The Impact of Foreign Direct Investment on Pakistan Economy Final Project

The Impact of Foreign Direct Investment on Pakistan Economy_____________________________________________________________________________________________________________________

INSTITUTE OF BUSINESS AND TECHNOLOGY

Impact of Foreign Direct Investment on

Pakistan Economy.Prepared By

XXXXX XXXXX

BM-250XX

Course Code : MKT-606

MBA (Banking and Finance)

FACULTY OF

MANAGEMENT AND SOCIAL SCIENCES

SPRING - 2011

Institute of Business and Technology


CONTENTS

Page No.

ACKNOWLEDGMENT………………….………………….. 2

ABSTRACT……………………………………………………. 3

CHAPTER NO.1 INTRODUCTION

1.1 Introduction…………………………………..…….. 4 1.2 Purpose of Study................................................. 5

1.3 Research Objectives………………………………. 5 1.4 Hypothesis………………………………………….. 6 1.5 Research Methodology……………………………. 6

CHAPTER NO.2 LITERATURE REVIEW

2.1 Early Literature……………………………………. 72.2 FDI in the context of growth and trade…………. 7

CHAPTER NO. 3 FOREIGN DIRECT INVESTMENT

3.1 Definition of Foreign Direct Investment………….. 123.2 Components of Foreign Direct Investment……… 133.3 Types of Foreign Direct Investment……………… 13

CHAPTER NO. 4 FOREIGN DIRECT INVESTMENT IN PAKISTAN

4.1 Growth……………………………………………….. 144.2 Sector Wise Investment……………………………. 154.3 Source of Investment……………………………..... 164.4 Problems…………………………………………….. 17 4.5 Future Prospects……………………………………. 19

CHAPTER 5 CONCLUSION & RECOMMENDATIONS

5.1 Conclusion…………………….…………………….. 225.2 Recommendations………………………………..... 23

BIBLOGRAPY 27

2



ACKNOWLEDGMENT

I would like to acknowledge our instructor, Dr. Noor Ahmed Memon for his co-ordination

and guidance. His research skills and knowledge marked a road map for our research

project throughout the semester. I appreciated his willingness to help me and guide me

in the research at any point in the semester.

Moreover, I would like to acknowledge all the respondents who took the time to cater

our informational needs. Without their input, this research would not have been

possible.

3



INSTITUTE OF BUSINESS AND TECHNOLOGY

SUBMITTED BY: Rakhman Ali Memon

DISCIPLINE: MBA (Finance)

TITLE OF PROJECT REPORT: Impact of Foreign Direct Investment on Pakistan Economy.

MONTH OF SUBMISSION: Spring, 2010

NAME OF PROJECT SUPERVISOR: Dr. Noor Ahmed Memon

ABSTRACT

Foreign direct investment (FDI) is often seen as an important catalyst 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. The main purpose of the study is to investigate

the impact of FDI on economic growth in Pakistan, for the period 1990-2006. The

relationship between FDI and economic growth will be analyzed by using the production

function based on the endogenous growth theory, other variables that affect economic

growth such as Trade, domestic capital, labor and human capital will also be used. The

expected results of the study are a positive and statistically significant relation between

the real per-capita GDP and FDI. Policy recommendations could be suggested in the

light of the results obtained, regarding the FDI in Pakistan.

4



1. INTRODUCTION

1.1 Introduction

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 (Kumar and

pardhan, 2001). The role of the foreign direct investment (FDI) has been widely

recognized as a growth-enhancing factor in the developing countries (Arshad, 2008).

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.

The potential advantages of the FDI on the host economy are it facilitates the

use and exploitation of local raw materials, it introduces modern techniques of

management and marketing, it eases the access to new technologies, Foreign inflows

could be used for financing current account deficits, finance flows in form of FDI do not

generate repayment of principal and interests (as opposed to external debt), it increases

the stock of human capital via on the job training. The local enterprises are able to learn

by watching if the economic framework is appropriate (Bhagwati, 1994) it stimulates the

investment in R&D (Calvo and Robles, 2003). The amount of foreign direct investment

increased significantly for developing economies during 1985 to 2000. The share of

developing countries in world FDI inflows and outflows has risen from 17.4% in 1985-90

to 26.1% during 1995-2000. For Pakistan the amount of FDI inflows increased from $

0.24 billion in 1990 to $ 55 billion in 2007(WDI indicators 2008). The present paper

tries to empirically estimate the effect of FDI on economic growth in Pakistan, using the

conventional neo-classical production function where FDI is considered to be an

additional input.

