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Last few decades has marked the change in the flow of foreign direct investment from developed to developing countries. FDI can be defined as the source of acquisition of managerial control by a business enterprise of a foreign country over a business activity in a host country (Graham,1982).The primary benefit of the FDI is the opportunities that they provide for the purpose of economic growth (Collins et. al, 1999). The patterns of FDI to Pakistan have shown mixed trends from the last two decades. Because of its dependence on debt it received little amount as FDI during 90's (Hukro and Ghumro, 2007). FDI performance was lackluster in this regard to attract the investors for incentives even after the liberalization (Khan and Kim ,1999). But after 1999 this trend changed and the FDI rose from 322million in 2000-2001 to 3.52billion in 2005-2006.
During the last decade, despite of this impressive rise in FDI when compared with other developing countries Pakistan FDI inflow remain meager. In 2007 the capital inflow to developing countries show a 7.5% of GDP but in the case of Pakistan that share was represented by only 4%. The country is again facing a decreasing rate in FDI stock merely reaching to 3.72billion in 2009 from 5.4 billion in the previous twelve months (Bloomberg).This fall can be involved into various factors ranging from conflict between investors and the government to unstable political environment. The recent wave of terrorism could be consider as another efficient factor towards this fall. It is considered that the association of FDI with the social, economic, political and financial factors of the host country can make them significant determinants of the FDI flow to the host country (Hanif, 2001).It must be realize that the list of the determinants of FDI is long and vague and it remains tend to change over time (Encyclopedia of developing countries). But it also suggests that these factors can be divided into three broad categories.
These categories are 1) Factors related to cost such as the availability of the labor and the low wage rate. 2) Factors which improves investment environment such as the foreign debt and the balance of payment situations. 3) Factor related to market such as the size and the growth of the GDP of the host country (Dunning, 1973).
Furthermore it must be kept in mind that the political instability in the host country cannot be ignored as it creates hurdles for the investors' confidence and make the investment risky. Political factors show that how stable is government of the host country and over a period of time how consistent its policies are (Shah and Ahmed, 2003). As in case of political instability it will be hurdle for investor's confidence so no matter how open and liberalized is your economy. Pakistan is a main economic power in Asia but the political instability in the country reflects the serious threat for not only its economic growth but also on the investment patterns in the country. The country has faced assassinations of the leaders, military rules as well as the sublime law and order situation over the years. Pakistan economic growth is associated with the political stability at the national level in the country according to the institute of peace and conflict studies.
Most of the recent studies argue that if to a certain level (threshold level) the local ï¬nancial sector is developed, then it will help to allow credit-constrained entrepreneurs to start their own ï¬rms. So when the number of varieties of intermediate goods increase, than it will cause an increase in demand for ï¬nal goods. As a result between the foreign and domestic ï¬rms capital recipient country beneï¬ts from the backward linkages. The efficiency of ï¬nancial sector eases the cost constraint for fulï¬lling the level of this increased demand and after that allows these linkages to turn into foreign inï¬‚ow spillovers. An economy which has more developed ï¬nancial markets and institutions tends to achieve signiï¬cantly higher economic growth rate and also the sizeable increase of foreign capital inï¬‚ows. Hence, development of ï¬nancial institutions is a first requirement to achieve positive spillovers from foreign capital inï¬‚ows. Inï¬‚ow of foreign capital plays an important and vital role for business in worldwide. A ï¬rm can approach new marketing channels and markets, production from cheaper facilities, can have access to new technology, products, skills and also ï¬nancing through foreign capital inï¬‚ows and resources. Foreign capital inï¬‚ows provide investment funds to host country or ï¬rm and also provide capital, processes, and management skills. With adoption of the new technology it can be the main advantage of inï¬‚ows of foreign capital and resources through its externalities, which can happen through licensing agreements, commencement, competition for the resources, export spillovers, employee training and knowledge. With the direct capital ï¬nancing together with these benefits aï¬€ect major macroeconomic variables like domestic investment, technology, employment opportunities and skilled labor, environment and export competitiveness in developing countries.
Pakistan seeks inï¬‚ows of capital and resources overseas energetically. In 1992, 1997 and 2000 with that three distinct government investment liberalization initiatives began, have opened Pakistan to foreign direct investment (FDI) progressively, to attract new foreign capital inï¬‚ows oï¬€ering broad arrays of incentives. During 1999-2002 The government also started a successful, broad-based macroeconomic reforms and structural adjustment programs. Foreign direct investment remains relatively modest inspite of this. While in ï¬scal year 2004 (the accounting year ending June 30, 2004) foreign direct investment jumped to US$ 949 million, this level remains far low according to Pakistan's perspective. For low FDI, there were numerous reasons such as poor and inadequate infrastructure, the volatility in stock markets and regulatory regime, political instability perceptions, difficulties in law and order, inconsistencies of policy, long-standing and unresolved disputes between foreign investors and the government, decreasing rates of domestic investment, and resistance to new policies by some elements of the bureaucracy which have not yet been fully adjusted in a more open economic environment. However, situation about total foreign investment is encouraging, in 2007-08. The FDI represents marginal increment; as compared to $ 5.139 billion for the ï¬scal year 2006-07 it has increased to $ 5.152 billion in 2007-08.
Foreign direct investment has grown at least twice as rapidly like trade over the last decade Meyer, (2003). With the shortage of capital in the developing countries, as they need capital for their development process, the marginal productivity of capital is higher in those countries. Investors in the developed world seek high returns for their capital on other hand. Hence with international movement of capital there is a mutual benefit. For inward FDI in these countries many developing countries the ongoing process of integration of the world economy and liberalization of the economies has now led to a fierce competition. In these countries the many controls and restrictions for the entry and operations of foreign firms are being replaced by some selective policies aimed at FDI inflows, just like incentives, both fiscal and in kind. These selective policies not only improve the fundamentals of the economy but they also aim for at attracting more foreign investments in the country. According to this, the government in Pakistan has initiated market-based economic reform policies during early 1980s. In 1988 these reforms began to take hold, and with that government has gradually liberalized its trade and investment regimes by facilitating them with generous trade and with more fiscal incentives to foreign investors through number of tax concessions, facilities of credit, and reduction of tariff and have also eased controls of foreign exchange Khan (1999). Further the government liberalized its policy and opened the sectors of agriculture, telecommunications in the 1990s; determinants of inward FDI emphasizes on the economic conditions and the fundamentals of the host countries relative to the home countries of FDI as determinants of FDI flows. This theory is in line with Dunning's eclectic paradigm (1993), which suggests pattern of FDI is determines in cross-countries through its locational advantages of the host countries e.g., the market size and level of income, skills, infrastructure, macroeconomic and political stability. Following this study Nishat and Anjum (1998) have estimated that foreign investors in Pakistan can be attracted when there is political stability, good law and order situation, leveled technical labor force and mineral resources and liberal policies of the government attracted. However, it has been also argued that in the globalised and more open economies of today the specific location advantages sought by foreign investors are changing.
