Pakistan Institute of Development Economics, Islamabad

The Determinants of Foreign Direct Investment in Pakistan [with Comments]

Author(s): Anjum Aqeel, Mohammed Nishat and Faiz Bilquees
Source: The Pakistan Development Review, Vol. 43, No. 4, Papers and Proceedings PART II
Twentieth Annual General Meeting and Conference of the Pakistan Society of
Development Economists Islamabad, January 10-12, 2005 (Winter 2004), pp. 651-664
Published by: Pakistan Institute of Development Economics, Islamabad
Stable URL: https://www.jstor.org/stable/41261019
Accessed: 30-10-2019 06:22 UTC

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The Pakistan Development Review
43 : 4 Part II (Winter 2004) pp. 651-664

The Determinants of Foreign Direct

Investment in Pakistan

Anjum Aqeel and Mohammed Nishat

1. INTRODUCTION

The significance of foreign direct investment (FDI) flows is well documen

in literature for both the developing and developed countries. Over the last de
foreign direct investment have grown at least twice as rapidly as trade M
(2003). As there is shortage of capital in the developing countries, which need ca
for their development process, the marginal productivity of capital is higher in
countries. On the other hand investors in the developed world seek high return
their capital. Hence there is a mutual benefit in the international moveme
capital.
The ongoing process of integration of the world economy and liberalisation of
the economies in many developing countries have led to a fierce competition for
inward FDI in these countries. The controls and restrictions over the entry and
operations of foreign firms in these countries are now being replaced by selective
policies aimed at FDI inflows, like incentives, both fiscal and in kind. The selective
policies not only improve the fundamentals of the economy but they aim at attracting
more foreign investments in the country.
Accordingly during early 1980s, the government in Pakistan has initiated
market-based economic reform policies. These reforms began to take hold in 1988,
and since than the government has gradually liberalised its trade and investment
regime by providing generous trade and fiscal incentives to foreign investors through
number of tax concessions, credit facilities, and tariff reduction and have also eased
foreign exchange controls Khan (1999). In the 1990s, the government further
liberalised the policy and opened the sectors of agriculture, telecommunications,
energy and insurance to FDI. But, due to rapid political changes and inconsistency in
policies the level of FDI remained low compared to other developing countries.

Anjum Aqeel is Research Economist/ Assistant Professor, Applied Economics Research Centre,
University of Karachi, Karachi. Mohammed Nishat is Professor and Chairman, Economics and Finance,
Institute of Business Administration, Karachi.

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 652 Aqeel and Nishat

Nevertheless, the time series data on FDI in

progress over time particularly during the r

Table 1

FDI in Pakistan
Averages

FDI Inflows in Million $ 18.00 88.83 500.27 305.10 385.40 823.00 1405.33
FDI Stock as % of GDP 3.06 8.93 11.31 9.68 9.99 10.66
FDI Inflows as %ofGFCF 8.89 16.54 54.93 3.62 5.01 10.32 15.42
Source: UNCTAD Data online.

Extensive empirical literature on determinants of inward FDI emphasises the

economic conditions or fundamentals of the host countries relative to the home
countries of FDI as determinants of FDI flows. This literature is in line with
Dunning's eclectic paradigm (1993), which suggests that it is the locational
advantages of the host countries e.g., market size and income levels, skills,
infrastructure and political and macroeconomic stability that determines cross-
country pattern of FDI. Following this approach Nishat and Anjum (1998), have
estimated that political stability, peaceful law and order situation, level of technical
labour force and mineral resources and liberal policies of the government attracted
foreign investors in Pakistan.
However, it has been argued that the location specific advantages sought by
foreign investors are changing in the globalised more open economies of today.
Accordingly, in his path breaking work Dunning (2002) finds out that FDI from
more advanced industrialised countries depends on government policies, transparent
governance and supportive infrastructure of the host country. However, very few
studies exist that have empirically estimated the impact of selective government
policies aimed at FDI.
The present study adds to the existing literature by empirically examining the
response of FDI to selective policies, namely tax and tariff policy, fiscal incentives
offered and exchange rate policies in Pakistan. More specifically, the objective of
this study is to find out the effectiveness of these policies during the reform period.
From this study we would be able to see which specific government policy is
attracting or distracting FDI in Pakistan. This study would be of interest to policy
makers in many developing countries where structural reforms are being
implemented.
The rest of the paper is organised that Section 2 reviews the literature and
describes the theoretical framework. Section 3 describes the econometric model and
data followed by estimation and interpretation of results in Section 4. The summary
and concluding remarks are provided in Section 5.