5



1.2 Purpose of Study

FDI has been one of the defining features of the world economy over the past

two decades. It has grown at an unprecedented pace for more than a decade. The past

decade has witnessed an unparallel opening and modernism of the economies in all

regions, encompassing deregulation, de-monopolization, privatization and private

participation in the provision of infrastructure, a and the reduction and simplification of

tariffs. An integral part of this process has been the liberalization of foreign investment

regime. Although Pakistan has not received any considerable amount of FDI as yet, but

has remained relatively greater over the past couple of decades as it adopted market

oriented policies. The present study found that the growth impact of FDI tends to be

greater under an export promotion (EP) trade regime compared to an import-

substitution (IS) regime by using data for Pakistan over the period 1970-2001.

1.3 Research Objectives

FDI in Pakistan consists primarily of three elements, namely, cash brought in,

capital equipment brought in, and re-invested earnings. The information provided in

Table 3 shows that the structure of the sources of financing FDI in Pakistan has

undergone a noticeable change. Though all the components of FDI exhibit considerable

fluctuations over time, the item labeled capital equipment brought in has remained

substantially low during 1983-1988. Though the major share of FDI in Pakistan

comprised cash brought in (on average 55.7% over the last 15 years), its share declined

slightly (on average 50.2% during 1991-1994) during the post-reform period. The share

of capital equipment brought in remained low, on average, over the last 15 years but it

has made considerable improvement during the postreform period. In particular, its

share jumped to 55.7% in 1994 mainly due to the equipment brought in for Hubco

Power Plant. Re-invested earnings contributed slightly less than one third to FDI over

the last 15 years but its share has declined to 23% during the postreform period.

6



1.4 Hypothesis

There is a significant relationship of FDI on economy of Pakistan.

1.5 Research Methodology

The main purpose of the study is to assess/quantify the impact of FDI on

economic growth in Pakistan. The Time period for study is 1990-2006, based on the

grounds that Pakistan started receiving significant amount of FDI inflows after the

1990s. The theoretical model that is used to investigate the interaction of FDI and

Economic growth is based on the following production function.

Y=A ka Lb

Where Y is the output, K is capital and L is labour and A is the technology or the

efficiency of production. The model is based on the endogenous growth theory, as

developed by (Balasubramanyam, Salisu, and Sapsford, 1996) and (Borensztein,

Gregorio,& Lee 1998). The model is based on the assumption that 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. As the

variable A captures the total factor productivity (TFP) effect on growth in output and it is

assumed that the effect of FDI on growth operates through variable A, and the effect of

FDI on A also depends on the human capital. The main purpose of the study is to

assess/quantify the impact of FDI on economic growth, in order to achieve the desired

objective, other independent variables which are assumed typically to influence the

economic growth will be included in the model. It is expected that this inclusion will

reduce or eliminate the specification error.

7



2. LITERATURE REVIEW

2.1 Early Literature

A number of studies have analyzed the relationship between FDI inflows and

economic growth, the issue is far from settled in view of the mixed findings reached.

Most of these studies have typically adopted standard growth accounting framework for

analyzing the effect of FDI inflows on growth of national income along with other factors

of production. Within the framework of the neo-classical models (Solow, 1956) the

impact of the FDI on the growth rate of output was constrained by the existence of

diminishing returns in the physical capital. Therefore, FDI could only exert a level effect

on the output per capita, but not a rate effect. In other words, it was unable to alter the

growth rate of output in the long run. It is not surprising, thus, that FDI was not

considered seriously as a drive engine of growth by mainstream economics. In the

contrast, the New Theory of Economic Growth, however, concludes that FDI may affect

not only the level of output per capita but also its rate of growth. This literature has

developed various arguments that explain why FDI may potentially enhance the growth

rate of per capita income in the host country, the identified channels to boost economic

growth include increased capital accumulation in the recipient economy, improved

efficiency of locally owned host country firms via contract and demonstration effects,

and their exposure to fierce competition, technological change, and human capital

augmentation and increased exports. However, the extent to which FDI contributes to

growth depends on the economic and social condition or in short, the quality of

environment of the recipient country (Buckley, Clegg, Wang, & Cross, 2002). This

quality of environment relates to the rate of savings in the host country, the degree of

openness and the level of technological development. Host countries with high rate of

savings, open trade regime and high technological product would benefit from increase

FDI to their economies.

