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Impacts Of Interest Rate And Inflation On Investment Finance Essay

The purpose of this study is to examine the affects of inflation and interest on investment in textile sector. Due to lack of data availability we have taken foreign direct investment (FDI) in textile industry as a proxy for investment inflows to the textile sector. Two hypotheses were tested to analyze the effects of inflation and interest rate on foreign direct investment (FDI). Statistical technique multiple linear regression was employed. We found no significant relationship between inflation and FDI. Similarly no significant relationship was observed between interest rate and FDI.

CHAPTER 1: INTRODUCTION

1.1 Overview:

Investment is the key ingredient for growth. Mainly, there are three categories of investment, FDI (foreign direct investment), bank loans and private equity. Number of factors such as lending rate, inflation, government restrictions, political stability, cost of doing business and etc play a key role in determining the quantum of investment. Investment of capital formation plays a twofold role in an economy. In the short run, investment affects aggregate demand and hence output and employment level. Aggregate demand or total spending in the economy is affected by investment and increase in investment steps up total spending which in turn raises the level of output and employment.

Hall (1982) suggests that inflation reflects a scenario where the aggregate demands and services exceeds their supply in an economy. Excessive money supply and/or deficit in aggregate output could trigger this phenomenon. Increase in price could be caused by increase in cost of production. For instance imported raw material becomes expensive which will cause inflations if not dealt with. Sustained expansionary monetary policy will cause the inflation to persist regardless of the initial causes. In this sense inflation can be referred as monetary phenomenon. Inflation has a negative effect on savings due to the fact that it money is worth more presently that in the future. This slows down the economic growth because certain levels of savings are required finance investment which is a key to economic growth. Inflation also makes it difficult for a business to plan for the future. The decision how much to produce becomes relatively difficult for a business

because predicting a demand at higher is prices is not easy (due to elasticity of demand), which a company will charge in order to cover their costs. Inflation also causes uncertainty about exchange rates, real interest rate and future prices. This leads to uncertainty making investment and production activity of firms become more risky.

Higher interest rates also curb the investment as the cost of borrowing money increases significantly. Every business requires working capital which is often financed by short term loans, as the interest rate goes up it makes it more costly to borrow. Furthermore long term debts are taken for improvement and investment in infrastructure. The higher the existing interest rates, the more expensive the debt becomes and therefore making it difficult for a business to invest funds in such projects.

1.2 Problem Statement

For following three reasons, the textile industry may be rightly called as the bolster of Pakistan’s economy. Firstly, the agricultural sector’s forward linkage to it, the life line of Pakistan’s economy, thereby makes it the strongest. Secondly, owing to the largest share of investment in production, value addition and employment, textile industry accounts for the biggest manufacturing unit the country. Last but not least, textile sector has the largest share in overall exports. The whole economy of Pakistan can suffer serious imbalances, if textile industry suffers from any internal or external disturbance, due to the comprehensive spillover effects in regards to this sector. Further strengthening the economic significance of this sector is its relative contribution to the manufacturing investment. In view of this enormous share of textile sector in investment, this industry has the largest share of value addition in the manufacturing sector and a

substantial amount is paid in the form of indirect taxes. The effects of inflation and interest rate on investment should be analyzed, since investment in the backbone of any sector.

1.3 Hypotheses

H1: Negative relationship exists between foreign direct investment and interest rate.

H2: Positive relationship exists between foreign direct investment and inflation

1.4 Outline of the Study

This study is organized as follows, after the introduction in chapter1, the section 2 reviews some literature on investment. Chapter 3 presents analytical framework of the model which includes data, variables description and briefs about the methodology, which is followed by the empirical results presented in section 4. Section 5 finally concludes the study.

1.5 Definitions

1. Foreign Direct Investment (FDI): refers to investment carried out by one country into another. Generally foreign direct investment is long term which results in transfer of technology and foreign assets.

2. Interest Rate: is a rate which is charged or paid for the utilization of money. An interest rate can also be described as an annual percentage of the principal. To calculate it, interest amount is divided by the principal amount.

3. Inflation: is a general increase in the prices of commodities and/or services in an economy (often caused by either increase in money supply or reduction in supply).

