direct investment enterprise and usually gives the direct investor an effective voice, or the potential for an effective voice, in the management of the direct investment enterprise. By convention, a direct investment is established when the direct investor has acquired 10 percent or more of the ordinary shares or voting power of an enterprise abroad.

The lasting interest in a direct investment enterprise typically involves the establishment of manufacturing facilities, bank premises, warehouses, and other permanent or long-term organizations abroad. This may involve the creation of a new establishment or investment (greenfield investments), joint ventures, or the acquisition of an existing enterprise abroad (cross-border mergers and acquisitions). The investment can be incorporated or unincorporated and includes, by convention, ownership of land and buildings by individuals. Direct investment comprises not only the initial transaction establishing the FDI relationship between the direct investor and the direct investment enterprise, but all subsequent transactions between them and among affiliated enterprises. Thus, the direct investment relationship steeds beyond the original direst investor and include foreign direct investor that are part of the “parent group.” Once FDI is established, increases in FDI can take the form of injections of additional equity apical, the reinvestment of earnings not distributed as dividends by subsidiaries or associated enterprises and undistributed branch profits, and various inter-company claims, such as the extension of suppliers’ credits or loans, all of which represent FDI capital. These transactions cover only one aspect of financing available to direct investment enterprises that can also expand their operations by borrowing in local markets and in international capital markets (with or without the guarantee of direct investors).

There are a number of popular misconceptions of what FDI is. FDI does not imply control of the enterprise, as only a 10 percent ownership is required to establish a direct investment relationship. FDI does not comprise a “10 percent ownership” (or more) by a group of “unrelated” investors domiciled in the same foreign country�it must be one investor or a “related group” of investors. FDI is not based on the nationality or citizenship of the direct investor; it is based on residency. Borrowings from unrelated parties abroad that are guaranteed by direct investors are also not PDI. As regards FDI positions, FDI does not cover all of the assets of the direct investment enterprise; it covers only that portion financed by the direct investor or foreign subsidiaries and affiliates of the direct investor that are part of the parent group.

Overview of FDI In Pakistan:

FDI has been instrumental in the development of the country. The presence of foreign companies in Pakistan develops confidence among foreign investors to invest. Currently, about 250 foreign companies are operating in the country. They have interest in almost each and every sector. These include pharmaceuticals and chemicals, oil and gas exploration and marketing, power generation, food and beverages, automotive assembly, insurance and banking etc. According to a large number of analysts, no foreign company, which entered Pakistan, has ever left the country; rather they have been expanding their operations through expansion and diversification.

Pakistan was among the first few countries in the region to open up the market in early nineties. Now the foreign investors can virtually invest in any sector except a few. Opening up of market and initiation of process of privatization made Pakistan a center of attraction. Foreign investment came in large volume, both as FDI and as portfolio funds. The FDI inflow to Pakistan in 1992-93 was US$ 307 million and exceeded US$ one billion in 1995-96. However, since then, it has been registering a constant downward trend.

To overcome this downward trend, it is necessary to understand the key factors influencing the flow of FDI globally. Traditional determinants of FDI are still key to attracting, the investment. The size and growth of domestic market, geographical proximity and access to key potential markets, including large regional markets, play the key role.

The challenge for Pakistan is practically to develop a well balanced and preferably unique combination of determinants of FDI, and to seek to match those determinants with the strategies, pursued.

Broad Problem Area

Foreign direct investment has increased significantly over the last few decades. Major factors behind these trends are increasing number of cross- border mergers and acquisitions, move towards privatization and growing competition among the countries to attract FDI in the recent years.

According to the data provided in the World Investment Report 2001 (WIR01), Asia, among developing countries of the world, has emerged as the largest recipient of FDI followed by Latin America and the Caribbean.

The intensity of such inflows is largely concentrated in the countries of South, East and Southeast Asia excluding Pakistan. This includes countries like China, Singapore, Indonesia, Malaysia, Thailand, India, Korea and Philippines being the top ten recipients of these flows during 90’s.

Given the fact that Pakistan possesses several clear locational advantages, it has never emerged as a major recipient of FDI in the Asian periphery. The important locational advantages include; a large domestic market, with potential for servicing dynamic adjacent regions such as the Gulf States and the transitional economies of Central Asia; and a substantial surplus labor force with relatively low wages. But the phenomenon of low FDI inflows in Pakistan alludes to the fact that there is a lack of some strategic factors complementing these locational advantages. An explanation of such factors definitely needs to be sought.