8



2.2 FDI in the context of growth and trade

Many empirical works are available in the economic literature showing the causal

relationship between FDI and growth. At the firm level, several studies provided

evidence of technological spillover and improved plant productivity. At the macro level,

FDI inflows in developing countries tend to “crowd in” other investment and are

associated with an overall increase in total investment. Most studies found that FDI

inflows led to higher per capita GDP, increase economic growth rate and higher

productivity growth (see e.g. De Mello 1997, Kumar and Siddharthan 1997, & Saggi

2000, for recent reviews of literature) FDI increases technical progress in the host

country by means of a contagion effect, (Findlay, 1978) which eases the adoption of

advanced managerial procedures by the local firms. Similarly (De Gregorio, 1992)

analyzed a panel of 12 Latin American countries in the period 150-1985. His results

suggest a positive and significant impact of FDI on economic growth. In addition the

study shows that the productivity of FDI is higher than the productivity of domestic

investment. While, (Fry, 1992) examined the role of FDI in promoting growth by using

the framework of a macro-model for a pooled time series cross section data of 16

developing countries for 1966-88 period. The countries included in the sample are

Argentina, Brazil, Chile, Egypt, India, Mexico, Nigeria,

Pakistan, Sri Lanka, Turkey, Venezuela, and 5 Pacific basin countries viz.

Indonesia, Korea, Malaysia, Philippines, Thailand. For his sample as a whole he did not

find FDI to exert a significantly different effect from domestically financed investment on

the rate of economic growth, as the coefficient of FDI after controlling for gross

investment rate was not significantly different from zero in statistical terms. FDI had a

significant negative effect on domestic investment suggesting that it crowds-out

domestic investment. Hence FDI appears to have been immiserizing. However, this

effect varies across countries and in the Pacific basin countries FDI seems to have

crowded-in domestic investment. FDI inflows had a significant positive effect on the

average growth rate of per capita income for a sample of 78 developing and 23

9



developed countries as found by (Blomström et.al, 1994). However, when the sample of

developing countries was split between two groups based on level of per capita income,

the effect of FDI on growth of lower income developing countries was not statistically

significant although still with a positive sign. They argue that least developed countries

learn very little from MNEs because domestic enterprises are too far behind in their

technological levels to be either imitators or suppliers to MNEs. In this regard, another

study was conducted by (Borensztein, et.al, 1995) he included 69 developing countries

in his sample. The study found that the effect of FDI on host country growth is

dependent on stock of human capital. They infer from it that flow of advanced

technology brought along by FDI can increase the growth rate only by interacting with

country’s absorptive capability. They also find FDI to be stimulating total fixed

investment more than proportionately. In other words, FDI crowds-in domestic

investment. However, the results are not robust across specifications. Export-oriented

strategy and the effect of FDI on average growth rate for the period 1970-85 for the

cross-section of 46 countries as well as the sub-sample of countries that are deemed to

pursue export-oriented strategy was found to be positive (Balasubramanyam et.al,

1996) and significant but not significant and some times negative for the sub-set of

countries pursuing inward-oriented strategy. Accordingly (Sanchez-Robles, 1998)

explored empirically the correlation among public infrastructure and economic growth in

Latin America in the period 1970-1985. She also found a positive and significant impact

of FDI on the economic growth of the countries of this area. Another economist (De

Mello 1999) also conducted time series as well as panel data estimation. He included a

sample of 15 developed and 17 developing countries for the period 1970-90. The study

found strong relationship between FDI, capital accumulation, output and productivity

growth. The time series estimations suggest that effect of FDI on growth or on capital

accumulation and total factor productivity (TFP) varies greatly across the countries. The

panel data estimation indicates a positive impact of FDI on output growth for developed

and developing country sub-samples.

However, the effect of FDI on capital accumulation and TFP growth varies across

developed (technological leaders) and developing countries (technological followers).

