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The impact of FDI on trade and economic growth

In this fast changing world economic landscape, virtually every country developed and developing, large and small alike have sought Foreign Direct Investment to facilitate their development. Foreign Direct Investment is usually undertaken with the intention of exercising control over an enterprise rather than merely attaining a passive voice in corporate affairs. Thus, foreign direct investment can exert a more profound influence on a country's growth, industrial structure, employment and trade patterns than other capital flows. These investment flows almost always take place through transnational corporations, the main actors in the global economy. The foreign content of their total output, assets and employment is often large. Hence, FDI can affect the level of output and trade of a country by serving as an engine of growth and development.

The FDI is usually favoured on the grounds that it is a source of filling the saving, foreign exchange, revenue, management and technology gaps of developing countries. By its very nature, foreign direct investment brings into the recipient economy resources which can play an important role in the modernization of the national economy. FDI is now considered to be an instrument through which economies are being integrated at the level of assets including capital, technology, managerial capacities and skills and access to foreign markets. It also stimulates technological capacity building for production, innovation and entrepreneurship within the larger domestic economy through catalyzing backward and forward linkages.

The world economy has changed over the last two decades and it has changed dramatically. In this era of liberalization, a number of studies have been carried out to analyze the impact of FDI on economic growth and international trade.

1.2 Problem Statement

To identify the relationship between FDI, growth and trade and analyse the impact of FDI on trade and economic growth together

1.3 Research Hypothesis:

H1: Changes in the output level and economic growth does not depends on the level of capital inflows

H2: There is a significant relation exist between Trade and level of Capital Inflows.

1.4 Outline of the study

This study attempts to analyze the important dimensions of foreign direct investment in Pakistan in the light of the various studies carried out by different researchers. It examines the pattern, trends in policies and investments flows to Pakistan flows.

The study indicated several areas of concern regarding FDI, Trade and economic growth. Study analyzed the impact of FDI on trade and economic growth over time series data since it is a dynamic problem which emerges over time. Moreover, it is also evident that literature on the subject matter is very limited, particularly; pertaining to Pakistan and further research is needed on the issues. One of the main reasons for undertaking this study is to draw the attention of the policy makers to address the issues which inhibit the growth of FDI in Pakistan. This study is a departure from the previous studies in the sense that it analyses the impact of FDI on international trade and economic growth together

1.5 Definitions

Foreign Direct investment is conventionally defined as a form of international non-debt, creating, inter-firm co-operation that involves equity stake and effective management decision power in, or ownership control of foreign enterprises.

Equity capital

The foreign direct investor's net purchase of the shares and loans of an enterprise in a country other than its own

Reinvested earnings

The part of an affiliates earnings accruing to the foreign investor that is reinvested in that enterprise.

Intra company loans

Short- or long-term loans from parent firms to affiliate enterprises or vice versa, In the case of banks, deposits, bills and short-term loans are not included.

Economic Growth

Economic growth is the increase of per capita gross domestic product (GDP) or other measure of aggregate income.

Import

The term "import" is derived from the conceptual meaning as to bring in the goods and services into the port of a country

CHAPTER 2

LITERATURE REVIEW

The concept of FDI is not new in the literature. Its different aspects have been explored and evaluated in the past. However, the determinants and impact of FDI in the past were explained theoretically without giving empirical evidence. With the passage of time econometric models equations and indices were used to find out the empirical results. These studies are different from the previous studies on various grounds. The previous studies were based on "pure" economic theory of international trade and firm. These theories also assumed the concept of perfect competition, identical production functions and no transportation cost etc.

FDI can be distinguished from broader, sometimes non-equity, forms of international co­operation, such as most types of quasi-investment arrangements (licensing, leasing, franchising, start-up and international production sharing agreements), joint ventures with minority foreign participation, and broad R&D co-operative ventures. In particular, FDI is considered to be the outcome of broad corporate strategies and investment decisions of multinational corporations (MNCs) facing world-wide competition, and differs significantly from debt-creating, short-term speculative capital flows. From the point of view of foreign investors, FDI is justified by significant differences in production costs due to factor productivity and remuneration differentials across countries. FDI is also often motivated by the need to consolidate market shares abroad and to reap the benefits of growth prospects and economies of scale in large consumer markets overseas. From the point of view of the recipient economy, FDI is desirable for a number of reasons, varying from growth-enhancement via capital accumulation and deepening, to technological upgrading. FDI is also expected to integrate domestic firms in global production and investment networks, which is likely to boost productivity and output growth. In addition, FDI constitutes a good source of current account financing and balance of payments relief, particularly if it is export-oriented and saving-enhancing. In a globalized economy, macroeconomic instability and policy-induced distortions in goods and capital markets tend to reduce the locational advantage of a host country in the competition for inward FD1 and capital inflows