China ranked first among the top ten host economies of foreign direct investment in developing countries. A comparison of FDI inflow into Pakistan in relation to that to China is shown in Fig.l.

Pakistan could not muster consistently even ten percent of investment flow into china over a decade clearly illustrate that the government initiatives are lacking.

As the competition for inward FDI intensifies across the globe in general and Asia in particular, the issue of competitiveness of Pakistan economy becomes vital. Such an issue needs to be evaluated in context of economic and political factors prevailing in Pakistan.

Rational of the Study

The major recipients of foreign direct investment possess important advantages that have attracted large quantities of foreign direct investment flows. The developing countries that received the lion’s share of the surge in foreign direct investment flows during the 1990s had more open policy regimes or hospitable regulatory framework, large markets, and favorable economic environment.

The share of FDI, flowing into Pakistan, is negligible when compared with the opportunities and economic fundamentals of the country. Pakistan nets less than one percent of global foreign direct investment and only about four percent of FDI flowing to the developing world. The highest FDI Pakistan received, was the amount of a little over one billion US dollars in 1995-96, ever since it has been experiencing a declining trend. Pakistan has to dramatically restructure its foreign direct investment climate to attract more global funds. It’s no secret that foreign investment can do wonders for an economy, from creating jobs to transferring technology to raising labor and product standards. The job part will be critical for Pakistan as unemployment is the major macro economic factor causing economic instability in the country.

Under the prevailing circumstances there is a need that economic mangers should take cognizance of the factors which are responsible for pushing the foreign investors away from Pakistan. These circumstances motivate me to work on this topic.

Problem Statement

The problem statement of the study is as follows:

“What are the main determinants of Foreign Direct Investment (FDI) and how they affect the flow of FDI in Pakistan?”

Explanation

Factors that may be important in affecting FDI are transport cost, market size, agglomeration effects, factor cost, fiscal incentives, business /investment climate and political, economic stability, trade policies, policies consistency and availability of skilled and productive labor force. While some of these factors are likely to affect all types of FDI, while certain factors may affect one type of FDI more than the other.

All the above stated factors are considered as determinants of foreign direct investment in any country.

However the variables tested in this study are;

  • Market size
  • Interest rates
  • Inflation
  • Trade policies
  • Government stability
  • Government policies (other than trade)

Instead of mentioning all the variables, the word “determinants” is used to, make the problem statement precise and accurate. The word “determinants” cover up the above listed variables. Reason for choosing these variables is explained in next section.

Theoretical Framework

The factors affecting the flow of FDI to any nation can be broadly divided into two categories i.e. Economic and Political factors.

Economic factors include the market size and the factor expressing the financial performance of the host country such as the inflation rate. Interest rate charged by the commercial banks of host country is also considered to be the potential economic factor affecting PDI as Sivakumar (2002) along with other factors used interest rate (as one of the important factor affecting FDI in India) in the model.

Political factors include the government stability and the policies implemented by the government. Governmental policies are important determinants of FDI flows since governments consider PDI flows as means to fight unemployment and to enhance national growth rates. Governmental policies can take a variety of forms such as tariffs, taxes, subsidies, regulatory regime and trade policy.

The survey was conducted recently by A.t. Kearney, a global management consulting firm on CEOs, CFOs, and other top corporate executives of the global 1000 companies. The survey cites large market size, political stability, inflation, interest rate, regulatory environment, and the govt. policies as the five most important factors affecting FDI (Development Business, 1999) . Therefore, all of these variables are tested as the determinants of FDI in Pakistan.

Determinants of FDI

Cheng and Kwan (2000) having examined empirical on governmental capabilities and resources found that governments are major catalysts for economic restructuring and location attraction of inward FDI.

Among all the government policies, trade policy is ten as a separate variable as Morrisey and Rai (1995) it out trade policy and openness of the recipient economy as the most important govt. policy to influence FDT .

Different explanatory variables have been used in various studies of FDI comprising a shopping list of variables. Dunning (2001), Hymer and Hawthorn (1970), Caves (1971) and Trevino and Daniels (1994) all have attributed market size, and inflation rate being important to the scope of international expansion.

Interest rates in an economy are important for the foreign investors. Foreign affiliates will be satisfied with higher interest rates on their term deposits but will be hesitant if commercial interest rates were high (Sivakumar, 2002). Therefore, interest rate is included (as a determinant of FDI in Pakistan) in the study.