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 The Determinants of Foreign Direct Investment 653

2. LITERATURE REVIEW AND THEORETICAL FRAMEWORK

An extensive set of determinants has been analysed in the literature on

determinants of FDI. Numerous empirical studies [Agarwal (1980); Gastan
al. (1998); Chakrabarti (2001) and Moosa (2002)] on the determinants of FDI lea
to select a set of explanatory variables that are widely used and found
significant determinants of FDI. For example [Markusen and Maskus (199
(2001); Love and Lage-Hidalgo (2000); Lipsey (2000) and Moosa (2002)] hig
how the domestic market size and differences in factor costs can relate to the

location of FDI. To foreign investors who operate in industries characterised by

relatively large economies of scale, the importance of the market size and its growth
is magnified. This is because they can exploit scales economies only after the market
attains a certain threshold size. The most widely used measures of market size are
GDP, GDP/capita and growth in GDP. The signs of these coefficients are usually
positive.
Discussing the labour cost which is one of the major components of the cost
function, it is mentioned that high nominal wage, other things being equal, deters
FDI. This must be particularly true for the firms, which engage in labour-intensive
production activities. Therefore, conventionally, the expected sign for this variable is
negative. The studies that find no significant or a negative relationship of wage and
FDI are: [Kravis and Lipsey (1982); Wheeler and Mody (1990); Lucas (1993); Wang
and Swain (1995) and Barrell and Pain (1996)]. Nonetheless, there are other
researchers who have found out that higher wages do not always deter FDI in all
industries and have shown a positive relationship between labour costs and FDI
[Moore (1993) and Love and Lage-Hidalgo (2000)]. Because higher wages indicate
higher productivity, hi-tech research oriented industries in which the quality of
labour matters, prefer high-quality labour to cheap labour with low productivity.
Recently, a few researchers have also studied the impact of specific policy
variables on FDI in the host countries. These policy variables include openness of
trade, tariff, taxes and exchange rate. Gastanaga, Nugent, and Pashamova (1998) and
Asiedu (2002) focus on policy reforms in developing countries as determinants of
foreign direct investment inflows. They find corporate tax rates and degree of
openness to foreign direct investment to be significant determinants of FDI.
Similarly many recent models highlight the effect of tariffs on FDI within the context
of horizontal and vertical specialisation within MNEs [Ether (1994,1996); Brainard
(1997); Carr, Markusen, and Maskus (2001)].
The horizontal FDI can be associated with market seeking behaviour and is
motivated by lower trade costs. Hence high tariff barriers induce firms to engage in
horizontal FDI, and thus, replace exports with production abroad by foreign affiliates
This "tariff jumping" theory implies a positive relationship between import duty and
FDI. While a typical vertical FDI can be characterised by individual affiliates
specialising in different stages of production of the output. The semi-finished products,

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 654 Aqeel and Nishat

in turn, are exported to other affiliates fo

production process, parent firms and a
differentials across countries. The MNEs, w
may be encouraged to invest in a country wi
cost of their imported intermediate produ
duty variable is negative in this case. Wit
liberalisation in the developing countrie
Pakistan, Khan (1999) confirms that impo
being liberalised as a result of the recent stru
For foreign investors the fiscal incen
important. The tax rate affects the profi
foreign investors seek locations where tax
often offered to multinationals as an ince
studies indicated a negative relationship be
[Newman and Sullivan (1988); Gastanaga
Masood (2002) and Campa (2002)]. On th
Rice (1994) and Hines (1996) found no
Interestingly, Swensen (1991) empirically f
on inward FDI.