The experiences of Far Eastern countries also show that FDI not only affects economic growth, it also depends on the host country's growth performance. Furthermore, the growth and FDI are closely linked with the International Trade. The relationship between trade and growth is well known. Economic growth, whether in the form of export promoting or import substituting strategy, can significantly affect trade flows. On the other hand, the export led growth argues that expansion of exports can promote economic growth by expanding the market size for developing countries. The link between FDI and trade follows two channels. First, countries that are more open are more likely to attract FDI where the degree of openness underscored to mean the size of trade (exports plus imports) relative to GDP1 Secondly, FDI can affect trade in many ways. Foreign investors, typically bring machines and equipment from outside the host country. Similarly, one of the objectives of multi-national companies to invest in less developed countries is to reduce their cost of production in order to compete in neighboring countries. This can increase exports of the host country. In a nut shell, it follows that growth and international trade are mutually dependent on one another.

Past Researcher analyzed the impact of Foreign Direct Investment with special reference to international trade. It was found that countries actively pursuing export led growth strategy can reap enormous benefits from foreign direct investment. Export led policy is defined as the one which equates average effective exchange rate on exports to the average effective exchange rate on imports. On the other hand, import substitution policies are worked out in such a way that the two exchange rates are not equal. The former policy favors free trade and underlines the need to boost exports whereas the latter emphasizes self-reliance through import substitution.

Foreign investment affects national incomes via the benefits accruing to the people of rural and urban sector. In the economy, foreign capital inflows improve national income and in turn the standards of living of the people independently of the pattern of international trade concluded that if the tariff is low and the absolute value of elasticity of rural wage is high, there is larger probability that foreign investment leads to higher national income. Large market size, low labor costs, and high returns in national resources are amongst the major determinants in the decision of the investors to invest in these countries.

For foreign investors profit is the prime motive and not the objective of growth. It has found that the higher the rate of return of undertaking a project, larger the volume of FDI into the host country. The study also shed light on the determinants of foreign direct investment. Market imperfections and custom duties can have a strong bearing on the pattern of FDI inflows. Apart from that, distortions in exchange rate can also play a vital role in determining the course of FDI. For instance if the exchange rate is undervalued it benefits the foreign investor whereas the local investors have no such incentive to invest abroad

The role of political factors determined the course of FDI. Two factors strongly influence the pattern of FDI in developing countries. These two factors are inefficient and corrupt political system and restrictive trade policies of the government to give protection to local industries. As regards the impact of volatile political situation, the evidence of the past studies shows mixed trends.

Dunning (1981) puts forward an eclectic Theory of foreign direct investment based on the theories of industrial organization and location of the firm. TNCs exploit ownership specific advantages in foreign countries by internalizing rather than externalizing them. The most important benefit of internalization is that it provides access to the whole range of TNCs technological and skill assets including its tacit knowledge. He included 67 countries in his study and divided them into three groups by cluster analysis. The evidence suggested that per capita income in the host country has the dominant influence. It is found that even if the FIJI crowds out some of the local investment, it might enable the host economy to expand its productive base and so use a large range of technologies because many technologies are available only in internalized form.

2.1 Foreign Investment in the context of endogenous growth

The key advantage of FDI is that it brings in new knowledge and entrepreneurial skills. This is now keenly understood by nearly everyone these days. The theory of Foreign Direct Investment deals with trade in ideas. New knowledge is the most important benefit of the international exchange of goods and services. There is a new theory of economic growth developed that deals directly with the benefits of ideas.

Researchers have argued forcefully that technological progress takes place because innovators entrepreneurs find it profitable to find new says of doing things. Research and Development (R&D) is carried out to make a profit on the introduction of a new product.

According to the endogenous growth models, technological progress is faster the larger is the level of accumulated human knowledge. This is because the cost of innovation falls as the level of human knowledge increases. Therefore, income growth will be faster among countries that have a relatively larger educated population and an economic environment which is favorable to the accumulation of human knowledge.