4. Consumer Price Index: is one of the indicator of inflation, measuring the change in the cost of a fixed basket of products and services.

interest rate

CHAPTER 2: LITERATURE REVIEW

Domestic and foreign investment play a positive development role in economic growth of host countries is well recognized in literature. Investment is channeled to the sectors that enjoy relative advantage over other sectors, consequently generating economies of scale and therefore raising productivity. The argument put forward supportive of foreign investment is that it not only brings capital and technology but also management skills and market access. For foreign investment, reimbursement is necessary only if investors earn profit and when profit is earned, they are likely to reinvest their profit rather than remit to their home country. Zakaria (2008) while reviewing the investment policies of Pakistan over the last six decades observe that during 1950s and 1960s the public sector was abridged to only three industries out of twenty seven basic industries and industrial investment largely came from private sector. By late 1960s important areas such as banking, insurance, certain fundamental industries, and international trade of major commodities were chiefly dominated by the private sector. During 1970s, commercial banks, financial institutions, insurance companies and ten major categories of industries were nationalized by the government. Public sector also increased the direct investment in new industries, such as steel mills, garments and confectionary items. Due to the miserable performance of the industries after the nationalization process of 1970s, government changed its approach. In 1980s, government decided to follow a model of mixed economy, allowing the public and private sector to support each other. In spite of various incentives, the tight control of

government over economy acted as a restraint to the inflows of private investment. In particular, foreign investment was discouraged by (a) significant public ownership, stringent industrial licensing and control over prices by the government, (b) the incompetent public financial sector, directed credits, and segmented markets and (c) and inefficient trade regime, imposing import licensing bans and high tariffs. During 1990s same rules and regulations were being applied by the government to foreign investors as to local investors. For foreign investment necessity for the government approval was detached with the exception of a few industries. During 2000s government decided to base its investment policies on the principal of privatization, fiscal incentives, easy remittance of profit and/or capital and deregulation. The rationale behind the policy is to promote investment in sophisticated, state-of-the-art and export oriented industries whereas nearly the entire economic activity in other areas, including social sectors, infrastructure, agricultural etc have been kept open for foreign investment with similar fiscal incentives and other facilities, including loans from the local banks.

Nasir and Khalid (2004) find that investment is significantly receptive to uncertainty, yield and domestic saving in Pakistan. Return on investment is an important factor for investment in the country. Its role in investment decisions making has such significance that it offsets the negative impact of increased rate of borrowing. Uncertainties and expectations play a significant role in investment decisions in Pakistan. While domestic

saving is major source of investment in Pakistan, foreign saving is ineffective. Zia (2004) argues that while Pakistan’s textile industry enjoys comparative advantage over other manufacturing activities of the country, so far it has not succeeded in achieving

competitiveness in terms of price through Balancing, Modernization and Restructuring (BMR), value addition and quality. Textile producers of Pakistan kept myopic view of the market and did not make any investment efforts which could have brought the country and the industry sustainability of high GDP growth rates and dividends of long-run viability respectively. Though, in all fairness, policy adopted by the government has been equally responsible for the ailment of Pakistan’s textile industry. In some cases 100 percent capital was provided by financial institutions, allowing the private sector to take control of state enterprises. Not surprisingly, the textile sector specifically it’s spinning and weaving sectors are currently under heavy burden of loans most of which are behind schedule in repayments. In spite of all efforts of the government and the banks and frequent rescheduling, the recovery position is weak due to high levels of default. The largest percentage of stuck-up loans belongs to the textile industry.

Aqeel and Nishat (2004), find that the determinants of inward FDI put emphasis on the essentials or economic conditions of the host countries in relation to the home countries. The study suggests that it is the geographic advantages of the host countries e.g. political and macroeconomic stability, infrastructure, skills, income level and market size that determine cross-country pattern of FDI. The study further suggests that foreign investors which sought location specific advantages are shifting towards the globalized and more open economies of today. Similarly, Dunning (2002) finds out that FDI from industrialized developed countries depends on factors such as transparent government, policies and supportive infrastructure of the host country. Though, very few empirical studies exist that have projected the impact of certain government policies aimed at FID.

Khan (1997) argues that despite offering many incentives over the last five decades, relatively large size population and geographical location, Pakistan failed to attract FDI like those of many East and South-East nations. The study highlights some of the factors essential for attracting FDI in Pakistan. Improved law and order situation is the most important factor in Pakistan for attracting FDI. No amount of fiscal and other concessions would draw the attention of foreign investors in the middle of disturbed law and order situation. Aside from law and order situation, consistent economic policies economic policies and macroeconomic stability are also important to encourage foreign investors to carry out economic activity in Pakistan. In Pakistan foreign investors have to cope with an intricate legal situation. The law and regulations should be simplified, transparent, updated and their discretionary application should not be encouraged. The availability of more reliable and better quality services in all areas of infrastructure are key elements of a business environment conducive to foreign investment.