Likewise the effect of exchange rate movements on FDI flows is a fairly well
studied topic, although the direction and magnitude of influence is far from certain.
Froot and Stein (1991) claimed that a depreciation of the host currency should
increase FDI into the host country, and conversely an appreciation of the host
currency should decrease FDI. Similarly, Love and Hidalgo (2000), also
acknowledge that the lagged variable of exchange rate is positive which indicates
that a depreciation of the peso encourages US direct investment in Mexico after
some time. Contrary to Froot and Stein (1991); Campa (1993), while analysing
foreign firms in the US puts forth the hypothesis that an appreciation of the host
currency will in fact increase FDI into the host country that suggests that an
appreciation of the host currency increases expectations of future profitability in
terms of the home currency.

3. ECONOMETRIC MODEL SPECIFICATION AND DATA

In the light of above discussion following model is formulated to deter

the impact of various types of selective government polices and other variab
attract FDI in Pakistan during 1961-2002:

FDIt =f(GDPt, WAGEt,, TARI Ft , TAXt, CREDITt , EXt, INDEXt, DUMlt, DUM

where

FDI = Growth in FDI inflows(deflated by GDP deflator).

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 The Determinants of Foreign Direct Investment 655

GDP = Log of GDP/Capita.

WAGE = Log of Average Annual wages of factory workers in perennial
Industries (deflated by GDP deflator).
TAX = Corporate Tax as a ratio to total Tax.
TARIF = Ratio of custom duties to total value of imports.
CREDIT = Share of credit of the private sector in total credit to public and
private sectors.
EX = Average Annual Exchange Rate as rupees/$.
INDEX = Log of General Share Price Index.
DUMI = 1 for the period 1972 to 2003, 0 otherwise.
DUMI = 1 for the period 1989 to 2003, 0 otherwise.

We expect that the coefficient of GDP would be positive because foreign

investors are only interested where there is a big market of their product. The
coefficient for WAGE would be negative as there is low level of skilled labour force
in Pakistan and only labour intensive FDI would be forthcoming as wages are low. It
has been observed that as trade is being liberalised and tariffs are being eliminated
on the import of machinery, FDI has increased in Pakistan. Therefore, we expect a
negative relationship between FDI and TARIF. As credit to foreign investors is an
investment incentive, we expect a positive sign for coefficient of CREDIT. The
coefficient for exchange rate (EX) is ambiguous in many studies. As it could be
positive if foreign investors are considering it as lower cost of capital and negative if
they are expecting a higher return on their investments. A positive sign for INDEX
suggests that the foreign investors are concerned with the investment climate of the
country. However, if the sign of INDEX is negative it could be interpreted that the
government pursues policies to attract FDI when capital market is sluggish. The data
used in the empirical investigation covers annual data for the period from 1961 to
2003. The data of FDI is collected from various issues of "Assets, Liabilities and
Foreign Investment" published by State Bank of Pakistan. The exchange rate is
extracted from the electronic data of "International Financial Statistics". The data of
all the other variables are from "50 Years of Pakistan" and various issues of
"Pakistan Statistical Year Book" published by Federal Bureau of Statistics,
Government of Pakistan.

4. ESTIMATION AND EMPIRICAL RESULTS

To investigate the nature of any long-run relationship between FDI inflows and
the variables suggested in our model, we now proceed to examine whether the seri
are cointegrated, implying that any deviations from any long run equilibriu
relationship that exists between them will themselves be stationary. Unless series ar
cointegrated, there is no equilibrium relationship between variables and inference
worthless. Our justification for employing the techniques of co-integration in thi

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65 6 Aqeel and Nishat

instance amount to two related reasons; Fir

integrated, allows for the use of error-correctio
out of long run and short run impacts; see Alo
presence of co-integration between two varia
levels yields consistent parameter estimates; E
effect signify whether there is a stable long run
empirical work by Dickey, Jansen and Thorn
(1988) maximum likelihood estimator of a
superior. Testing for cointegration using a sing
than one cointegrating relationship is present
variables to be 1(1) and some 1(0) [see Cheng a