There are many lessons from endogenous growth theories for the theory of foreign investment. What the theory says is that ideas are as important as inputs. An economy can grow, just because new ideas beget more new ideas. International trade, foreign investment and the multinational corporations can be looked at as vehicles for not only the transfer of goods and services but, more fundamentally also of ideas. The theory of endogenous growth envisions that FDI leads to spillover effects in the economy. And many studies have found that industries that have been the recipients of FDI have higher rates of technological progress and consequently, the economy experiences a higher rate of economic growth.

2.2 Types of Foreign Direct Investment

According to the motivations of investors, FDI can be divided into the following four main types: natural resource-seeking, market-seeking, efficiency-seeking and strategic asset seeking:

Natural resource-seeking FDI

Natural resource-seeking FDI is the oldest form of FD1. One of the prime motives of such early foreign investors as the East India Company, the Virginia Company and the Massachusetts Bay Company in the seventeenth century was to search for raw materials, besides extending trade and creating settlements. But now many developing countries are reopening this sector to foreign investors. This gives firms from those developing economies, which are less endowed with natural resources, but more advanced in terms of technological development (such as from the Republic of Korea and Taiwan Province of China), greater chances of investing in this sector to strengthen their resource-based competitiveness.

Market-seeking FDI

Market-seeking FDI is attracted by the size and growth prospects of host country markets, advantages linked to a direct presence in consumers' vicinity, avoidance of import barriers, discriminatory Government-procurement policies and high transport costs in supplying markets through exports. Market size and growth have proved to be the most prominent determinants of FDI in most empirical studies. Market-seeking FDI can also be a result of oligopolistic competition, as TNCs try to get a foothold in each other's market. Much of infra-industry EDI is associated with oligopolistic competition.

Market-seeking FDI became the predominant motive for investing in the manufacturing sector of developing countries in the 1960s and 1970s during the heyday of import-substitution industrialization. This motivation also was paramount in the wave of United States manufacturing investments in Europe in the early postwar period and in Japanese investment in the United States since the early 1980s. Recently, the formation or strengthening of regional groupings has given rise to significant investments in order to serve the enlarged markets of the integration schemes.

Until recently, all FDI in services could be regarded as market seeking, because services were largely not tradable internationally. The services sector accounts for more than half of all outward FD1 flows and stocks from major developed countries. Services dominate FD1 flows and stocks and that much manufacturing FDI is market seeking, market-seeking FDI is still the most important..

Efficiency-seeking FD1

Efficiency-seeking FDI is attracted generally by lower costs of labor or environmental resources in host than in home countries. The oldest such investments have been labor-seeking ones. As wages rose in home countries, TNCs sought to obtain access to low-cost labor in developing countries through locating labor-intensive industries or segments of their production processes in them.

Other, more complex, forms of efficiency-seeking investments are closely related to the emergence of integrated international production. One increasingly important form for developing countries is component outsourcing which requires greater skills and higher productivity than is typical of labour-seeking began their penetration of markets of developed countries through the production of original-equipment manufacturing products, which they later replaced with their own brand names.

Still another form of efficiency-seeking FDI is horizontal FD1 in differentiated products; this is less common in developing countries and tends to be associated largely with investment flows (for example, in automobiles, computers, chemicals and consumer goods) among developed countries. It occurs because of the need to adapt products to the tastes or quality requirements of a particular market. These investments require a relatively large market, as they are related to the demand for different brands of a similar product in industries that are characterized by significant economies of scale. As the markets of developing countries are enlarged through regional trading arrangements, such investment are likely to become more common in those countries as well.

Strategic asset-seeking FD1

Strategic asset-seeking FD1 usually takes place at an advanced stage of the globalization of a firm's activities. Firms, including a few from developing countries, may invest abroad in order to acquire research and development (R&D) capabilities. Integrated international production involves the location of any component in the value-added chain where it contributes most to a TNC's competitiveness, and ultimately to its profitability. Thus, it may be efficient for a firm to relocate design, R&D (or other high value-added activities) from its home base to an overseas affiliate. Some developing countries are, or can make themselves, able to attract this kind of FDI through investment in human resources and infrastructure.