Accordingly, Dunning (2002) finds out that from more advanced industrialized countries FDI depends on policies of government, supportive infrastructure of the host country and transparent governess. However, there are very few studies exist that have empirically estimated that the impact of some selective government policies aimed at FDI. The present studies add to the examining the response of FDI to selective policies which are named as tax and tariff policy, offered fiscal incentives and exchange rate policies in Pakistan. Specially, the main objective of this study is to find out the effectiveness during the reform period of these mentioned policies. From this study we would be able to examine that which specific government policy is attracting or distracting for FDI in Pakistan. In many developing countries this study would be of interest to policy makers where structural reforms are being implemented. But, due to rapidly changes political conditions and inconsistency in these policies the level of FDI remained low comparing with other developing countries.
To speed up the economic growth and development FDI is very essential component of efficient International Economic system. However, the benefits of FDI do not arise spontaneously rather they depend on national and international investment policies of the different regions. Despite of that FDI has great attraction for home and host countries both, but it also arise some costs for these regions. The benefits, which a host country receives, they depend on the cooperation of government of host countries.
There are many numbers of facets to state that "why foreign investors make investment abroad". Firstly, FDI causes to mobilize the capital from rich countries in capital to scarce countries, and both the countries are than able to derive benefits from this capital flow. Secondly, FDI enables to take the ownership advantage for the foreign investors in the foreign firms and also to place them in oligopolistic position. Thirdly, foreign investors able to invest abroad in order to access the availability of cheap raw material and labor force for the purpose of minimization of production cost. Fourth facet is, FDI plays very essential role in strengthening the currencies of both home and investing countries. Fifth facet is, the political stability in host country and political instability in home country encourages the foreign investors to invest their capital in abroad. In fact, for developing countries FDI is considered as a life blood because it brings in needed capital, transfer the technology, managerial level skills, and raises employment rate and also enhances the productivity of home country. With that on the other hand, foreign investors can also access the global markets and can enjoy highest return with their investment. These following are some benefits of FDI from the point of view of home and host economies. Remarkably Pakistan has attractive climate for foreign investment, especially in agriculture sector, IT and telecommunication, power sector and Services sectors. Mostly it is said that commodity producing sector has more attraction for foreign investment because in Pakistan GOP has offered 100% equity investment in that sector except of few specific sectors like arms and ammunitions, radioactive substances, security and currency printing and high explosive items.
Pakistan has now relaxed its investment policy and also opened up almost all the sectors of the economy for foreign investment recently, especially FDI. Enabling to achieve 100% ownership for investment in many sectors, now GOP (Government of Pakistan) is offering tax exemptions and many incentives for foreign investors in new investment policy. GOP has provided equal Investment Opportunities for both home and host countries. Now GOP has also entered in an agreement with 39 countries, particularly with developed countries through various sources in Pakistan to evade Double Taxation on income generated. During fiscal year (FY) 2007 to 2008, Pakistan has received $5409.8 Million of total FDI which is 5.27% higher than of FY2006 to 2007 and also 53.64 % higher than of FY 2005 to 2006. FDI in commodity producing sector was accounted for $903.5 million during FY 2007 to 2008, which was just 16.70% of the total FDI inflows in Pakistan, while during FY 2006 to 2007, in this sector FDI inflows was 33% of the total. In Commodity Producing Sector of Pakistan main purpose of this research study is to examine the economic determinants of FDI.
By developing countries various forms of foreign capital inflows, Foreign Direct Investment, grants, loans and portfolio investment is welcomed for bridging up the gap between domestic savings and investment and also to accelerate growth (Chenery and Strout, 1966). Due to world globalization since international capital inflows become more important economic activities in different countries. Most of the studies have highlighted the important role of FDI on economic growth and found out that through the process of technological diffusion FDI from developed countries has positive effect for the purpose of economic growth in less developed countries (Borensztein, et al., 1998). In 1971-75 World inflow of FDI increases same as the inflow was US$ 20450.61 million, where some US$ 15262.08 million went to developed countries and its remaining amount of US$ 5188.5 million went to the less developed countries, where US$ 1160.16 million went to Asia and after that only US$ 8.6 million came into Pakistan. FDI inflows of the world increased to US$ 648146 million, some of which US$ 38002 million, US$ 233227 million, US$ 147611 million, US$ 1117 million came into developed and less developed countries included Asia and Pakistan respectively (World Investment Report, 2005). Majority of the developing countries obviously including Pakistan want to attract more and more FDI for the purpose to achieve desirable level of economic growth. FDI not only help to bridge up the gap between saving and investment and foreign exchange, but also provide more jobs opportunities, management skills, and technological advancements etc. Pakistan seeks actively to enhance foreign investment due to the shortage of capital and other limitations, and for this goal in 1992, 1997 and 1999 three distinct government investment liberalization initiatives began. They have progressively opened Pakistan to foreign investment. In that regard Pakistan offering many incentives mainly FDI for enhancing new capital inflows and have also created friendly environment for investment in the country. The purpose of this study paper is to analyze the effects of different factors in Pakistan like social and political factors i.e., political instability and human capital on FDI. Though all these, there are various factors determining FDI inflow like as social, economic and political factors but this study emphasizes only on social factors such as human capital and political factor ( like political instability) of FDI in Pakistan.