10



FDI has a positive effect on TFP growth in developed countries but a negative effect in

developing countries but the pattern is reversed in case of effect on capital

accumulation. De Mello infers from these findings that the extent to which FDI is growth-

enhancing depends on the degree of complementarity between FDI and domestic

investment, in line with the eclectic approach given by (Dunning, 1981). The degree of

substitutability between foreign and domestic capital stocks appears to be greater in

technologically advanced countries than in developing countries. Developing countries

may have difficulty in using and diffusing new technologies of MNEs. Findings of (Xu,

2000) for US FDI in 40 countries for the period 1966-94 also support the finding of De

Mello that technology transfer from FDI contributes to productivity growth in developed

countries but not in developing countries, which he attributes to lack of adequate human

capital. (Agosin and Mayer, 2000) analyzed the effect of lagged values of FDI inflows on

investment rates in host countries to examine whether FDI crowds-in or crowds-out

domestic investment over the 1970-95 period. They conclude that FDI crowds-in

domestic investment in Asian countries crowds-out in Latin American countries while in

Africa their relationship is neutral (or one-to-one between FDI and total investment).

Therefore, they conclude that effects of FDI have by no means always favourable and

simplistic policies are unlikely to be optimal. These regional patterns tend to corroborate

the findings of (Fry, 1992) who also reported East Asian countries to have a

complementarity between FDI and total investment.

In another study by (Pradhan, 2001) found a significant positive effect of lagged

FDI inflows on growth rates only for Latin American countries. He used a panel data

estimation covering 1975-95 period for 71 developing countries. The study sheds light

that the effect of FDI was not significantly different from zero for the overall sample and

for other regions. A number of early studies have generally reported an insignificant

effect of FDI on growth in developing host countries. FDI may have negative effect on

the growth prospect of the recipient economy if they give rise to a substantial reverse

flows in the form of remittances of profits, particularly if resources are remitted through

transfer pricing and dividends and/or if the transnational corporations (TNCs) obtain

substantial or other concessions from the host country. For instance, Singh, (1988)

11



found FDI penetration variable to have a little or no consequences for economic or

industrial growth in a sample of 73 developing countries. In the same way (Hien, 1992)

reported an insignificant effect of FDI inflows on medium term economic growth of per

capita income for a sample of 41developing countries. For studies conducted in

Pakistan a study was conducted by (Shabir and Mahmood, 1992) analyzed the

relationship between foreign private investment FPI and economic growth in Pakistan.

The study used the data for 1959-60 to 1987-88; the study concluded that net foreign

private investment (FPI) and disbursements of grants and external loans (DISB) had a

positive impact on the rate of growth of real GNP. However they did not treat FDI as a

separate variable. Similarly (Ahmed, Butt, and Alam, 2003) examined the causal

relationship between FDI, exports and output by employing Granger non-causality

procedure over the period 1972 to 2001 in Pakistan. They found significant effect from

FDI to domestic output, in contrast to the above mentioned studies.

12



3. FOREIGN DIRECT INVESTMENT

3.1 Definition of Foreign Direct Investment

Foreign direct investment (FDI) refers to long term participation by country A into

country B. It usually involves participation in management, joint, transfer of

technology and "know-how". There are two types of FDI: inward foreign

direct investment and outward foreign direct investment, resulting in

a net FDI inflow (positive or negative).

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. Figure below shows net inflows of

foreign direct investment as a percentage of gross domestic product (GDP). The largest

flows of foreign investment occur between the industrialized countries (America,

Western and Japan). But flows to non-industrialized countries are increasing sharply.

3.2 Components of Foreign Direct Investment

low corporate tax and income tax rates

tax holidays

other types of tax concessions

preferential tariffs

special economic zones

investment financial subsidies

soft loan or loan guarantees

free land or land subsidies

relocation & expatriation subsidies

job training & employment subsidies

infrastructure subsidies

R&D support

derogation from regulations (usually for very large projects)13



3.3 Types of Foreign Direct Investment

an individual;

a group of related individuals;

an incorporated or unincorporated entity;

a public company or private company;

a group of related enterprises;

a government body;

an estate (law), trust or other societal organization; or

any combination of the above.

14



4. FOREIGN DIRECT INVESTMENT IN PAKISTAN

4.1 Growth

15



4.2 Sector Wise Investment

16



4.3 Source of Investment

17



4.4 Problems

The success of FDI policies can be judged by the size of the inflows of capital.