Historically, the need for promotional action arose when countries changed their attitudes and policies towards the role of FDI in their development from negative to positive, but investors did not respond to the changes or responded more weakly than desired. Such countries had to deal with an image problem vis-a-vis foreign investors, who continued to perceive them as places not friendly to FDI. Ireland and Canada, for example, at one point undertook information and advertising campaigns aimed at changing unfavorable perceptions concerning their investment climates. As many developing countries and virtually all economies in transition have faced similar problems, their liberalization efforts have been increasingly complemented by promotional programs, typically executed by investment promotion agencies (IPAs) that were newly established or transformed from earlier screening and monitoring agencies,

With time, promotional activity has become more important. Countries that have changed their FDI policies, countries that wanted to regain investors' attention, and countries that were invisible or unattractive to investors have all begun to resort to it

CHAPTER 3

RESEARCH METHOD

This chapter explains the methodology which has been used to study the effects of FDI on economic growth and trade. This is important because the role of FDI as a handmaiden of growth and development is being increasingly appreciated and is now largely reflected in FDI policies. On the other hand, trade and trade policies can exert various influences on the size, direction and composition of FDI flows. Research focused the attention on econometric techniques that are used to analyze the relationship between Foreign Direct Investment, economic growth and trade.

3.1 Selection of the main Variables

This study consists of five variables that include Output, growth, trade, foreign direct investment and domestic investment. It is useful to specify the variables that have taken into account. These variables include output, Foreign Direct Investment, imports and exports and domestic investment. The economy-wide output is measured by real GDP, that is, GDP at constant prices of some base year. Trade-FDI linkages can be analyzed in different ways by type of FD1, by the strategy of transnational corporation by sector of economic activity, by group of countries and their levels of development, or by the evolution of thinking and theorizing about the subject. In order to explore this FDI trade linkage, research have constructed trade variable as the sum of exports and imports as the percentage of GDP. The reason is that the other variables (i.e. value of trade or trade deficit) have several difficulties. Since the main components of FDI are equity capital, reinvested earnings and intra-company loans, the pattern of these components is also critically analyzed separately. In particular, the role of reinvested earnings is very important since they originate as savings from investment previously made.

Last but not the least, this study basically analyzed the inter-relationship between growth, foreign direct investment and trade. In this context the role of domestic investment in the growth process cannot be denied. This is why; domestic investment is also included in the list of the key variables. One of the reasons to include domestic investment is that it leads to improved understanding of the interlinkages and provides a background and basis for discussions at the national level as regards appropriate policy arrangements.

3.2 Method of data collection

Secondary data/published data.

3.3 Sample Size and Sampling Technique

The analysis will be performed using the data using annual data for the period 2001-2009.

3.4 Statistical technique used:

In this research, Multiple Linear Regression is used as a statistical tool. The reason of using this technique is when the purpose is to study the impact of more than one variable on other regression analysis is used. In order to run regression analysis all the selected variables should be scale in nature. In this study all the analysis variables are scale as there mean, median can easily be calculated and primarily the focus is to analyze the impact of FDI on economic factors.

CHAPTER 4

RESULTS

Hypothesis Assessment:

H1: Level of capital inflows has a significant impact on the changes in output level

Initially when the regression analysis was applied on the given variables the value of the Durbin Watson was 0.692 as it can bee observed in the above table. The lower value of the Durbin Watson indicates that there is a presence of the positive auto correlation in the data set. In order to resolve the issue of Auto correlation lag variables are calculated on the first level.

In order to develop the results FDI (Level of capital inflows) and Lag first level entered as independent variable by using regression analysis.

The Adjusted R Square value of the above table is 0.997 or 99.7% it means that one unit change in predictors set will bring out the 99.7% change in the variation of dependent variable that is output (GDP). From the above table it can be observed that the value of Durbin Watson is 1.927 almost 2 means that there is no presence of auto correlation. The Durbin Watson value closer to 2 indicates that by the generation of Lag Variable the issue of auto correlation in the data set has been resolved.

The significant value of the ANOVA table is less than 0.05 that is 0.000 it means that the regression model is appropriate to apply on the data set.

The above table explains the impact of level of capital inflows on the output of country, as it can be observed in the above table that the beta value of the level of capital Inflows (FDI) is 2.514 means that the 1 unit change in the capital inflow will bring out 2.514 increases in output (GDP) of the country. The significant value of the level of capital inflow is less than 0.05 it means that level of capital inflows has a significant impact on output of a country therefore null hypothesis is not rejected. The beta value of the lag variable explains that the next year output of the country is dependent on the last year. For example if the output of the current year is equal to 1 the next year total output of the country would be equal to 1.047. The VIF value is also on a lower side equal to 3.598, a value of VIF less than 5 is acceptable, the lower value of VIF indicated that there is no such issue of the multi co linearity in the model. However, the constant in study becomes insignificant meaning that if there were no independent variables the output of the country will be equal to zero.