For increasing productive capacity, economic development of a country includes proper utilization of resources. In many developing countries especially in Pakistan, optimal utilization of resources is seemed to be impossible because of the scarcity of domestic capital. Lizondo (1991) examined that a better choice of techniques by developing countries of foreign direct investment (FDI) instead of depending on bank loans and bonds. These developing countries could promote their economic growth with receiving FDI (where in 1997 China is a classy example, FDI contribution was about 15% of domestic investment, 41% of total exports, 19 % of industrial output, 13% of tax revenues and 18 million employment opportunities). Firstly FDI transfers financial resources to recipients (host) countries which could be used to increase production facilities in the host countries. Secondly technological and managerial know-how which play important roles in accelerating economic growth may be transferred to the host countries for the purpose of participating in different networks like as sales and procurement networks of foreign investors. With the use of international networks, host countries could not only increase their exports, which in turn would improve productivity in the host countries. On the other hand, the critics of FDI claim that foreign investors monopolize resources, supplant domestic enterprise, introduce inappropriate products and technology, and aggravate the balance of payments problem through high remittances. They often use transfer pricing to minimize their tax liabilities. They may also come to wield considerable political influence, distort the path of development, exacerbate income inequality, and exploit the weak environmental standards in developing countries. Pakistan needs FDI as being a capital-deficit country. The Government of Pakistan has initiated a number of policies and regulatory measures for attracting the FDI since late 1990s. Such as, for foreign investment the requirement of Government approval has been removed and 100% of ownership for foreigners is permitted, with exception of some projects. Foreign investment is used in that area of agricultural land and also in other areas like forestry, irrigation, real estates, insurance policies, health and related services. In the sector of petroleum, the government has launched a new petroleum policy which is efficiently conducive for foreign investment. One of the most important and significant measures is liberalization of the foreign exchange regime to attract FDI. Resident and non-resident of Pakistan and foreigners are now permitted to bring in for possess and also to take out foreign currency, open accounts and hold certificates in form foreign currency. Export incentives have been now broadened. The 55% income tax for exports of high value added products, and a 50% rebates for all rest of products is implemented. Import policy is also has been liberalized to attract FDI. Depending on whether a project is located in a rural area, urban area and industrial estate, machinery of import is not manufactured locally and is partially or fully exempted from import duties. Many varieties of other fiscal and monetary incentives also have been offered for projects in some selected industries such as electronics, tourism, pharmaceutical, dairy farming, mining, engineering, fertilizer and cement. The rate of return on FDI is increasing for Pakistan especially in the major host countries of Asia. The averaged rate of return in world is 5.5, of developing countries is 4.2, average rate of other is Pakistan 7.0, China 5.8 and Indonesia 5.4 (UNCTAD 2003). Despite of these facts in 2004-05 Pakistan has been able to get FDI of US$632.5 million that is much less from China, India, Korea, Malaysia and Hong Kong. In 2004-05 the biggest foreign investor in Pakistan is Switzerland which has 31.9% of total FDI. After that comes the USA and UK with 27.9% and 12% share of FDI in Pakistan (SBP 2005). In a developing country such as Pakistan has abundant of natural resources and higher return is obtained in resource oriented industries which results the inflow of capital into many industries. Pakistan's financial sector has absorbed the maximum of the FDI, after this oil and gas, and petroleum refining has obtained 23.9% and 8.6% of FDI. Textile is the biggest manufacturing sector of our country, which attract 4.2% of FDI and it has more absorbing capacity.
The industry of construction is passing through the condition of boom for the last many years. It has also taken a small contribution of 3.3% of FDI (SBP 2005).International capital flow theory of classical stated that FDI is said to be the function of international differences in the rates of return on capital. From UK and Canada into the US during 1950-1970 by Blais (1975), its analysis of FDI supported the hypothesis. Weintraub (1976) observed that there is no significant relationship between the US capital flow and the relative rates of return on contrary bases. The traditional factor endowments theory assumes that factors are immobile internationally. This is very unrealistic assumption as there are some factors, which are more relatively freely mobile. That's why, it is compulsory to differentiate between these factors, which are mobile, and those, factors which are not. At this extent, for the traditional theory requirement there is need to be modified as it has considered as an impact on the decision for locating investment in a region and after that influencing the movement of mobilized factors. From the last three decades the FDI has changed its form and also its structure of the contemporary global economy. Grossman and Helpman (1991) have considered that small developed countries for example Sweden and Switzerland are very much into invest abroad suggesting an inverse relationship in FDI and donor GDP. Along with empirical evidences the supply and demand determinants of FDI have been explained theoretically. The work of Lucas (1993 in East and South Asia) and Jun and Singh (1996 in developing economies) have emphasized on the business environment, integration of trade, costs of labor and form of process of the privatization p. Shamsuddin (1994) has examined the effects for 36 developing countries of per capita income, GDP rate in host country, wages rate, per capita debt and inflow of public aid, validation of prices and also the availability of energy in the host country on FDI by using the cross section data (in the years 1971-81) through single equation econometric model. Garribaldi et al. (1999) and Resmini (2000) have focused on access of market, along with some variables. These studies analyzed that political and economic factors, the timing and the form of the process of privatization and need to secure their market access are considered as the primary determinants of the allocation of FDI. In the Central and Easter Europe, Bevan and Estrin (2000) have focused on that FDI inflows are influenced by risk significantly, per unit cost of labor, host country market size and gravity factors. Therefore at the second stage of analysis, they have found that development in private sector, industrialized development, balances of government, gross reserves and corruption are very significant determinants of risk. Urata and Kawai (2000) analyzed the factors in the recipient countries that attract FDI by Japanese short and medium size of enterprises. Factors at supply side include abundance of low wages availability of labor and well-developed infrastructure, and also the well governance of the local government, while important factors at demand side concluded is presence of sizable local market. Asiedu (2002) emphasized on policy reforms in the developing countries like determinants of FDI inflows. The study concluded that corporate rates of tax and openness degree to foreign direct investment are effective determinants of FDI. Bolingen (2005) has reviewed of its significance of FDI cross countries and suggested that further research in that direction.