4.1. Unit Root Test

To test for Cointegration, we first verify that all the above-mentioned variables
that we expect to be cointegrated with growth in FDI flows are each individually 1(1).
In this section we perform unit root tests for stationarity on the levels and the first
differences of all eight variables. The Phillips Perron unit-root test with trend show the
existence of unit roots at 3 lags (Table2), and therefore non-stationarity, in the levels of
some variables (TARIF, TAX, CREDIT, IIDEX, GDP and WAGE). However, the first
differences of these six variables are stationary at 1 percent significance level. Hence
we conclude that these variables are integrated of order 1. The FDI is stationary at the
level, and is therefore an 1(0) variable. The variable EX is stationary in levels with out
trend and stationary at first difference with trend.

Table 2

Phillips-Perron Unit Root Test

FDI -6.27*
TARIF -2.30 -5.53*
TAX -3.06 -7.85*
CREDIT -2.75 -6.69*
EX 1.06 -5.82*
INDEX -2.23 -6.47*
GDP -4.02 -10.51*

WAGE

* Significan
** Significa

4.2. Estim
In order
the prev

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 The Determinants of Foreign Direct Investment 657

undertaking the cointegration tests, we first specify the relevant order of lags (
the vector autoregressions (VAR) model.
Since the sample size is relatively small, we select 1 for the order of the VA
[Pesaran and Pesaran (1997)]. The results of rank and trace statistics obtained fr
the Johansen-Juselius (JJ) method using the assumption of linear deterministic t
in the data are presented in Table 3. The trace and the rank tests suggest r = 1
and 10 percent significance levels respectively. Therefore, our annual data appe
support the proposition that in Pakistan there exists a long-run relation betwe
growth of FDI and its determinants. The normalised cointegrating vector has b
reported in Table 4 for reference.

Table 3

Johansen 's Cointegration Test Results

Alternative Alternative Trace Test Rank Test

Null

r = 0 r>' r=' 160.97** 48.42***

r<' r>2 r = 2 112.55 39.837
r<2 r>3 r = 3 72.71 23.391
r<3 r>4 r = 4 49.32 21.48
r<4 r>5 r = 5 21 M 12.89
r<5 r>6 r = 6 14.95 9.25
r<6 r>l r = l 5.70 5.09

r<l

** Signif
*** Signi
See Lenu

Table 4

Normalised Long-run Cointegration Equation

Cointegrating Equation Cointegrating Equation 1
FDICG(-l) i
TARIF(-l) -32.56
-17.80

TAX(-l) -11.80
-5.56

CRERR(-l) 7.37
2.65

EXAVG(-l) -0.39
-10.70

GINDL(-l) -0.85
-3.99

GDPCPLC-l) 26.47
16.17

WAGCU-l) 0.18
0.78

_C

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 65 8 Aqeel and Nishat

4.3. Estimation of an Error-correction Model

After confirming the long run relationship among the variables, we can
proceed to model the short run adjustment behaviour of the variables as further
confirmation of our results. Following Love and Lage-Hidalgo (2000), we can
choose to estimate the short run VAR in error correction form (VECM). The VECM
model is intended to describe the short-term dynamics of growth of FDI inflows in
Pakistan. This type of model explains the immediate short-term changes in
dependent variable by means of deviations from a particular equilibrium relationship
between the dependent variable and the explanatory variables. The common
approach is to reformulate the long run relationship to include lagged values of first
differences in the relevant variables with the error correction term explicitly
included.

So now we use deviations from the cointegration relation estimated in the

previous section as the error-correction term when building the ECM. Two error
correction models with and without dummies are estimated to distinguish the
behaviour of foreign direct investment during non-reform and reform periods. In
particular, two dummies are used to reflect the changes in the government measures,
which could have affected the growth of FDI. One DUMI reflects the structural
break reflecting a massive devaluation of rupee of about 58 percent in 1972, it takes
the value of 1 for 1972 and onwards and the other DUM2 which reflects the
liberalisation measures taken under the structural reforms of 1988, takes the value of
1 for 1989 and onwards.1 The results of estimation of the ECMs are shown in Table
4.The lags of the explanatory variables are chosen in according to Akaike
Information Criteria and indicate lags upto two periods.