Khan and Khan (2007), observe that negligible impact of real interest rate on private investment reflects the non-responsiveness of private investment to interest rate. The results show that most traditional factors have insignificant effects on private investment in case of Pakistan. The results also support the view that poor quality institutions are responsible for low investment in Pakistan. The crowding out effect of public investment also indicates the inefficiency and corruption of government officials in utilizing resources. Kalim and Ahmed (2003) point out that during (1978-2002) private investment in Pakistan reached its lowest level. One major reason was lack of confidence in private investor. Non economic factors were equally responsible for the sharp decline in

investment. Economic policies were devised keeping in view the short term objective that was to reduce fiscal deficit. Long term objectives of improving overall economic performance and investment were not made part of the economic policies. For reducing the external trade deficits, a policy of devaluation resulted in increased cost of production through increase in the prices of imported raw material.

Banga (2003) exhibit the important role of educational attainment, labor productivity and labor cost in attracting FDI into Asian countries. Infrastructure is often mentioned as a key element in FDI. The study finds that the availability of electricity is also an important factor in FDI flows. Results also confirm that FDI restrictions have a negative effect on FDI inflows. Furthermore the study suggests that due to extensive growth in FDI flows to developing countries, there is an increased competition amongst the developing countries to attract FDI, which has resulted in higher investment incentives offered by the host governments and relaxing the restrictions on operations of foreign firms in their

countries. Economic fundamentals, such as, lower external debt, availability of high skill levels (captured by secondary enrolment ratio and labor productivity), low labor cost (in terms of real wages), large market size and extent to which electricity is consumed in the economy are also significant determinants of aggregate FDI. Moreover FDI policies are another important determinant of FDI inflows. Results also revealed that low tariffs rates attract FDI inflows. Results show that removal of restrictions in attracting FDI inflows are more significant as compared to the fiscal incentives offered by the host governments. Bilateral investment treaties (BITs), which put emphasis on non discriminatory treatment of FDI, have also a significant role to play in attracting FDI inflows into developing

countries. However, bilateral investment agreements with developing and developed countries may have different impact. The study shows that BITs with developed countries have a robust and more significant impact on FDI inflows as compared to BITs with developing countries. As far as regional investment agreements are concerned, the study finds that different regional investment agreements have different impact. On FDI inflows APEC is was found to have a significant positive impact while ASEAN was not found to affect FDI inflow. However, it was noted that regional agreements may be relatively new to illustrate an impact in the period studied. The analysis with regards to FDI from developed and developing countries showed that economic fundamentals vary in terms of their significance to attract FDI from developing and developed countries. As regard to FDI from developed countries, it is attracted by mainly large market size, higher education levels, higher labor productivity, lower domestic lending rates and better communication and transport facilities. On the other hand cost factors play a more

significant role in attracting FDI from developing countries. The significant determinants are large market size, potential market size, low labor cost, lower budget deficit, low lending rate and better transport and communication facilities. The impact of FDI policies also has a different impact on FDI from developing and developed countries. Lower tariff rates do not attract FDI from developed countries but are significant determinant to attract FDI from developing countries. Removal of restrictions on the operations of foreign firms attracts FDI from developed countries and fiscal incentives were found to attract FDI from developing countries. Antonio (2002) points out that more attention should be given to distinguish FDI by type, and suggests that FDI with advanced

technological content might play a significant role. With regards to developing countries, the study finds strong evidence of FDI flows with high technological content to countries that enjoy larger population and a larger stock of human capital with less uncertainty. The evidence also points out towards a positive relationship between the quantum of economic development in the host country and the share of technology embodied into FDI. Agarwal (1997) finds four statistically significant determinants of foreign portfolio investment (FPI) in six developing Asian countries. These include real exchange rate, inflation, index of economic activity and the level of domestic capital market in the world stock market capitalization. In the study inflation rate appeared to be inversely proportional to FPI while exchange rate, index of economic activity and share of domestic capital market were directly proportional to FPI. Malik and Pentecost (2007) empirically investigate the economic and socio-political determinants of the level of FDI in Pakistan from 1973-2004. Results suggested that in the long run the level of GDP is the primary determinant