H2: There is a significant relation exist between Trade and level of Capital Inflows.

From the above table it can be observed that the significant value of correlation table is less than 0.05 that is 0.000 it means that there is a strong relationship exists between Level of capital inflows and trade of the country therefore Null hypothesis is not rejected. The correlation value of both the variables is 0.916 it means that there is a strong correlation exists between the two variables.

CHAPTER 5

CONCLUSION

5.1 Conclusion

Concluding this research, it was found that FDI plays an important role in the development of the country as the foreign investment helps in increasing the business activities in the country. If there is continuous increase in the FDI over the years more business activities take place in the country resulting increase in the output of the country. FDI is very important for any country as it provides employment to the people of the country also increase the value of money. Higher the GDP means higher the growth of the country.

Research analyzed the policies and trends in the context of foreign direct investment in Pakistan. Research attempted to find out the reasons why Pakistan has not been able to attract sufficiently large FDI inflows despite liberalization of its economy. The factors responsible for low levels of FDI inflows are volatile political situation deteriorating law and order situation in Karachi, the largest industrial and commercial centre of the country. In addition to this, the red tapism, the unfavorable business climate inadequate physical infrastructure and inconsistent policies on the part of the government have discouraged foreign investors. The lack of educated and skilled work force, along with other distortions in the labor market have prevented economic expansion and closed all doors to productive investment. Government must pay attention to the cost, convenience and capability aspects in order to encourage foreign investors in the country. Any policy package, not embracing these conditions is doomed to failure.

5.2 Discussion and Implications:

The high indebtedness of many State-owned enterprises may constitute another obstacle to privatization. However, the Government may avail itself of another option under such conditions, namely: debt- equity swaps, which can help avoid further delays in its privatization. Various foreign investors and creditor banks have shown an interest in the capitalization of debt in Pakistan, partly because of the resulting indirect price discounts on the assets earmarked for privatization. However, a detailed discussion of how to deal with the social consequences of rapid privatization is beyond the scope of this study. As emphasized earlier, privatization alone does not guarantee economic efficiency, and may cause unemployment and social disruption in the short term. When the Government retains a controlling stake in privatized companies in order to moderate adverse social consequences, reduced private investor interest is a possible result, especially if TNCs consider substantial restructuring to be necessary for the prospective affiliate's integration into global strategies. Efficiency gains are most likely to be achieved in industries in which privatization and FDI inflows lead to more competition.

5.3 Recommendations

If Pakistan is to make best use of its potential to attract FIN through privatization and reap the associated benefits, several issues deserve attention. A first set of questions refers to the timing of privatization. Most importantly, there is a need to evaluate whether State-owned enterprises should be restructured prior to sale. Government revenues may increase if the efficiency of State-owned enterprises earmarked for privatization is improved through restructuring. However, the price effects of restructuring have to be weighed against the Government outlays required for restructuring. The opportunity costs of Government financed restructuring may be large, considering the substantial post-privatization FDI related to the modernization of inefficient enterprises in this country. Moreover, international experience suggests that TNCs "are frequently not impressed with the enterprise restructuring efforts of Governments prior to privatisation. The reason is that the TNC that wins the bid has not only its own conception of what needs to be done to make the enterprise viable, but also its own understanding of how the newly privatised enterprises fit into its transnational network. Just how much of an implied subsidy is obtained by this means depends critically on the extent of the post-acquisition restructuring programme.

To gain the potential efficiencies in services and infrastructure, policies towards restrictions on foreign ownership as regards some of the firms earmarked for privatization are important. Such findings suggest that the existing policies are no impediment to the planned sales. However, further improvements may be desirable with regard to investment protection, for which Pakistan received a lower ranking than most of other developing countries.

All these arguments can be combined into two general issues. One is that the potential for greatly accelerated FDI in privatization in Pakistan is quite considerable. The other is the associated effect of spurring FD1 by firms in other industries. Both experienced investors and those who have not yet invested in Pakistan have pointed to the need for an acceleration of an "open" privatization regime. This, they have argued, would be one of the strongest possible signals of the Government's serious intention to transform the economy. But whether or not particular State-owned firms should be privatized is entirely up to the Government

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