Pakistan has been making efforts to attract FDI and such efforts have been intensified

with the advent of deregulation, privatization, and liberalization policies initiated at the

end of the 1980s. Table 1 documents the size of the inflow of foreign investment in

Pakistan during the last two decades. The amount of foreign investment rose from a tiny

$10.7 million in 1976/1977 to $1296 million in 1995/1996, thus growing at the annual

compound growth rate of 25.7 percent. However, it declined to $950 million in

1996/1997. With the beginning of the overall liberalization program (1991/1992

onwards) the inflow of foreign investment grew at the compound growth rate of 15.2

percent. Investment inflows in 1995/1996 increased by 93.3% mainly due to the inflow

of investment in power sector.

Although significant by absolute terms, the increase appears trivial when

compared to the relatively more buoyant economies of East and Southeast Asia. While

FDI flows to all developing countries reached $150 billion in 1997, East and Southeast

Asia received the bulk of this share.

Total foreign investment consists of direct and portfolio investment. Prior to 1991/

1992, portfolio investment has not only been low but also exhibited a fluctuating trend.

However, with the beginning of liberalization policies in 1991/1992, portfolio investment

crossed the $1.0 billion mark in 1994/1995. This impressive increase does not reflect

the true picture of the trends in portfolio investment witnessed during the

postliberalization period. If the $862.2 million sale of Pakistan Telecommunications

Corporation (PTC) vouchers, which was a one-time phenomenon, was excluded, the

portfolio investment not only declined to $227.8 million in 1994/1995 but followed an

average trend of $215.4 million during 1991/ 1992 to 1995/1996 as against an average

flows of only $9.0 million prior to reform (1984/ 1985 to 1990/1991).

18



Foreign participation appears to be the major factor responsible for the increase

in portfolio investment in the 1990s. The decline in international interest rates was also

important in portfolio allocations toward Pakistani assets. With globalization, numerous

international portfolio funds were created that were invested in emerging capital markets

seeking for better returns. Pakistan was among the first countries in emerging markets

to take measures to open up its stock markets to foreign investors. However, in relation

to the total flows directed to developing countries, interest in Pakistan has been very

modest (Khan 1996). Portfolio inflows, because of their inherently volatile nature, have

proved to be reversible more than other forms in developing countries. Their potential

volatility is great in Pakistan as well since portfolio investment in Pakistan is directed

mainly toward short-term and some medium-term public debt instruments and the stock

exchanges.

Despite yearly fluctuations, the amount of FDI rose from $70.3 million in

1984/1985 to $1090.7 million in 1995/1996, thus growing at the compound growth rate

of 25.7 percent. However, it decreased to $682 million in 1996/1997. Since the

beginning of the liberalization program (1991/1992), FDI has grown faster than in the

preliberalization period (1984/1985-1990/1991). In particular, 1995/1996 registered a

phenomenal growth of 146.5% mainly due to the inflow of FDI in the power sector. FDI,

on average, accounted for nearly 80-85% of total inflows over the period 1984/1985 to

1996/1997.

It reports the inflow of FDI by origin since 1981/1982. The US and UK have been

the major sources of FDI in Pakistan, although the shares of both US and UK have

fluctuated widely, falling as low as 8.8% for the US and 4.7% for the UK and rising as

high as 63.7% and 35.2%, respectively. The share of the US has been, by far, the

largest of all the countries, averaging 32.4% over the last 16 years followed by the UK

(12.9%), UAE (11.6%), Japan (5.7%), and Germany (5.4%). During the post-reform era,

the share of the US further rose to 42.0% followed by the UK (12.3%), Japan (6.4%),

Germany (5.4%), and the UAE (4.7%). It may be noted that Japan, which has emerged

19



as a major investor globally (averaging $27.9 billion during 1990-1997), has annually

invested only $32.3 million (or 0.1%) in Pakistan during the same period.

4.5 Future Prospects

FDI in Pakistan consists primarily of three elements, namely, cash brought in,

capital equipment brought in, and re-invested earnings. The information provided in

Table 3 shows that the structure of the sources of financing FDI in Pakistan has

undergone a noticeable change. Though all the components of FDI exhibit considerable

fluctuations over time, the item labeled capital equipment brought in has remained

substantially low during 1983-1988. Though the major share of FDI in Pakistan

comprised cash brought in (on average 55.7% over the last 15 years), its share declined

slightly (on average 50.2% during 1991-1994) during the post-reform period. The share

of capital equipment brought in remained low, on average, over the last 15 years but it

has made considerable improvement during the postreform period. In particular, its

share jumped to 55.7% in 1994 mainly due to the equipment brought in for Hubco

Power Plant. Re-invested earnings contributed slightly less than one third to FDI over

the last 15 years but its share has declined to 23% during the postreform period.