of FDI in Pakistan. In the short run degree of political risk was also found to be significant determinant of new inflows of FDI. Dua & Rashid (1998) investigate the relationship between FDI and economic activity in India in the post liberalization era. Results revealed that FDI flows respond to the level of industrial production. These findings were in line with of Malik and Pentecost (2007). Nayak and Basu (2007) argue that in India there has been an unprecedented shift in the flows of FDI and subsequent evolution of the country into a state-of-the art, low cost R&D intensive giant which can not only sustain research and development intensive industries but show noteworthy

growth in both quantity and quality. Studying the qualitative shift in the FDI inflows, they found that country is not just cost-effective but attractive destination for R&D activities. Peter (2009) discusses the recent trends in the world and the conflict theory of foreign direct investment (FDI). He argues that the bulk of FDI taking place is horizontal and the theory predicts when trade costs fall, horizontal FDI also shrinks. Experience of 1990s, tells us otherwise. FDI grew much faster than trade even when trade costs fell due to technological change and trade liberalization. Catia (2009) aims to study the role of social sector expenditure and its relation with corporate taxation in determining the destination of FDI flows. Study revealed that multinationals value the state policies of redistributive social welfare as they may indirectly signal a government’s pledge to social stability. Meurer and Silva (2010) examine the relationship between foreign investment and stock returns in Brazil. Results revealed that foreign investment inflows boosted the returns over the period of 1995 to 2005. Results also showed that exchange rate along with foreign investment, country risk and influence of the world stock markets can explain 73% of the variations occurred in the stock returns over the period.

Cieslik and Ryan (2009) analyze the multinational enterprises (MNEs) theory which suggests that FDI often originates from (MNEs) with non-core activities and not single-product firms. Hypothesis that such firms are more productive than MNEs without non-core activities as well as non-MNE firms was tested. Results revealed that both manufacturing and service multinational firms with non-core foreign investments stochastically dominate firms without non-core activities.

CHAPTER 3: RESEARCH METHODS

3.1 Method of Data Collection

For the purpose of this study secondary date has been used. All the data has been acquired from different publications of State Bank of Pakistan.

3.2 Sample Size

Since the data of total investment inflows to the textile sector is not available, we will use foreign direct investment in textile sector as a proxy for investment in textile sector. For this purpose monthly data of foreign direct investment in textile sector, consumer price index and interest rate from July 2003 to August 2010 has been employed.

3.3 Research Model developed

In our model there are two dependent and two independent variables. We have employed a statistical technique in order to evaluate the affects of independent variables on dependent variable.

3.4 Statistical Technique

We have employed a multiple linear regression as used by Bell (2007). Multiple linear regression is a technique which determines the linear relationship between one dependent variable and two or more independent variables. The equation of multiple linear regression of our model can be presented as below:

FDI = α + β1 (CPI) + β2 (IR) +

Where as,

FDI = foreign direct investment in textile sector.

α = the intercept of the equation.

β1 = the coefficient of consumer price index.

CPI = consumer price index as a measure of inflation rate.

β2 = the coefficient of interest rate.

IR = Weighted average lending rate of all banks.

= the error term.

Transformation of Variables

Foreign direct investment (FDI) is dependent variable in our model. Transformation is applied by taking a log of each value. After taking a log our new variable is ln_FDI

Inflation (CPI) is independent variable in our model. In order to fix the normality issue we have taken a difference of inflation. It is calculated by subtracting the current value by its previous value. Since our data is monthly, we have subtracted each month’s value from its previous month’s value. The new values represent our new variable which is indicated by diff1_inflation.

Lending rate is also independent variable in our model. It is transformed first by taking inverse of each value and then subtracting each month’s value from its previous month’s value. New values represent our new variable which is indicated by inv_diff_interest_rate in our model.

CHAPTER 4: RESULTS

Following are the results.

Table No. 1

Model Summary

R

R Square

Adjusted R Square

Std. Error of the Estimate

Durbin-Watson

Model

1

.274

.075

.052

.31003

1.705

Predictors: (Constant), inv_diff1_intrest_rate, diff1_inflation

Dependent Variable: ln_FDI

R is the correlation between observed and predicted values of dependent variable. If the value of R is close to 1 it means that the correlation is very high between observed and predicted values. Above table shows the value of R which is 0.274. It reveals that the correlation between observed and predicted values is very weak. R Square represents the proportion of variation in dependent variable explained by a model. In our model value of R Square is 0.075 which is very low. When we have two or more predictors in a model we consider Adjusted R Square’s value instead of R Square. In our model Adjusted R Square is 0.052 which shows that model is not best fitted.

