Impact of FDI on the economic growth rate in Pakistan

Introduction

Foreign direct investment (FDI) is a measure of foreign ownership of productive assets, such as factories, mines and land. Increasing foreign investment can be used as one measure of growing economic globalization. The largest flows of foreign investment occur between the industrialized countries (North America, Western Europe and Japan). But flows to non-industrialized countries are increasing sharply. FDI is entitled for the long time period such as 5 years.

FDI and economic growth:

Economic growth is the aspect to a nation’s progress and prosperity. Investment provides base to the economic development to the developing countries. Standard economic theory points to a direct, causal relationship between economic growth and FDI that can run in either direction. On the one hand, FDI flows can be induced by host country economic growth if the host country offers a sizeable consumer market, in which case FDI serves as a substitute for commodity trade or if growth leads to greater economies of scale and cost efficiency in the host country. On the other hand, FDI itself may contribute to host country economic growth, by augmenting the country’s capital stock, introducing complementary inputs, inducing technology transfer and skill acquisition, or increasing competition in the local industry. Of course, FDI may also inhibit competition and thus hamper growth, especially if the host country government affords extra protection to foreign investors in the process of attracting their capital. Foreign Direct Investment (FDI) has emerged as the most important source of external resource flows to developing countries over the 1990s and has become a significant part of capital formation in the developing countries despite their share in global distribution of FDI continuing to remain small or even declining. The role of the foreign direct investment (FDI) has been widely recognized as a growth-enhancing factor in the developing countries. The effects of FDI in the host economy are normally believed to be increase in the employment, increase in productivity, and increase in exports and, of course, increased pace of transfer of technology. FDI contributes to economic growth directly through new technologies and other inputs as well as indirectly through improving human capital, infrastructure, and institutions and the level of a country’s productivity depends on the FDI, trade, domestic investment. Since the mid 1970s, however, developed countries have attracted the bulk of FDI and correspondingly, the developing countries failed to create an enabling environment for foreign investors. The 1980s and 1990s have seen considerable changes in the level and composition of FDI in the developing countries. Except for 1989, inflows of FDI to developing countries increased steadily between 1984 and 1992. Most remarkably, while inflows to the developed countries declined in 1991, they grew by more than 20 percent to the developing countries, to $ 39 billion. In 1995, FDI into developing countries increased to at least $ 100 billion. This boom in investment flows is a reflection of sustained economic growth and continuing liberalization and privatization in developing countries.

FDI to Pakistan:

Pakistan, being a developing country, has not been traditionally a large recipient of FDI. In the 1980s the average annual inflows of FDI were around $ 42 million for Pakistan. If FDI is taken in relation to total gross domestic investments, it constitutes 1.4 percent of it. Foreign direct investment brings into the recipient economy resources which can play an important role in the modernization of the national economy. FDI is now considered to be an instrument through which economies are being integrated at the level of production into the globalizing world economy by bringing a package of assets including capital, technology, managerial capacities and skills and access to foreign markets.

Chapter#2

Review of literature:

The author described that foreign direct investment (FDI) is often seen as an important channel for economic growth in the developing countries. It affects the economic growth by stimulating domestic investment, increasing human capital formation and by facilitating the technology transfer in the host countries. (Falki, 2007).

According to the author it is described in the article that there are two major views, which are independently and often jointly challenged. First is the policy view: Aid works only in the presence of good policy i.e., the interaction term has a positive and significant effect on growth good policy is mostly important in the determination of growth. Second Diminishing Returns view: Aid works, but with diminishing returns, irrespective of good policy i.e., the aid-squared term drives away the significance of the interaction term. If the policies of the recipient country are very bad then it would not growth-enhancing at all. It is only in this sense that we suggest reasonably good policy is needed to achieve any aid effectiveness (Alvi, Mukherjee, Shukralla, 2008).

In this article the author described that in Pakistan the saving rate in Pakistan is very low as compared to other developing countries. The most important factor affecting saving rate according to the author is foreign capital inflow. Because the major portion of the foreign capital inflow to Pakistan was utilized in consumption purpose so the inflow of foreign capital into Pakistan’s economy has reduced the saving rate in private and public sector. It is suggested by the author that saving rate can be increased by liberating the foreign trade and payment sector (Khan, Hasan, Malik, 1992).