On average, during 1980-1994, 30% of FDI in Pakistan originated from re-

invested earnings, whereas 70% (55.7% as cash and 14.2% as capital equipment)

came from abroad. During the postreform a structural shift appears to have taken place

as the share of re-invested earnings in total FDI declined to 23% while those coming

from abroad rose to 77 percent. It is important to note that the share of re-invested

earnings in FDI has been declining since 1990, falling from 31% in 1989 to 12% in

1994. There appears to be two reasons for such a rapid decline. Firstly, as a result of

chronic inflation, the cost of production has gone up considerably and along with the

plethora of taxes due to the fiscal consideration, the after tax profit of foreign firms has

declined. Consequently, the reinvested earnings that originate as savings from the

investment previously made have slowed down. Secondly, as a result of liberalization,

the entry barriers of foreign firms were removed, which led to higher inflows of new

20



investment. Consequently, the relative share of re-invested earnings in total FDI

declined considerably after 1990.

Having examined the trends and structural pattern of FDI, it is worthwhile to

review its overall sectoral distribution pattern. The analysis of sectoral distribution of FDI

may reflect two things: on the one hand, it may reflect the preferential treatment given

by the government to certain sectors while encouraging FDI, and on the other hand, it

may also indicate the foreign investors’ own preferences.

As revealed by the information presented in Tables 4 and 5, a noteworthy

change can be easily observed in the sectoral composition of FDI flow into Pakistan

over the last 15 years. On the broad sectoral basis, manufacturing industries, mining

and quarrying, and commerce are seen to have traditionally dominated the preferences

of the foreign investors during 1980-1994 accounting for over 83% of total inflow of FDI.

However, like total FDI flows, sectoral shares also exhibit considerable year-to-year

fluctuations. For example, the sectoral share of manufacturing industries, though

highest, continued to fluctuate violently overtime, falling from 74.6% in 1982 to 26.0% in

1983 and once again rising to 54.7% in 1984. The share of manufacturing industries in

overall FDI averaged only 11% during 1987-1993 but rose to 35% in 1994. The general

decline in manufacturing share is largely substituted by the rise in the share of mining

and quarrying, which stood next to manufacturing (28.1%) over the last 15 years. It

appears that foreign investors preferred the petroleum sector (natural gas in particular)

during the period. A significant change in the composition of FDI was also witnessed

during the prereform and postreform periods. Manufacturing and mining and quarrying

registered a sharp decline during the postreform period as against the prereform era.

On the other hand, commerce, construction, and utilities experienced substantial

increase in total FDI during the postreform period.

It may be noted that the share of utilities in total FDI jumped from almost zero in

1993 to 31.7% in 1994. This massive increase was entirely due to the inflow of FDI in

21



the power sector with the Hubco Corporation alone accounting for Rs 7 billion out of Rs

7.6 billion in 1994.

In the remaining economic sectors (i.e., agriculture, transport, storage and

communication) the flow of FDI has been meager and erratic because of the limited

opportunities open for foreign exploitation in these areas.

22



5. CONCLUSION & RECOMMENDATIONS

5.1 Conclusion

FDI has been one of the defining features of the world economy over the past

two decades. It has grown at an unprecedented pace for more than a decade. The past

decade has witnessed an unparallel opening and modernism of the economies in all

regions, encompassing deregulation, de-monopolization, privatization and private

participation in the provision of infrastructure, a and the reduction and simplification of

tariffs. An integral part of this process has been the liberalization of foreign investment

regime. Although Pakistan has not received any considerable amount of FDI as yet, but

has remained relatively greater over the past couple of decades as it adopted market

oriented policies. The present study found that the growth impact of FDI tends to be

greater under an export promotion (EP) trade regime compared to an import-

substitution (IS) regime by using data for Pakistan over the period 1970-2001.