4.4. Interpretation of Empirical Results

The analysis of the results of these two ECM models presented in Table 5
suggests that model 2 has more explanatory power with adjusted R2 = 0.84, and
satisfies the relevant diagnostic checks for serial correlation, functional form, non-
normality and heteroscedasticity and thus has the desirable properties for OLS
estimation. The results of model 2 indicate that the error correction coefficient,
estimated at -1.87 is statistically significant at the 1 percent level, has the correct
sign, and suggests a good speed of convergence to equilibrium. As indicated all the
variables except the average wage and index of general share prices are statistically
significant and have the expected signs. The insignificant behaviour of stock market
index indicates that during the study period the stock market is not contributing in
explaining the growth in FDI inflows in Pakistan. Furthermore, the lagged dependent
variable included in the error-correction model has positive sign and is statistically

'Dummy for the period 1998 and onwards for nuclear test was also tried but indicated statistically
insignificant impact on FDI.

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 The Determinants of Foreign Direct Investment 659

Table 5

Vector Error-correction Models

Error-correction: D(FDICG) D(FDICG)

CointEql -1.36* (-4.34) -1.87* (-9.85)
D(FDI(-1)) 0.38 (1.48) 0.42* (3.10)
D(FDI(-2)) 0.30 (1.36) 0.19 (1.62)
D(TARIF(-1)) -35.67** (-2.46) -21.34** (-2.64)
D(TARIF(-2)) -25.68 (-1.60) -16.06 (-1.67)
D(TAX(-1)) 28.91 (1.20) -47.74* (-3.38)
D(TAX(-2)) 6.88 (0.30) -36.22** (-2.59)
D(CREDIT(-1)) -1.16 (-0.05) 48.69* (3.37)
D(CREDIT(-2)) 45.94** (2.22) 43.82* (3.70)
D(EX(-1)) -0.55 (-1.02) -0.65*** (-2.00)
D(EX(-2)) 1.47*** (2.05) -0.64 (-1.53)
D(INDEX(-1)) -5.81*** (-1.88) -1.70 (-0.91)
D(INDEX(-2)) 2.45 (0.89) -2.49 (-1.44)
D(GDP(-1)) 53.23* (3.08) 35.84* (3.69)
D(GDP(-2)) -14.05 (-0.69) 23.11*** (1.87)
D(WAGE(-1)) -3.16*** (-1.81) -1.30 (-1.34)
D(WAGE(-2)) -4.00*** (-1.73) 0.01 (0.01)
С -1.79 (-1.54) -15.95* (-9.09)
DUM2 6.71* (6.39)
DUMI 16.88* (13.40)
fl-squared 0.72 0.92
Adj.fl-squared 0.50 0.84
RESET 0.71 (0.409) .04 (0.85)
LM 3.51 (0.050) 0.99 (0.39)
WHITE 2.96 (0.149) 1.11 (0.58)
JGB

* Significant at 1 perc
** Significant at 5 per
*** Significant at 10 p

significant. This m
by the previous
"clustering effec
tariffs and cor
Moreover, the coe
appreciates, FDI
expect high retu

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660 Aqeel and Nishat

indicates that devaluation had decreased the cost of assets in Pakistan and
attracted foreign investment or perhaps since the data on FDI is in rupees, there
is just a nominal jump in the data. Additionally, encouraging private sector
through its generous credit policy would accelerate the growth of FDI. More
importantly, the statistical significance of our dummy DUM2 reinforces our
results that the liberalisation measures taken to attract FDI have positive impacts
on the growth of FDI in Pakistan.