Grosse and Trevino (1994) included geographical distance and cultural distance along with other variables such as trade policies, home country GDP, and interest rate to explain FDI in the United States. The impact of distance barrier has been significantly reduced due to the advent of technology. Transportation cost still remains a factor but the relative spread of access has considerably increased. The pace of communication has dramatically increased and also has become truly cost effective. Cultural distance may be treated as a dependent variable than as a dependent variable to predict FDI governance, sequence and performance (Shanker, 2001). The studies regarding fiscal incentives on FDI have shown mixed empirical results. Reuber (1973) do not find fiscal and tax incentives to be important, noting also that many previous studies had found little or no effect on FDI. So, these factors are not included in the study.

Objectives of the Study

The rapid growth of developing Asia has attracted, and been facilitated by, foreign direct investment, flows of which have increased substantially in recent decades. Part of the reason for this is that developing countries in Asia have removed restrictions and implemented policies to attract FDI inflows to benefit from the investments and potential spillover effects. Governments throughout the region have been striving to find an appropriate policy mix for FDI that will maximize the net benefits for their economies. Consequently, there is considerable variation in policies and experiences with FDI across countries, reflecting differing economic, social, and political conditions. Pakistaii being the important part of developing Asia is also facing this kind ot’ problems. Au mentioned earlier, the challenge for Pakistan is precisely to develop well balanced and preferably unique combination of determinants of FDI, and to seek to match those determinants with the strategies, pursued.

Therefore the objectives of this study are:

  • To determine the unique combination of determinants of FDI
  • To examine the reasons of fluctuations in FDI flow to Pakistan
  • To highlight the relation between FDI and its Economic and Political determinants
  • To give suggestions to the government to attract foreign investors in the country.

Hypothesis Development

Following are the hypothesis tested in this study:

    1. Ho: p=0 There is no significant relationship between market size and flow of FDI in Pakistan.

Hi: p^O There is a direct and significant relationship between market size and flow of FDI in Pakistan.

    1. Ho: p=0 There is no significant relationship between interest rate and flow of FDI in Pakistan.

Hi: p^O There is a significant relationship between interest rate and flow of FDI in Pakistan.

    1. Ho: p=0 There is no significant relationship between inflation and flow of FDI in Pakistan.

Hi: p^O There is a significant relationship between inflation and flow of FDI in Pakistan.

    1. Ho: p=0 There is no significant relationship between trade policies and flow of FDI in Pakistan.

Hi: p^O There is a direct and significant relationship between trade policies and flow of FDI in Pakistan.

    1. Ho: p=0 There is no significant relationship between FDI (in Pak.) and its economic & political determinants (market size, interest rate, inflation, trade policies).

Hi: p^O There is a significant relationship between FDI (in Pak.) and its economic & political determinants.

Definition of the Terms

Following are some of the important terms (used in the study) with their explanation.

Foreign Direct Investment

  1. Direct investments in productive assets by a company incorporated in a foreign country, as opposed to investments in shares of local companies by foreign entities. An important feature of an increasingly globalized economic system.
  2. The acquisition abroad of physical assets such as plant and equipment, with operating control residing in the parent corporation.

Domestic Investment

When comp purchase an item of value for income or capital appreciation within their own country, the investment is called domestic investment.

Multinational Enterprises

Multinational enterprises are the firms that own headquarter in one country and operate in several foreign countries across the globe.

Mergers

Mergers is defined as the collaboration of two firms nationally or internationally to cater the upcoming market or enter in a new market.

Acquisition

When one company takes over a controlling interest in, or procures the assets of, another company through purchase or merger is called acquisition.

Green field Investment

A firm actually purchase new assets and have their own full control of operations, usually a far more complicated and expensive operation than acquisition, but allows a company more freedom in designing the plant, choosing suppliers and hiring workforce.

Diversification

A portfolio strategy designed to reduce exposure to risk by combining a variety of investments, such as stocks, bonds, and real estate, which are unlikely to all move in the same direction. The goal of diversification is to reduce the risk in a portfolio. Volatility is limited by the fact that not all asset classes or industries or individual companies move up and down in value at the same time or at the same rate. Diversification reduces both the upside and downside potential and allows for more consistent performance under a wide range of economic conditions.

Privatization

The process of moving from a government-controlled system to a privately run, for-profit system is called privatization.

Fiscal

Pertaining to money, especially government taxation and spending policies.



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