FDI has received great attention from developed countries generaly as a growth enhancing component and particularly in less developed countries in recent decades. For many economists now it has been a matter of great concern that how FDI can affect economic growth of recipient country. Having no access to foreign saving in a closed economy, from domestic savings investment is financed solely. But investment is financed in both through domestic savings and inflows of foreign capital in open economy, including FDI. The investments which are in form of FDI make enable investment receiving (recipient) countries to attain investment levels their capacity beyond to save. FDI has remained the biggest form of capital flow over the last couple of decades in the developing countries. FDI accounted for 45% of net foreign resource flows to developing countries in 1997, comparing with 16% in 1986 [Perkins (2001)]. The World Bank (2002) reported moreover that in 1997 developing countries received 36% of total FDI flows. Most of developing countries consider now that FDI like an important source of development, but the economic effects of FDI are almost impossible with precision to either predict or measure. But through empirical studies it has shown that there is significant role of FDI in economic growth of recipient developing countries, from the impact of FDI and TNCs (Transnational Corporation) on growth of a country depends on various factors. In one of the key factors is trade policy regime that impact FDI with a great deal in recipient countries. The trade policy regime plays a decisive role in the decision of foreign investor. Bhagwati (1973) has explored a great amount of work and the importance of trade regime for benefiting the recipient countries in the terms of economic growth and economic activity [Bhagwati (1978, 1994); Brecher and Findlay (1983); Brecher and Diaz-Alejandro (1977)].
The main premise of the studies which is conducted is that the countries who gain more from FDI are those that follow the export promotion trade regime instead of those working below the protection of Import substitution policies. The main objective that makes the impact of the trade policies differ for the countries who are operating below various trade regimes is that countries who are working under IS target and very short size domestic market of the consumers differentiating with the countries with widely open policies of EP, having bigger international target customer market. Because of this the countries with EP regime are able to attract more foreign investment comparing with the countries who are operating below the policies of IS trade. There has been considered that progress in trade reforms in many developing countries, turning from strategy of import substitution to the export oriented approach since the middle 1970s. Policy of Pakistan's trade has also been turning towards more openness and fewer control. The rates of tariff have tumbled down steadily. There are only few studies which are available who have tested the hypothesis of Bhagwati for developing countries and the best of our knowledge and there is no such study is available in case of Pakistan. The available studies have used cross sectional data for their research moreover who has restricted homogeneity assumption for that it cannot capture the difference between the countries despite variations between developing countries considerably in relation to different structural features and institutional aspect that have direct bearing on FDI relationship of growth. The objective of this paper is to find out the effects of policy of trade regime with the contribution in development in human resources, transfer of technology and capital formation and also international trade.
Shamusddin (1994) used the Dunning model for his own study and he mentioned the three groups of FDI. And in this those factors are Cost factors, Market factors and climate of Investment. This study did not classify the political factors and focused only on the economic factors with the use of single equation of econometric model for 36 less developing countries in the year of 1983. The market size is very important determinant of FDI according to this study. This determinant was measured with the help of per capita GDP. Second other significant factor of this study was measured as the cost of wages which was the cost factor and finally the last factor climate of investment was affecting the flow of FDI and it was measured by per capita debt. The flow of FDI was remained discouraging in Pakistan despite of liberalization program which was implemented in early 90's (Khan, 1997). He tries to mention the reasons of the low or decreasing flow of FDIs in Pakistan. The determinants that he founds are instability in political factors, poor law and order situation of the country and economic weakness behind that discouraging trend of FDI flow. After that he divides the determinants into four main categories. These are cost, and convenience, concessions, and last is the capability. Everything else is lacking except for the concessions in Pakistan. Shah and Ahmed (2003) have divided the determinants of FDI into four broader and main categories such as market size factors, political and social factors and last are the cost factors. For the period of 1960-61 to 1999-00 Johansen and Juselius (1990) used time series data of Pakistan. Furthermore for this hypothesis was tested by using advance co integration techniques. The regression result of this study showed that there is a positive effect of market size on the inward flow of FDI. Also with its significance coefficient of cost and of capital, tariffs and capital cost points, the important role of that is government can play its role for attracting the flow of FDI in Pakistan.
Hukro and Ghumro (2007) classified the factors which are responsible for increase in FDI in Pakistan recently. This study was taken in account in the period of liberalization and also mentioned all the variables of investment macro-economic, cost and risk and stability factors in the short run and also in the long run. The result suggested that the economic factors which are under followed by the cost factors are taken as very important factors in determining the FDI. With that some researchers have also used to study the impact of policies of liberalization on FDI in the recipient countries. In these studies variables include like openness, tariff, taxes and exchange rate of economy which are measured with import and exports of the recipient country. Gastanaga, Nugent, and Pashamova (1998) studied the policy reforms in developing countries like the determinants of FDI inflows. They also analyzed that the rates of corporate tax and economy openness were the most significant determinant of the FDI inflow for Pakistan. Ozturk et al (2007) pointed the deterioration of Balance of payments towards, when the profit is repatriated back. He argues that there is no universal positive relation exists between the flows of FDI and the economic growth of the countries. There is positive relationship exists in the case of LDC but in case of DC there is no benefit was found in growth. This relationship was studied by using Engle Granger co integration test for the period of 1975-2004. After that the result finds that it is the GDP which is the main determinant of FDI in case of Pakistan.
Collins et al (1999) suggested that the capital inflows to any country are mostly influenced by the domestic economic conditions of the host country. The objectives for FDI are differentiated for different types of FDIs. In this the motive could be seeking of markets and efficiency seeking (Hanif, 2001).The study is in Pakistan is about the location determinants of the FDI. The findings of their regression analysis suggested that the economic factors are very much significant determinants of the FDI comparing with the political factors. The significance of exchange rate in the determination of FDI flows in a country is much studied topic in literature. (Froot and Stein, 1991 and Klein and Rosenger, 1994) focused on that when there is devaluation of currency in a country, the result of it will be in the reduction of the cost of production, when it is measured in form of foreign currency it will show result in rise inflow of FDI as it will also cause to grow the wealth of foreign investors. Feng YI (2001) studied the effects of democracy and different characteristics of political institutions on the investment flow in a country. The determinants that he used to test with help of regression analysis are such as political freedom, political instability and uncertainty in policy. The findings of this study show that political freedom help for promoting the investment but the political instability which was measured by the political freedom variance has negative effect on the investment flow into a country.