Table No. 2

ANOVA

 

Sum of Squares

df

Mean Square

F

Model

1

Regression

0.624

2

0.312

3.247

Residual

7.689

80

0.096

 

Total

8.314

82

 

 

a. Predictors: (Constant), inv_diff1_intrest_rate, diff1_inflation

b. Dependent Variable: ln_FDI

The sig-value of our model is 0.044. The value shows that regression model we developed is significant.

Table No.3

Coefficients

 

Unstandardized Coefficients

Standardized Coefficients

t

Co linearity Statistics

B

Std.Error

Beta

Tolerance

VIF

Model

1

(Constant)

1.102

0.288

 

3.547

 

 

diff1_inflation

-.043

0.027

-.171

-1.582

0.986

1.014

inv_diff1_intrest_rate

0.809

0.373

0.235

2.170

0.986

1.014

Dependent Variable: ln_FDI

Table No.3 shows that one variable is significant which is inv_diff1_intrest_rate. Variable(s) in order to be significant need to have a sig value of less than 0.05. Inflation and interest rate have sig-values of 0.118 and 0.33 respectively. We will rerun the regression to see if interest rate alone is significant in our model or not.

Table No. 4

Model Summary

R

R Square

Adjusted R Square

Std. Error of the Estimate

Durbin-Watson

Model

1

0.215

0.046

0.034

0.31289

1.653

Predictors: (Constant), inv_diff1_intrest_rate

Dependent Variable: ln_FDI

In the above table value of adjusted R square is 0.034. It shows that relationship between independent and dependent variable is very weak.

Table No.5

ANOVA

 

Sum of Squares

df

Mean Square

F

Model

1

Regression

.384

1

.384

3.918

Residual

7.930

81

.098

Total

8.314

82

Predictors: (Constant), inv_diff1_intrest_rate

Dependent Variable: ln_FDI

The sig-value of our model is 0.051. The value shows that regression model we developed is insignificant.

Table No.6

Coefficients

 

Unstandardized Coefficients

Standardized Coefficients

t

Co linearity Statistics

B

Std.Error

Beta

Tolerance

VIF

Model

1

(Constant)

.960

.288

3.337

 

 

inv_diff1_intrest_rate

.739

.374

.215

1.980

1.000

1.000

a. Dependent Variable: ln_FDI

Interest rate alone is insignificant in our model since its sig-value is 0.051. After employing the regression twice we found no empirical evidence that foreign direct investment in textile sector in affected by inflation rate and interest rate.

4.2 Hypothesis Assessment Summary

Table No.7

Hypothesis

Sig Value

Empirical Findings

H1: Negative relationship exists between foreign direct investment and interest rate.

0.051

Hypothesis not accepted.

H2: Positive relationship exists between foreign direct investment and inflation

0.118

Hypothesis not accepted

CHAPTER 5: DISCUSSION, CONCLUSION,

IMPLICATIONS AND FUTURE RESEARCH

5.1 Conclusion:

The study intended to examine the affects of inflation and interest on investment in the textile sector of Pakistan. The investigation has been conducted using linear regression technique. Since the data of total investment inflows to the textile sector is not available, foreign direct investment in textile sector has been used as a proxy for investment. After performing analysis, the results brought to the conclusion that interest rate and inflation are not significant predictor of foreign direct investment. The hypothesis that Interest rate is inversely related to FDI in textile sector is not accepted and it’s concluded that there is no significant relationship between interest rate and foreign direct investment. Similarly the hypothesis that Inflation is positively related to FDI in textile sector is not accepted either and concluded that inflation has no significant relationship with foreign direct investment. These findings reveal that investment in textile sector is not affected by interest rate and inflations and they have no significant relationship with investment. It is possible that there would be some other variables which can affect investment in textile sector.

5.2 Discussions

We used FDI in textile sector as a proxy for investment in textile sector due to lack of data. Government should work to design policies in a way that it reduces the overall input cost of business so that our industries become competitive globally.

5.3 Implications and Recommendations

In a country like Pakistan where high rate of inflation exists, interest rates are of key importance to curd the inflation. Normally interest rates are increased to curb inflation but it also has a downside, it increases the cost of borrowing. As our results suggest that FDI in textile sector is not affected by interest rate and inflation, in a way it is favorable for the textile sector.

5.4 Future Research

The present study should be of significant interest to both researchers and policymakers in the arena of economic development. Certainly, the present findings are Pakistan-specific, and further work is needed to establish whether it may be generalized results for the global economy. Future research could be conducted to find the variables that effect the overall investment in textile sector since in our findings both predictors are found to be insignificant.

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