Paper 4 Growth FDI and Exports in Pakistan
Paper 4 Growth FDI and Exports in Pakistan
Paper 4 Growth FDI and Exports in Pakistan
Abstract
Most of the empirical work has identified openness with trade to
analyze the impacts of outward-oriented policies in developing
countries. The exports promote both growth and foreign trade,
and foreign direct investment is one of the important factors of
foreign trade. Therefore, this study analyses the long run co-
integrating relationship among foreign direct investment,
exports and GDP. The result shows that long run relationship
exists between growth and exports but not with FDI. Therefore,
FDI is not a significant determinant of growth in the long run.
This study also analyses the causality among these variables in
the short-run, FDI is also not affecting the growth, but growth
affects both FDI and exports. Moreover, export and FDI are
also not significantly influencing each other in the short-run.
I. Introduction
A large numbers of empirical studies have analysed the impacts of
foreign direct investment (FDI) and exports on economic growth. Most of the
studies focussed the export-led-growth hypotheses (ELG) to analyze the
relationship between exports and growth. The ELG hypothesis (ELG)
suggests a positive correlation between export and growth, and also
considered exports as a main determinant of overall economic growth.
Because export sector; generates positive externalities through more efficient
management and improved production techniques (Feder, 1982), increase
productivity by offering potential for scale economies and alleviate foreign
exchange constraints and greater access to international market. Therefore,
export-oriented policies always positively contributed to economic growth.
The Growth rates attained by the South-East Asian tigers since the mid 1960s
(higher than those achieved elsewhere in the world) are normally cited as the
1
The authors are Assistant Professors at Department of Economics, Forman Christian College
(A Chartered University), Lahore. E-mail: ghulamshabbir@fccollege.edu.pk
Shabbir and Amjad
best example for the success of the ELG strategy. These export oriented
policies not only increased the trade but also foreign direct investment.
The flow of FDI to was significantly increased during the decades of
1980s & 1990s, and is considered as an important source of advanced
technologies for the recipient countries (Barrell and Pain 1997, Cuadros 2001
and Henrik et al 2004). The FDI has grown at least twice rapidly as trade
(Meyer, 2003). The very first reason for this increase is the shortage of capital
in developing countries that leads to higher marginal productivity of capital in
these nations. The second reason is capital owner’s desire for higher return on
their capital. According to Borensztein et al, (1998), FDI played a key role in
the technological progress of the recipient countries. Besides this, FDI also
effects economic growth by generating productivity spill over. Blomstrom
(1986) found that FDI has positive significant spillover effects on the labour
productivity of domestic firms and growth of domestic productivity in
Mexico.
The developing countries have changed their strategies from import
substitution to export-orientation. These policies were in line with the body of
literature, created to examine the determinants of exports & FDI and their
impacts on economic growth. The FDI has multi-dimensional issues that
include trade, employment, cost of production etc2. The inward FDI not only
stimulate the local investment but also increase the host country’s export
capacity. Therefore, liberalization policies of developing countries increased
their trade as well as inflow of FDI (Goldberg and Klien, 1999).
Pakistan has also followed the export-oriented policies and reframed
its commercial policy towards fewer and fewer controls. The tariffs rates were
reduced to enhance the degree of openness. These policies have significantly
affected the infow of FDI and it reached to $500.27 million in the decade of
1990s as compared to $88.83 million in the decades of 1980s. These
liberalization policies further enhanced the inflow of FDI that reached to
$3.52 billion in 2005-2006, $5.14 billion in 2006-2007 and $5.41 billion in
2007-2008. But poor economic performance and terrorist’s activities badly
affected the flow of FDI. The FDI was suddenly dropped to the level of $3.72
billion in 2008-09 and $1.72 billion in 2009-10. This reduction in FDI was
53% as compared to previous year and 68% as compared to its highest value
in 2007-08. The main sectors that have shows largely reduction in FDI were
2
See, Freenstra and Hanson (1997).