In this study the literature explains various channels through which host country can obtain fruits of inï¬‚ows of foreign resources and capital. First one is that FDI promotes domestic investment by providing new markets access, inputs for demand and new technology that spills over the economy, along with that alleviating balance of payment deï¬cits in current account partly [Zhang (2001), Hermesand Lensink (2003), Omran and Bolbol (2003), Ahmad et al. (2003), Alfaro and Rodriguez-Clare (2006)]. The comprehensive studies of Bennell (1997), Lim and Sidall (1997) and, Cotton and Ramachandran (2001) provide evidence on the eï¬€ect of foreign capital inï¬‚ows for domestic investment. They conclude that within increase of one dollar in foreign capital inï¬‚ows is related with the increase in domestic investment by 50 cents. Foreign capital inï¬‚ows are presented to correlate one for one increase in domestic investment. It is generally said that foreign capital inï¬‚ows can be the reason to increase competition and making markets (also including ï¬nancial markets) more prescient.
Foreign capital inï¬‚ows are use to promote economic growth because it can promote the technology transfer through rising production, its eï¬ƒciency, improvement in the quality of factors of production, creating an inï¬‚ow of investment funds in the balance of payment, all of these will lead to increase in exports, increase in saving and investment and also ultimately faster growth of output and employment rate (Khor 2000). Finally, investment in new sector in recipient country can rise the growth of new industry and of new products [Ramachandran and Shah (1999), Cotton and Ramachandran (2001), Naveed and Shabeer (2006) and Shahbaz et al. (2007)]. Besides of that, a inï¬‚ow of foreign capital and resources create backward as well as forward linkages, and multinationals corporations (MNCs) contribute help of technical to promote the domestic ï¬rms and markets, it is expected that the technological level and productivity (with both labor and capital) of domestic the producers will increase [Lim and Sidall (1997), Zhang (2001), Aqeel and Nishat (2004) and Shahbaz et al. (2010a)]. Financial sector which is consider more eï¬€ective for pooling savings of individuals may have profound eï¬€ect at economic growth. With direct eï¬€ect of savings on accumulation of capital, mobilization of better savings can improve the resource allocation and can boost up technological innovation [Cotton and Ramachandran (2001), Maureen (2001), Omran and Bolbol (2003), Ahmad et al. ( 2003) and Alfro et al. (2004)]. Studies of many countries are available in literature which pointed out to examine the results of spillover eï¬€ects of foreign capital inï¬‚ows on the economic growth. Positive impacts of spillovers have been found, such as Mexico (Blomstrom and Wolï¬€, 1994), Uruguay (Kokko et al. 1996), Indonesia (Sjoholm, 1999), Thailand (Kohpaiboon, 2003) and Pakistan (Ahmad et al. 2003) and (Aqeel and Nishat, 2004) but there is no spillover is traced in studies for Morocco (Haddad and Harrison, 1993) and for Venezuela (Aitken et al. 1997, Aitken and Harrison, 1999). Those conï¬‚icting results may be underline the important role of host country characteristics essential to permit foreign inï¬‚ows positive and effective contribution to economic growth with spillovers. Alfro and Rodriguez-Clare (2006) argue that there is lack of development of markets of local finance which could limit the economy's ability to take more advantage of potential foreign inï¬‚ows spillovers. If the entrepreneurship allows higher assimilation and adoption of advance and best technological practices which are made available by foreign capital inï¬‚ows, then with the absence of well developed ï¬nancial markets, it can limit the positive foreign inï¬‚ow externalities [Hermes and Lensink (2003),Bailliu (2000) and Omran and Bolbol (2003)].
The fruitful advantages from advanced technology can only be reaped through some specific characteristics of host country. These characteristics are not only determining the capability of technological spillover of the recipient country but also increase this capacity. It is showed that inï¬‚ow of foreign capital and resources can accelerate the process of economic growth with spillovers eï¬€ects. It is only possible when there will be an ample room for the absorptive capacity of recipient country [Alfro and Rodriguez-Clare (2006), Choong and Lim (2009) and Ang (2008, 2009)]. The rapidity change in technological innovation that spurs the patterns of economic growth of the country is more dependent on domestic ï¬nancial institutions and development of markets. Advanced capital goods are needed with labor that is able to use and work with new advance technology. The technological spillovers are possible only when host country has a specific minimum level or threshold level of stock of human capital [Borensztein et al. (1998), Zhang (2001), Omran and Bolbol (2003), Hermes and Lensink (2003), Ahmad et al. (2003) and Alfro and Rodriguez-Clare (2006)]. This study suggests that foreign capital inï¬‚ows and human capital stock are necessary for the exploitation of new advanced technology. Under these conditions, foreign capital inï¬‚ows ensure that competition and distortions of lessen markets improving the exchange of enhanced knowledge amongst the ï¬rms [Balasubramanyam et al. (1996) and, Barro and Sala-i-Martin (1995)]. There are varieties of cross sectional studies which provide evidences about the idea of effective functioning ï¬nancial markets to achieve positive spillovers from foreign capital inï¬‚ows that increase the rate of economic growth. System of developed domestic ï¬nancial is able to mobilize the savings and also to screen and monitor projects of investment, which will further contribute to boost rate of economic growth (Hermes and Lensink, 2003 and, Omran and Bolbol (2003). But, Hsu and Wu (2006) argue that cross country evidence cannot support effect of growth of foreign capital inï¬‚ows with ï¬nancial development. It shows that developed ï¬nancial market is not a pre-requirement to achieve beneï¬t from foreign capital inï¬‚ows to enhance economic growth. Sometimes the series studies show the essential role of ï¬nancial sector development in developing countries and provide strong positive, significant and electiveness of foreign capital inï¬‚ows for economic growth. Because of that, Ljunwal and Li (2007) investigate that is there any relationship between FDI and economic growth with role of ï¬nancial sector in China. Their empirical ï¬ndings support their view by Bailliu (2000).