The significance of foreign direct investment (FDI) flows is well documented in literature for both the developing and developed countries. Over the last decade foreign direct investment have grown at least twice as rapidly as trade (Meyer, 2003).

In this article the author described that because of shortage of capital in the developing countries, there is need of capital for their development process, and the marginal productivity of capital is higher in these countries. Mostly investors in the developed countries seek high returns for their capital. Hence there is a common benefit in the international movement of capital. Liberalization of the economies in many developing countries has led to a severe competition for inward FDI in these countries. As far as Pakistan is concerned during early 1980s, the government in Pakistan has initiated market-based economic reform policies. These reforms began to take hold in 1988. In the 1990s, the government further liberalized the policy and opened the sectors of agriculture, telecommunications, energy and insurance to FDI. But, due to political instability FDI remained low. Author further described that political stability, peaceful law and order situation, level of technical labor force and mineral resources and liberal policies of the government attracted foreign investors in Pakistan (Nishat & Anjum, 1998).

FDI can be considered as one of the main transmission vehicles of advanced technology from leaders to developing countries (Borensztein et al, 1998).

According to the author in this article FDI may have a positive impact on the productive efficiency of domestic enterprises. Local firms have an opportunity to improve their efficiency by learning and interacting with foreign firms. FDI increases technical progress in the host country by means of a contagion effect, which eases the adoption of advanced managerial procedures by the local firms. But in order to get the benefit of FDI the concerned governments should try hard to achieve a sound degree of political and economical stability, together with a liberalized environment (Calvo, 2001).

This article is based on following basic arguments upon export-led growth that postulates that export is a main determinant of overall economic growth. The first argument is that export sector may generate positive externalities on non-export sectors through more efficient management styles and improved production techniques. The second argument is that export expansion will increase productivity by offering potential for scale economies. Thirdly, exports are likely to alleviate foreign exchange constraints and so can provide greater access to international market. FDI can contribute in growth in both direct and indirect ways. By the introduction of new technology (Ahmad, Alam, Butt, 2003).

The author in the article describes that foreign investments have significant positive effect on productivity of domestic firms. Foreign technical collaborations increase productivity in part through its effect on the FDI inflows. Developing countries witnessed a surge in FDI inflows post 1990s. In many developing countries the rate of growth of FDI inflows exceeds the growth rates of foreign trade. At macro level, the role of FDI has become crucial because it provides new capital, additional investments in human as well as physical capital, which can be beneficial for developing countries which are capital scarce. The inflow of new knowledge like: greater production methods; new technologies; organizational and managerial techniques; management and marketing skills and activities may benefit domestic firms through imitation, increased competition, mobility of human capital from foreign firms to domestic firms, thereby leading to increase in overall productivity levels. The most of the developing countries are keen to attract FDI not only because of the flow effects of ideas and innovations (vadlamannati, 2009).

In this article the author is focusing on two main points that according to him may occur in developing countries like Pakistan due the FDI inflows, first is that the foreign capital inflow may have positive impact on the economy of the developing country by justifying sever domestic savings and exchange rate constraints. The second effect is that the foreign capital inflow may have negative effects on the saving side because most of the investment is used for the consumption process and thus the recipient country became more dependent on the FDI (Hasan, 2002).

According to this article FDI is an important source of transferring the technical assistance, and enhanced technology contributes a lot to the domestic investment. The high productivity through foreign direct investment rely on the entrance of human stock, most of the developing country have human capital but do not have enough technology so the utilization of human capital remains low. But due to the availability of new technology the human capital investment increases and ultimately productivity of firms increases (Borensztein, Gregorio, 1995).

In the article it is stated that the FDI is playing an important role in motivating the growth processes, particularly in developing countries. It is stated that foreign direct investment can help developing countries in two ways, in shot term view FDI can help mitigate problems encountered in external debt management. In this case FDI enables countries to manage their problems arising out of escalating external debt by providing an alternative source of long-term finance. Secondly FDI has the potential of meeting the domestic resource gaps of developing countries thereby enhancing their growth prospects. It is based on the argument that the long-term view of benefits arising out of FDI is based on the perception that such inflows of capital act as ‘engines of growth’ in developing countries. Due to increased inflow of the foreign investment the level f capital formation raises that significantly contributes to the countries’ growth processes (Dhar, Roy, 1996).