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Growth, FDI and Exports in Pakistan
3
Pakistan Economic Survey (various issues).
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Therefore, growth augmenting FDI and its positive relation with market size
created a bi-directional behaviour between two variables FDI and GDP. This
bi-directional behaviour also becomes the cause for simultaneity bias between
these two variables. In contrast, Charkovic and Levine (2005) have shown
either insignificant or negative impact of FDI on growth. This might be due to
crowding out effect of FDI on domestic capital.
A similar two-way causality discussion exists in empirical literature
for exports and GDP. The first way makes export led growth hypothesis
(ELG), while the other way is also equally appealing hypothesis that GDP
growth leads to exports growth also. According to Shiva and Somwaru
(2004), argued that export growth leads to increase in factor productivity. This
might be result of gains acquired from increasing returns to scale. Moreover,
export’s growth enhances the foreign exchange reserves that make possible to
increase the import of capital/technology-intensive intermediate inputs. The
rises in exports also enhance the efficiency of exporters and make them able
to compete in foreign markets. This practice results in domestically
improvement in technology and grooming of domestic entrepreneurs. The
open trade regime supports the inflow of better technologies that lead to better
investment environment (Grossman and Helpman, 1991). This hypothesis is
further supported by the findings of studies like Giles and Williams (2000)
and, Ahmad, Alam and Butt (2004).
On the other hand, Jung and Marshal (1985) supported the second
hypothesis and suggested that in a growing economy, the process of
technological change and learning are not the results of government’s export
promotion policies. This process might be the result of human capital
formation, cumulative productive process, transfer of technology via direct
investment or physical capital accumulation. This increased growth leads to
increase in the production of goods and if domestic market not able to absorb
it. Then, exporters look outward to sell this increased output. This implies that
increased growth leads to increase in exports. This causal relationship
becomes negative if increased output result in decrease in export instead of
increase. This might be due to domestically increased consumers demand for
these exportable goods.
At last, there exists a third bi-directional causality between FDI and
export. According to Hsiao and Hsiao (2006), exports increase the inflow of
FDI. This might be through paving the way for FDI by gathering information
about the host country that helps in reduction of investors’ transaction costs.
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Growth, FDI and Exports in Pakistan
The FDI also become the source of reduction in exports by serving the foreign
markets through establishing production facilities there. Therefore, Petri and
Plummer (1998) argued that it is not clear whether causality runs from FDI to
exports or exports to FDI. Some studies have also mentioned other aspects of
FDI like Gray (1998) pointed out market seeking FDI or efficiency seeking
FDI, Kjima (1973) mentioned whether FDI is trade oriented or anti trade
oriented and Vernon (1966) explored that FDI can be at the early product life
cycle stage (substitute) or at the mature stage (complement). Moreover,
Johanson & Widershen (1975), Nicholas (1982) and UNCTAD (1996) tried to
analyze the linkages between exports and FDI. These studies suggest that
manufacturing firms first start trade with foreign nation before making the
investment in these economies. They consieder it less risky than FDI. After
getting full informations about these countries economies, political and social
conditions, these firms establish subsidiaries in these nations and then
subsidiary exports. Therefore, FDI-export nexus is also as complicated as the
other bivariate causal discussion.
This study uses a multivariate cointegration instead of bi-variate
causality tests using three variables FDI, exports and GDP. When we consider
two relations like export-GDP and GDP-FDI, then relation between exports
and FDI might be through GDP. Because export’s growth leads to GDP
growth and GDP growth make possible further inflow of FDI. This implies
that exports are the driving force for FDI through GDP. After pinpointing the
channeling effect, it is necessary to explore that this established causality is
either effective in the short run, long run or both.