For Malaysian economy, Ang (2008) examines that is there relationship exist between foreign capital inï¬‚ows and economic growth under the role ï¬nancial sector. The results show that ï¬nancial development and foreign capital inï¬‚ows has positive outcomes on economic growth. Causally evidence indicates that economic growth cause foreign capital inï¬‚ows in the long-run. In the case of Thailand Ang (2009) examines role of ï¬nancial development on foreign capital inï¬‚ows and economic growth. The empirical ï¬ndings has revealed that ï¬nancial development stimulates the economic growth but foreign capital inï¬‚ows have negative outcomes on expansion of output. It is also investigated that within rise in level of ï¬nancial development causes Thailand's economy to achieve more from foreign capital inï¬‚ows. As it is, it also seems to that the impact of foreign capital inï¬‚ows on the output of growth can be improved with development of ï¬nancial markets. Chong and Lim (2009) investigate the dynamic endogenous growth function that contributes the impact of FDI and development in ï¬nancial sector through locational determinants. Their ï¬ndings show that FDI, labor, investment, and government expenditures play a crucial and essential role for promoting local economic activities and its prosperity. For Malaysia, the interaction between FDI and ï¬nancial development has a positive and important impact on economic growth. That's why the above discussion reflects that ï¬ndings are very much revealing and also there is need of case by case study for viewing of each unique characteristic of countries. With reference to Pakistan this study is important contribution for literature. In case of Pakistan the specific objective of present study is to examine the interactions between FDI and economic growth with development in ï¬nancial sectors.
The different sets of determinants have been investigated in the literature on the determinants of foreign direct investment. Many empirical studies [Agarwal (1980); Gastanaga et. al. (1998); Chakrabarti (2001) and Moosa (2002)] on the determinants of FDI show us to choose the sets of explanatory variables which are very much used and found to be important determinants of FDI. Such as [Markusen and Maskus (1999); Lim (2001); Love and Lage-Hidalgo (2000); Lipsey (2000) and Moosa (2002)] examined that how the size of domestic market and their differences in costs of factor can relate the FDI location. The foreign investors who operate in characterized industries with relatively large scale economies; the significance of size of the markets and its growth is much magnified. The reason is that they can exploit economies of scales only when the market obtains the certain size of threshold. The mostly used measures of size of markets are GDP, per capita GDP and growth in the GDP. These signs of coefficients are positive usually. Higher rate of productivity, hi-tech industries oriented with research in which there matters the quality of labor, prefer high quality of labor to cheap labor having low productivity. Now, some researchers have also analyzed the impact of variables of policy on FDI in the recipient countries. Those variables of policy include trade openness, tariff, taxes and exchange rate. Gastanaga, Nugent, and Pashamova (1998) and Asiedu (2002) focus on reforms of policy in developing countries as the determinants of FDI inflows. They find corporate rates of tax and degree of openness to FDI to be important determinants of FDI. Like many recent models show the effect of tariffs on FDI through the context of horizontal and vertical specialization within MNEs [Ether (1994, 1996); Brainard (1997); Carr, Markusen, and Maskus (2001)]. The horizontal FDI can be related with market seeking behavior and motivated towards by lower costs of trade. So that high rates of tariff barriers induce firms to be in horizontal FDI, and hence to replace exports with the production of abroad by foreign affiliates this is "tariff jumping" theory which implies the positive interaction between import duty and FDI. Besides of that a typical vertical FDI can be characterized by the individual's affiliations sp in different stages of output production. The products of semi finished, discussing the cost of labor which is one of the big components of function of cost, it is noted that high rate nominal wages, and other things equal to it, deters the FDI. This must be especially true for the firms, which are in activities of labor intensive production. This is why; conventionally the expected sign of that variable is negative. The studies that find no importance and a negative relationship of wage rate and FDI are: [Kravis and Lipsey (1982), Wheeler and Mody (1990), Lucas (1993), Wang and Swain (1995) and Barrell and Pain (1996)]. Besides of that, there are many other researchers who have investigated that higher rates of wages do not always deter FDI in all industries and have a positive impact on relationship between costs of labor and FDI [Moore (1993) and Love and Lage-Hidalgo (2000)]. Because higher wages shows in turn, and are exported to other affiliated for processing it further. The process of production, parent firms who are affiliates take advantage of factor price differentials across different countries by fragmenting. The MNEs, which imply the vertical networks of production, may be motivated to invest in a country with relatively low rates of tariff barriers due to the lower cost of their intermediate imported products. Resulting this, the expected sign of variable of import duty is negative. With the decrease in tariff rate because of trade liberalization in the developing countries, now imports have increased by MNC's. Khan (1999) show that imports have raised by MNC's as trade is now being liberalized for Pakistan within recent structural reforms. For investors of foreign the fiscal incentives and taxation structure is very significant. The tax rate affects the projects of investment profitably. Reasoning foreign investors locates where taxes are declining. Different tax break regimes are sometimes offered to multinationals like an incentive to attract FDI inflows. Empirical studies showed the negative relationship between taxes and the locational businesses [Newman and Sullivan (1988), Gastanaga, et al. (1998), Billington (1999), Shah and Masood (2002) and Campa (2002)]. On the other side Carlton (1983), Hines and Rice (1994) and Hines (1996) fount that there is no support on the impact of taxes on FDI.
Swenson (1991) empirically finds an effective positive effect of taxes on inward FDI Interestingly. Just like the effect of movements of exchange rate on FDI flows is a fairly good studied topic, except of that the direction and magnitude of influence is in distance from certain. Froot and Stein (1991) argued that a depreciation of the recipient currency should raise FDI into the recipient country, and with that an appreciation of the host currency should lower the FDI. Love and Hidalgo (2000), also studied that the lagged exchange rate variable is positive which shows that a depreciation of US direct investment of the peso encourages in Mexico after some time similarly. Differentiating to Froot and Stein (1991), Campa (1993), while investigating firms of foreign in the US puts forth their hypothesis that is an appreciation of the recipient currency will in fact rise in FDI into the recipient country that analyze that an appreciation of the recipient currency raises the expectations of profitability in terms of the home currency in future.