The author in this article described the importance of the foreign direct investment for the financial development of the developing countries as if the country has much financial resources the development process would be as fast as the finance is required for the developmental projects. But the contribution of financial development can be dependent on the political situation of the recipient nation. If the country is politically stable it can attract more and more foreign investment and the higher political stability aids financial institutions to reap the benefits of FDI efficiently. Financial Development is an integral component of the growth process of an economy. For the financial development through FDI it is important to measure the market size, efficiency of financial intermediaries and markets. Political stability is important in a sense that it helps build institutions that provide protection for the rights of the investors that is important enough to attract and retain new foreign investment and alternatively it would aid the financial sector. Most of the foreign firms are willing to invest in those countries which experience political stability (Dutta, ea al., 2008).

The author emphasized on the positive as well as negative aspects of the foreign direct investment on the economic growth to developing countries. The positive impact of the FDI can be measure in terms of rapid economic growth; FDI may affect economic growth, through its impact on capital stock, technology transfer, skill acquisition, or market competition. FDI and growth may also exhibit a negative relationship, particularly if the inflow of FDI leads to increased monopolization of local industries, thus compromising efficiency and growth dynamics (Rahman, Dhkal, Upadhyaya, 2006).

This article is more focused on the fact that foreign direct investment is the important mean of the transfer of technology from the industrialized countries to the developing countries. Thus, FDI contributes to economic growth; the higher productivity through FDI can be achieved only when the host country has a minimum projection stock of human capital. The economic growth of the recipient country through FDI is simply attached to the phenomenon that due to FDI inflows there is capital accumulation in the host country. It is stated that FDI could increase economic growth if it is more productive, or efficient, than domestic investment. Domestic firms have better knowledge and access to domestic markets; if a foreign firm decides to enter the market, it must compensate for the advantages enjoyed by domestic firms. Thus foreign firm enjoys lower costs and higher productive efficiency than its domestic competitors. Effect of FDI on economic growth is dependent on the level of human capital available in the host economy (Borensztein & Lee, 1998).

This article is related to fact that the impact of FDI and Transnational Corporation on growth of a country depends on many factors. Among these factors one important factor that impact FDI to a great deal is the trade policy regime in host countries. The decision of foreign inventors is more concern with the trade policy regime of the host country. The main idea of the study is that those countries gain more from FDI which follow the export promotion trade regime rather than those working under the protection of Imports substitution policies. Main focus of foreign investors always remains towards those countries which facilitate them in terms of both infrastructure and favorable policies for investments. Pakistan received relatively higher amount of FDI over the last two decades. Especially during the decade of 1990s, Pakistan adopted, market oriented policies, favorable environment for investment and declared the private sector as the engine of economic growth. FDI can enhance the stock of human capital, and may increase productivity of labor and other factors of production. In short, it can be suggested that Pakistan’s capacity to progress on economic development is more dependent on her performance in attracting FDI through export promotion strategy (Atique, Hasanain, Azhar, 2007).

This article stresses that FDI is major source for the economic growth of the low income countries. Foreign direct investment mostly deals with two types of complication such as shortages of financial resources and technology and skills. That has made it the centre of attention for policy-makers in low-income countries in particular. But only a few of the developing countries have been successful in attracting significant FDI flows, because of their market size, government trade policies, structural weaknesses of these economies, the inefficiencies of their small markets, their skill shortages and weak technological capabilities, are all characteristics that lower the potential profitability of investment.

In this article authors have analyzed its negative impacts on growth. They argued that the foreign capital could adversely affect the economic growth by substituting the domestic savings (Leff, 1969 & Griffin, 1970).

In this article the author concluded that foreign aid has played an extremely important role in influencing the pace of development, especially investments and imports have to a large extent depended upon the amount of foreign aid. However, this dependence on foreign aid, on the other hand, has led to the emergence of rising debt burden (Khan, 1993).