III. Methodology and Data Sources
This study used Vector Auto Regressive (VAR) model and co-
integration to investigate the short run and long run relationship among
exports, FDI and Growth. For VAR model estimation and co-integration
analysis, it is necessary that all data series must have same cointegration
order. Therefore, first we examined the all data series for the presence of unit
root (stationarity test for data series). The stationarity of data series can be
verified by various techniques like plotting the correlogram of the data series,
applying Dickey and Fuller (1979), Augmented Dickey-Fuller (1981),
Phillips-Perron test (1988) and Kwiatkowski, et al. (KPSS, 1992). Out of
these, we used two main tests KPSS and ADF to check the stationarity
problem of all three data series.
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∆ Y t = β 1 + β 2 t + δ Y t −1 + ε t
This test also faces some weaknesses; Blough (1992) discussed the
trade-off between the size and power of unit root tests, these tests have either
a high probability of falsely rejecting the null of non-stationarity when the
DGP (data generating process) is a nearly stationary process, or low power
against a stationary alternative. Because, in finite samples, it was observed
that some unit root processes display their behaviour closer to stationary
(white noise) than to a non-stationary (random walk), while some trend-
stationary processes behave more likely to random walks (Harris, 1995).
Therefore, considering these issues, we also used KPSS test to examine the
unit root problem of all data series.
4
For detail see, Basic Econometrics (4th edition), page 815.
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Growth, FDI and Exports in Pakistan
−2
∑ S t2
KPSS = LM =T t =1
s 2
(l )
l
s 2 (l ) = T −1
∑ e t2 + 2 T −1
∑ w τl ∑ e t e t −τ
τ =1
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Shabbir and Amjad
(iii) Failure to reject null hypothesis both ADF and KPSS will indicate that
data is not able to give sufficient information required for the long-run
characteristics of the process.
(iv) Rejection of null hypothesis by both tests ADF and KPSS indicate that
the process is described by neither I(0) nor I(1) processes.
3.3. Multivariate Cointegration Analysis and Error Correction
Modeling
A common method for testing the long run relationship (cointegration)
among the economic series is the Engel-Granger’s two-step bivariate,
residual-based method. According to Banerjee et al. (1990), “this method is
incapable to deal multivariate cases due to; a priori assumption of a single co-
integrating vector in the system, it tends to yield biased parameter estimates in
small samples and is sensitive to the choice of endogenous variables in the co-
integrating regression”. Therefore, Johansen (1988), Johansen and Juselius’
(1990), Maximum Likelihood (ML) procedures are considered the best
alternative to the Engle-Granger technique. The main charm in this method is
its capability to test the possibility of multiple co-integrating relationships
among the variables. Johansen and Juselius (1990), further formulated time
series in the form of reduced rank regression. In this procedure, they
calculated the ML estimates in the multivariate cointegration model with the
help of Gaussian Errors. This model is based on the Error Correction that can
be shown as follows:
p −1
∆X = µ + ∑ Γi ∆X t −i + ∏ X t −1 + ε t (A)
i =1
Where Xt is an (n*1) column vector of k variables, µ is an (n*1) vector
of constant terms, Γ and Π represent coefficient matrices, ∆ is a difference
operator, p denotes the lag length and εt is i.i.d. k-dimensional Gaussian Error,
which has mean zero and variance matrix (white noise disturbance term). The
coefficient matrix Π is called impact matrix that contains information about
the long-run relationships among variables. Equation (A) shows VAR model
in first differences, except the term, lagged level of Xt-1 and an error correction
term. This error correction term provides information about the long run
relationship among variables in the vector Xt. This way of specifying the
equation system is known as VECM model. This model gives information
about short run as well as long run adjustment to changes in Xt through the
estimates of Γ and Π, respectively. The VECM equation allows three
following model specifications.
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Growth, FDI and Exports in Pakistan
The second test statistic is known as the maximal eigen value test or
‘max test’ that computes the null hypothesis that there are exactly r
cointegrating vectors in Xt and is as follows:
λmas = − T ln(1 − λr )
The distributions for these tests are not usual chi-squared distributions.
The asymptotic critical values for these likelihood ratio (LR) tests are
calculated by Johansen & Juselius (1990) and Osterwald-Lenum (1992)
through numerical simulations.