Many studies have been conducted by different researchers to show the importance of FDI. That's why the review of few some important studies is that context is explained. For the period of 1973 to 2004, Yousaf et al (2008) researched with the use of annual time series data. Some influencing factors for FDI are GDP deflator, real GDP, exports volume and imports volume, unit value of exports and imports and FDI as a percentage of GDP used in this study. This study found that in the case of import model and FDI there exist the short run and long run positive association between real imports of demand, but in the case of model of export, they analyzed that there is short run negative relationship exists in FDI and real exports, but it is positive in long run. For the period of 2000 to 2004 Demirhan and Masca (2008) used the cross sectional data of 38 developing countries to find out the determinants of FDI in developing countries. They used econometric model for their study and examined that per capita income,rate of growth, main telephone lines existence, and openness of trade have effectively positive impact on FDI inflows. Rate of inflation and tax also attract significantly FDI similarly with negative sign. On the other side, in developing countries they saw that risk and cost of labor is very insignificant to FDI inflows. Surge et al. (2008) used to study on Determinants of FDI inflows into Rwanda with use of time series data for the period of 1971 to 2003. After that they concluded that growth rate and openness of trade are statistically found significant with positive sign, which attracts the investors of foreigners. Exchange rate is statistically also found significant with negative sign. But rate of inflation was found insignificant statistically with negative sign in this study. Kolstad and Villanger (2008) analyzed their study to investigate the determinants of FDI in Service industry by using 57 countries industries FDI data in the period 1989 to 2000. Results show significance between market size to service FDI, but openness of trade is insignificant statistically to FDI inflows. This study also shows that FDI in sector of manufacturing, in finance and transport sectors are very strongly associated. Khondoker (2007) conducted his study to examine the factors, which determine the FDI inflows for developing countries and to conclude the correlation in FDI and economic growth. Panel data was used for this study of 60 countries having low income for the year of 2003, 2004 and 2005. Results show that developing countries can have capacity to attract more FDI if their GDP is high and growth rate is also high, there are friendly investment policies and good established communication system. Moosa and Cardack (2006) analyzed that Determinants of FDI. They used cross sectional data for their study and also applied extreme boundaries analysis of 136 countries in the year of 1998 to 2000. The variables which were used in this study was real GDP, GDP growth rate (CGD), EXP (export as a percentage of GDP), TEL (telephones lines), ENG (commercial energy), DIG (domestic gross fixed capital formation), TER ( students as in tertiary education like a percentage of total population) and CRK (country risk). They examined that countries which have large economies, high degree of openness of trade and low country risk can attract more and more FDI to their countries. They also explored that real GDP, rate of growth, energy consumption and domestic gross fixed capital formation etc boost up FDI inflows insignificantly. For the period of 1961 to 2000 Shah and Ahmed (2004) conducted their research through the use of time series data. They concluded that there is long term association have been existing in FDI flows and factors consisted on political stability, market size, cost of capital, expenditures of transport and communication in Pakistan. Campos and Kinoshita (2003) study is consisted on 25 transition economies for the year of 1990 to 1998. The examined that in those countries, FDI is affected by size of market, clusters of economy, low cost of labor and the availability of natural resources. Results also show that sound institutions, openness of trade and low degree of restrictions to FDI inflows are very much significant. Holland et al. (2000) suggested that market size and growth prospective are the significant determinants of FDI.
There are many studies which examined only economic variables, but with that social and political variables have been neglected or given limited attentention (Schneider and Frey, 1985). Such as, Hanson, (1996) studied that human capital is an important indicator about the availability of a skilled work force or labor force and is also a significant determinant of the location advantage of a recipient country. Tallman (1988) found that there are positive as well as significant results of political risk on the FDI but Akhtar (2000) found that political instability is insignificant in his analysis. Singh and Jun (1995) concluded the result empirically that social and political instability has its negative impact on investment flows. Quazi and Mahmud (2004) also found that there is significantly increase in FDI within increase in human capital inflow into South Asia, but political instability discourages it. Asiedu, (2005) findings suggests that there is negative impact of political instability on FDI to Africa. For sure, there are various social and political determinants of FDI but there would be only human capital and political risk be analyzed in the present study.
Human capital is an essential explanatory variable of FDI. Almost all multinational corporations (MNCs) obviously use to intend hire more skill work force or labor force in order to attain maximum profit. The number of researchers used human capital as their determinant of FDI and found various results. As Cheng and Kwan, (2000), found positive result and significant result. However, Banga, Ioannatos, (2003), found insignificant but positive results. A plant which is located abroad would want the opportunity to select workers or labors from educated pool. The level of workers quality would be very essential for firm that is locating in recipient country primarily to use their labor as a less expensive input or on lower wages than the labor in their home country. Such those firms located in a country to perform for that country's domestic market that would need to hire local labors and thus show a high quality of workers as their advantage. Taveira (1984) Schneider and Frey (1985) used the percentage of population for their study in secondary education, but they found no evidence which can be significance. In this study resulting expected positive relationship in between human capital and FDI inflows and utilizing the primary school enrollment as proxy for the level of human capital.
Political Instability: Jun and Singh (1996) claimed that political instability is consider as a qualitative phenomenon and the clear measurement of which is consider as complicated issue in terms of what investors would be perceiving as politically risky and also a constraint for their investment. Many econometric studies are frequently failed to create a relationship between political risk and FDI flows (Cahse et al., 1998). Lucas (1993) concluded that because of political risk, capital does not shift from developed countries to developing countries. Multinational corporations suggest a location that is economically and politically both stable for the investment. That's why a political stability of a country is considered as an important consideration for MNCs at the time of choosing the destination for their investment. The stable and safer environment will help to lower the risk for the MNCs (Poon, 2000). Akhtar (2000) shows that there is political instability in Pakistan which has been a frequent phenomenon. In this literature political Instability were measured through different variables that all are important variables such as number of riots and strikes and workdays lost etc. They have proved in some studies significant, although these quantitative estimations can capture only some of the qualitative aspects of nature of political instability. However, there is the non-availability of exact data on political risk when rating for Pakistan. In this study the political stability means about democracy in Pakistan etc. As it was argued that the democratic government is more important for foreign investors.