5. SUMMARY AND CONCLUDING REMARKS

The paper empirically identifies the determinants of growth in fore

direct investment (FDI) in Pakistan over the period 1961 to 2003. Our ma
interest is to study how different variables or indicators reflecting trade, fisc
and financial sector liberalisation attract FDI in Pakistan. The study uses
Cointegration and error-correction techniques to identify the variables
explaining the FDI in Pakistan. The study considers the tariff rate, exchange ra
tax rate, credit to private sector and index of general share price variables if t
explain the inflow of foreign direct investment. Also included are wages and p
capita GDP to test for relative demand for labour and market size hypoth
All variables indicated correct signs and are statistically significant except
wage rate and share price index. The study clearly emphasises the role of t
policy variables in attracting FDI and determining its growth in both short
long run in Pakistan. The study also indicates a positive and significant impact
reforms on FDI in Pakistan.

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Comments

Analysis of all aspects of foreign direct investment is essential. Therefore this

paper is very timely and useful. The authors must be appreciated for their continued
interest in the determinants of FDI, as they have already published a paper on this
important issue in 1999. It is interesting to see that they have utilised their survey of
literature to divide the relevant variables very systematically into two papers.
In this paper two variables in particular need to be discussed. One is the use of
dummy variables, and second the variable of general share price index. They have
used two very extended dummies: one for 1972-2003 and the other for 1989-2003.
The positive coefficient of the first dummy is interpreted to indicate that devaluation
had decreased the cost of Pakistani assets which attracted foreign direct investment.
That may be so, but it is quite strange that they ignore the Nationalisation of 1972
which has haunted even the domestic investors for a long time.
Another important period with reference to FDI was the year 1991 when
foreign investors were given complete freedom to choose entities of investment,
repatriation of profits and capital, raising of equity in the domestic markets etc. This
was followed by another important event - the imposition of sanctions on Pakistan in
1998. The authors would agree that the sanctions swallowed any benefits accruing
from the 1991 liberalisation of FDI. Therefore it is suggested that a more appropriate
dummy would be for 1991-1998, and/or 1998 onwards.
In case of the share price index we need me to refer to the earlier paper since
this is a common variable in both the papers. In the earlier paper covering the period
1963-94 this portfolio investment variable is defined as the indicator of a stable
environment in terms of law and order and political stability, and its positive sign is
interpreted to attract FDI. In this paper on page 4 it is said that if the sign of the
index is negative it indicates that the government pursues policies to attract FDI
when capital market is sluggish. However on page 6, in the interpretation of results
the negative sign of index is not analysed, it is simply reported to be against the
expectations.
There is some confusion about this variable and we need to discuss this. With

regard to the positive sing of the index, portfolio investment need not stay put in a
country even if the law and order situation is ideal if profits elsewhere are higher.
How would it affect the FDI in that case?

In case of a negative sign consider this; portfolio investors are very shrewed -
not only they move out simply because profits are higher elsewhere, they would also
move in when the market is sluggish to earn higher profits later. So sluggish market

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 664 Fmz Bilquees

may indirectly help the inflow of c

take it to be a strong determinant of
Therefore, portfolio investment w
one interpretation, and that mak
indicator of political stability or law
in or out so easily as the portfolio
DAWN this morning despite the
Balochistan, killings in Gilgit, block
Exchange is continuously rising set
brokers who have defined it to be g
investment index cannot be a good i
There is also some confusion abou
is said that the wage coefficient wo
skilled labour force in Pakistan
forthcoming. On page 6 in the sectio
also reported as the unexpected sign
not clear as to what is implied by la
the rest of the paper, it would be usef
The econometrics reported in the
it is not clear why the outcomes of
trends are reported but neither is e
with the intercept, if the trend is in
intercept is also insignificant you ap
Since there is no justification for tes
this issue, the authors need to co
Phillips Perron test you do not exp
Thirdly, in the same table the FDI is
use co-integration you require all var
After Table 3 the authors should
long run, but for some reason they s
However in these short-run equatio
which is not in the normal range (0
I hope these comments and queri
paper.

Faiz Bilquees
Pakistan Institute of Development E
Islamabad.

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