For short run dynamic analysis, we included an Error Correction (EC)
term in the differenced model to capture the equilibrium relationship among
the co-integrating variables in their dynamic behavior, following the Granger
Representation Theorem. This addition of EC in the first differentiated VAR
model, make possible to separate the long-term relationship among economic
variables from their short-run responses. This will also determine the direction
of the Granger causality. Following Johansen and Juselius (1990), the
corresponding ECM can be written as follows:
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Shabbir and Amjad
Values in parenthesis () are MacKinnon critical values while in KPSS tests, we used Automatic
bandwidth selection (maxlag) and Autocovariances weighted by Quadratic Spectral kernel.
5
Annual Publications of State Bank of Pakistan (various issues).
6
For detail see, figure 1 in appendix.
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Growth, FDI and Exports in Pakistan
null hypothesis while KPSS rejected the null hypotheses in all cases. As all
data series are having same integrating order I(1), so we further proceed for
the investigation of long run equilibrium analysis through co-integration. The
co-integration concept is closely linked with the notion of long-run
equilibrium in case of economic theory. According to this notion, the
variables in a system may deviate from their steady sate value in the short run
but in the long run, it is expected that they ultimately converge to their steady
state. To examine the long run equilibrium relationship among FDI, exports
and GDP, we used Johansen and Juselius (1990) procedure.
4.2. Multivariate Cointegration Results
The results of unit root tests predict that all data series are first
difference stationary I(1). We used VAR to investigate the relationship
between variables. First, we determined the lag length of the VAR model
using AIC and SC criterion. We also applied LR test by estimating VAR
twice, each with different lags (to compute LR statistic). We estimated VAR
with lag order 2 and 37. Since the lower the values of AIC or SC, statistics
give the evidence for better model. On the basis of these values, we can say
that model one with lag order 2 is more parsimonious than the model with lag
order 3. The same is confirmed by the results of LR test.
We estimated VAR (2) to investigate the long run relationship among
Exports, GDP and FDI. We applied Johansen (1988) procedure to estimate the
VAR (2) cointegration analysis because it gives the most efficient estimate of
the long-run relationship between non-stationary variables at level. The Trace
test results indicate that only one co-integrating vector exists. The co-
integrating vector is shown in figure 1. The results of trace test are presented
Figure: 1. Co-integrating Vector
4.8
vector1
4.6
4.4
4.2
4.0
3.8
3.6
7
For results see, table A1 in appendix.
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Shabbir and Amjad
8
See for example, Ahmad et al. 2004.
9
For results see, appendix table A2.
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Growth, FDI and Exports in Pakistan
GDP and FDI have negative sign in α metrics. This implies that both
variables also respond to correct their own past disequilibrium error.
According to the signs of the adjustment coefficient, co-integrating relation is
error correcting10.
Table: 4. Identification Restrictions on β
confirm that long-run equilibrium relationship exists between GDP and export
but FDI is not co-integrating with these variables. We also carried out short
run dynamic analysis to capture the short-run affects.
10
For restrictions on α metrics, see appendix table A3.
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Shabbir and Amjad
Variables ∆GDPt-1 ∆FDI t-1 ∆EXP t-1 ECM t-1 Wald Prob Status
Test
∆GDPt ------ 00000 ------ ------ 2.73 0.11 Accepted
∆GDPt ------ ------ 00000 00000 2.71 0.08 Accepted
∆FDIt 00000 ------ ------ ------ 4.63 0.04 Rejected
∆FDIt ------ ------ 00000 ------ 0.204 0.654 Accepted
∆EXPt 00000 ------ ------ 00000 5.75 0.007 Rejected
∆EXPt ------ 00000 ------ ------ 3.13 0.08 Accepted
0000 indicates the exclusion restrictions on particular variable and ------ indicates no restrictions just
their coefficients.
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Appendix
GDP FDI
15 10.0
14
7.5
13
12
5.0
11
0 10 20 30 40 0 10 20 30 40
EXP
12
10
0 10 20 30 40
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