Khan (1997) studied about the factors which are responsible for lower level of FDI in Pakistan. The study identified that there are number of factors such as lack of political stability, law and order situation, economic strength, policies of government, government bureaucracy, local business environment, infrastructure of country, quality of labor force, quality of life standard and welcome attitude. Shah and Ahmad (2002) study concluded that fiscal policy and high return from the investment patterns have played an important role for attracting FDI in Pakistan. For the period of 1960-1999 a data set concluded that capital cost has strong impact on investment. The study was proposed to lower the cost and raise the returns of FDI to attract FDI in Pakistan. The determinants of FDI in Pakistan which are estimated by Shah and Ahmad (2003) for that they took market size, cost factor, political and social factors as determining variables of FDI. For the time period of 1980-1999, they applied OLS method and Co integration test and Error Correction Method (ECM) on their data. The model is a supply side model while they ignored the demand side aspects. However, Ahmed et al (2003) have conducted Granger's concept about the causality on the data for the year of 1972-2000, to see the effect of exports, production, domestic output, foreign income and rate of exchange on inflow of FDI in Pakistan. They analyzed that domestic output is very powerful determinant of FDI. The domestic output is all about micro level concepts, because of that Pakistan should stress on micro economic approach, therefore there would increase domestic output of international standard. Aqeel and Nishat (2004) have examined the determinants of FDI in Pakistan by focusing on tariff, rate of exchange, indexes of price, wages rate (as proxies of demands for labor) and GDP by using error correction model on the data for the year 1960-61 and to 2003-04. For South Asia, the determinants and trend of FDI are examined by Sahoor (2006). This study explored about that high rise in private capital flows to developing countries come but despite of that uncertainties is caused by high prices of oil, rising global rates of interest and globally growing payment imbalances. The increase in capital flows to developing economies was basically derived by abundant of global liquidities, steadily improvements in the credit quality of developing countries, lower of yield in rich countries, and lastly the expansion in interest of investors for emerging market assets. FDI linkages can also be analyzed through different ways like by the type of FDI, the strategy for transnational corporations, economic sector activity, and also by the group of different countries and their developmental level. There may be the numbers of different variables, which may determine the FDI in Pakistan and in other developing countries for example exports of goods and services, wages rate in per day, imported energy, energy prices, per capita debt and public aid, foreign income, rate of exchange, population of human, labor force quality, rate of inflation, tariffs rate, degree of openness for FDI, privatization, GDP growth rate, political conditions of country, political relationship between countries, credit rationing of the countries (such as measure of economical. political and institutional performances), infrastructure of countries, welcome attitude returns to FDI, GDP rate of domestic country and GDP rate of the donor country. They have included annual growth rate of GDP (like a measure of size of market), annual average rate of exchange, whole sale index of prices, custom duty on imports and export of goods as the explanatory variables which are affecting FDI in Pakistan.
Empirical studies which evaluate the determinants of FDI inbound are based on three approaches generally and these are econometric study which is micro oriented, survey analysis of data, and aggregate analysis of econometric. An important survey of the determinants of FDI which is based on different methodologies and concepts is provided in Pearce, Islam, and Sauvant (1992). Additionally with traditional economic variables for examples per capita GDP, GDP growth rate, and cost of wages, some antecedent factors which may enhance the flows of FDI include social and political variables. Although political risk is smoothly thought to influence the decisions for investment in another country the empirical findings do not encourage this hypothesis always. Aharoni (1966) investigated the executive's rank political instability like a most important variable, apart from the potential of market. Conversely, Bennett and Green (1972) analyzed that direct investments in U.S are not affected by political instability in the host countries. Levis (1979), found that there is the absence of aggressive domestic behavior in the political system against different groups and officeholders to be as a significant determinant of FDI for the current time period, although not for a lagged period. For a lagged time period another variable the legitimacy of the regime was found to be more significant but it was not significant for the current period.
Root and Ahmed (1979) did the discriminate analysis of 58 developing countries, they found that the number of constitutional(regular) changes in leadership of government for the period 1956 and 1967" was significant. Although other political variables, like the numbers of internal armed attacks, nationalism degree, colonial affiliation, was not significant. Schneider and Frey (1985) found that there is a negative relationship in the number of political strikes and riots in recipient countries and inflow of FDI. Nigh (1985) found the COBDAB database, which is used to construct aggregate measures of intra and Inter country, conflict and cooperation. He examined that for the developed countries inter country political events were much significant determinants of FDI than events of intra country. On other side, for developing countries political events of intra country had much robust relationship with FDI. Wheeler and Mody (1992) found broader principal component measure of the administrative efficiency more recently and political risk as insignificant statistically. Lucas (1993) does not incorporate proxies for social and political risk directly. However, he finds that episodic dummies for good events like the Asian and Olympic games in accession of Korea, and Aquino in the Philippines, as positively related to FDI. Negative events like rule of Sukarno in Indonesia, assassination of Park in Korea, and martial law of Macro in the Philippines have its negative effect on FDI.
Stephen Kobrin (1981) observed that the term oolitical risk appears as constrained from an analytical and operational viewpoint both more than ten years ago. What we are, or what we should be concerned with, is all about the impacts of events which are political in the sense that all these arise from authority or power relationships after that which affect (or have stamina to affect) the operation of firms. Not the events or quarterly events, although their potential manifestation like constraints upon the foreign investors should be concerned. The empirical evidences shows that there is not unequivocal on the impact of political risk, because it is very difficult to achieve the reliable quantitative estimations of this qualitative phenomenon partly to an extended time period, political risk aspect particularly that are viewed like direct constraint by foreign investors. Political instability is considered as a complex phenomenon. Valuable mostly proxies are available and capture only for some aspects of this determinant.
Chakrabarti (2001) and Moosa, 2002) guide us to select the set of explanatory variables on the determinants of FDI that are broadly used and also found to be very significant determinants of FDI. Such as Markusen and Maskus (1999), Lim (2001), Love and Lage-Hidalgo (2000), Lipsey (2000) and Moosa (2002) find that how the domestic size of market and its differences in costs of factors can relate for the location of FDI. For foreign investors that operate in industries which are characterized by the relatively large scale economies, the significance of the market size and its growth rate is magnified. Through that they can exploit economies of scales only when the market achieves a particular size of threshold. The mostly used measures of size of market size widely are GDP, per capita GDP and growth rate in GDP. All these coefficients are usually have positive signs. Discussing about labor c