In this article the author describes the relationship between domestic capital formation and various sources of gross savings was worked out, FDI being included, FDI as one of the major components of savings. The study found a negative relationship between foreign capital inflows and capital formation in host countries (Areskoug, 1976).

In this article it has shown that in Latin American economies, foreign capital inflows since the late 1980s have not led to significant rise in investment rates in these economies. The study attributes this observed phenomenon to two factors: first, inflows have financed debt service payments, and secondly, the economic policies have led to dampening investment propensities with exchange rate appreciation and credit conditions remaining tight (Agosin, 1994).

Author analyzed the impact of Foreign Direct Investment with special reference to international trade. He found that countries actively pursuing export led growth strategy can reap enormous benefits from foreign direct investment. Export led policy is defined as the one which equates average effective exchange rate on exports to the average effective exchange rate on imports. On the other hand, import substitution policies are worked out in such a way that the two exchange rates are not equal. The former policy favors free trade and underlines the need to boost exports whereas the latter emphasizes self-reliance through import substitution (Bhagwati, 1978).

In this article analyzed that in most of the LDCs’ there is a debt crisis due to lack of capital. For this reason, they are facing disequilibrium in the balance of payments, debt re-servicing, and macroeconomic instability and growth deficiencies. There are two main objectives of the study, firstly to analyze that whether FDI has a transitory or permanent impact upon host country. Secondly, whether the FDI is growth promoting or growth depressing. The study used the data of four years (1989-1993) for 31 developing countries (Malik, 1996).

Author has analyzed the FDI flows to low income countries. He concluded his paper by the review of the evidence that over the last 25 40 years, FDI ¡n low-income countries has been highly concentrated in three countries, China, Nigeria and India. Large market size, low labor costs, and high returns in national resources are amongst the major determinants in the decision of the investors to invest in these countries (Ana, 1996).

Chapter#3

Theoretical framework:

Independent variable Dependent variable

Foreign Direct Investment Economic growth and Trade

Dimensions

Political situation

Market size

Economic growth rate

Infrastructure

Government policies

Economic environment

Incentives to investors

Hypothesis:

Hi: Increased level of Foreign Direct Investment increases economic growth

Hii: Government policies directly affect the trends of inflow of foreign direct investment

Hiii: Increased level of FDI increases international trade

Purpose of study:

This study analyses the relationship of FDI and economic growth. In order to understand the flows of foreign investment and its dimensions in Pakistan various studies of different researchers have been considered. As far as Pakistan is concerned as developing country it has not been large recipient of foreign direct investment, because of lack of infrastructure, political instability, less market openness etc. It is mostly depends upon the host country’s growth performance. Foreign direct investment (FDI) has emerged as a major source of private external flows for Pakistan as well amidst widening savings investment gap. During the last two decades developing countries like Pakistan have liberalized their FDI regimes and followed investment- friendly economic policies to attract investment to maximize the benefits of foreign presence in the host economy. In many developing countries, FDI has generated technology spillovers, assisted human capital formation, contributed to international trade integration, helped in creating a more competitive business environment and promoted enterprise development. These developments contributed positively to higher economic growth in many developing countries, which is the most potent tool for alleviating poverty.

(Economic survey of Pakistan 2007-08).

Objectives of study:

To analyze the mold of Foreign Direct Investment in Pakistan

To discover the role of FDI in the economic growth of Pakistan

To learn the determinants of FDI to Pakistan and its role on economic growth of Pakistan.

To investigate the role of international trade in economic growth and what are the distinct effects of imports and exports on economic growth

To study the changes during 1990s and their impact on economic growth, FDI and international trade.

To know obvious financial reforms, political and institutional instability, and debt crises.

Problem statement:

What is the impact of Foreign Direct Investment on the economic growth of the country?

Research Type:

The research type should be qualitative and quantitative based on the previous researches.

Sample:

Trends of FDI inflow to Pakistan from 1990-2008.

Data source:

For this type of search data can be collected by the economic survey of Pakistan, State Bank of Pakistan foreign trade, statistical year book of international trade, international finance statistics.