The effect of FDI in import substitution industries may be different from those of

export oriented industries since former target mostly the limited domestic market, while

the latter target the larger international market. Moreover, it is more likely to generate

more employment and, therefore spillover due to the expected larger production

capacity associated with larger market. FDI can stimulate human resources

development through investment in education and training. This enhances the stock of

human capital, and increases productivity of labor and other factors of production. In

short, these finding suggest that Pakistan’s capacity to progress on economic

development will depend on her performance in attracting FDI. Pakistan’s outward

looking development strategy should include FDI as an essential part in addition to

export promotion strategy.

23



5.2 Recommendations

General Recommendations

First of all, Pakistan should make stronger efforts to attract as much FDI as

possible to the foreign exchange sectors in the short term. Taking into account

unfavorable balance of payments prospects, it should refrain from attracting any further

massive FDI in the nonforeign-exchange-earning sectors for some years in the future.

Political stability and satisfactory law and order are likewise critical to attract FDI.

The international press and media coverage Pakistan has received in recent

years is not at all conducive to attracting foreign investors. News items on Pakistan

being one of the most corrupt countries in the world, its bomb detonations, and its use

of child labor will hardly encourage foreign investors to undertake initiatives in Pakistan.

The country’s political leadership must take practical steps to improve the law and order

situation particularly in the major “growth poles” of the country including Karachi.

Macroeconomic stability plays a key role in boosting economic growth (see Kim 1993)

and restoring foreign investors’ confidence on the economy. In an environment of large

fiscal deficit and precarious foreign exchange reserves position, foreign investors are

unlikely to increase their participation. Pakistan’s fiscal situation and foreign exchange

reserves position will remain under considerable strain for some time making the

macroeconomic environment less conducive for foreign investors. Some drastic and far-

reaching measures are needed to reduce the fiscal deficit on the one hand and raise

foreign exchange reserves on the other. Inconsistent economic policies discourage

foreign investors in undertaking projects of medium to long-run duration. Several recent

examples of inconsistent economic policies pursued by Pakistan have sent wrong

signals to foreign investors.

There is a strong perception among foreign investors that the probusiness

policies and inducements used to attract prospective new investors are somehow lost in

the reality they encounter when they actually begin to set up and operate their business

24



in Pakistan. Although the investment approval requirement has been removed,

numerous permits and clearances from different government agencies at national,

regional, and local levels are still applied to foreign investors, causing delays to

complete the process. The authorities should streamline administrative procedures

regarding approval and official clearances. Foreign investors in Pakistan have to cope

with a complex legal situation. Law based on different legal systems are applied

independently and it is often not obvious which one will take precedence. The legal

situation is even further complicated by the fact that government agencies are

empowered to introduce certain changes through administrative orders and SROs. The

laws and regulations should be simplified, updated, modernized, made more

transparent, and their discretionary application must be discouraged.

Specific Recommendations

Taxes

Payment of taxes and contributions in Pakistan is complex and cumbersome. In

addition to corporate income taxes, a large number of indirect taxes are levied at the

federal, provincial, and local levels. Essentially, separate collection of taxes and

contributions have forced enterprises to face unnecessary, cumbersome, and costly

administrative procedures, and to deal with a large number of collecting agencies at all

three levels of government. There is an urgent need to reduce the number of taxes and

contributions; streamline tax regulations and administrative procedures; and most

importantly reduce the contact of foreign firms with a large number of tax and

contributions-collecting agencies. The existence of such a large number of taxes and

collecting agencies may breed corruption, which adds to the cost of production. Import

tariffs on plant and machinery have discouraged investment, more so in Pakistan where

capital is scarce and cost of borrowing is high. Because of this high cost, manufacturers

are discouraged to modernize and the quality of local industry products are restricted

against international competition. There is a need to examine tariffs of plant and

machinery with a view to substantially reducing them.

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Credit Facilities

Foreign firms operating in Pakistan are currently facing cash flow problems as a

result of many taxes and the Asian crisis. That these firms cannot borrow more than

their equity capital have further aggravated the cash flow problem. There is a need to

review this policy.

Anti-monopoly Restrictions

The existing monopoly control laws that benchmark the concentration of

economic power to an unrealistically low limit of Rs 300 million for assets discourage

capital formation. The monopoly control authority must review the limit in consultation

with the Overseas Investors Chamber of Commerce and Industry in Pakistan.

Labor Laws

Overprotective labor laws do not encourage productivity and frighten away much

needed productive investment. There is a need to rationalize the labor laws and multiple

levies on employment that inhibit business expansion and job creation.

Infrastructure

The availability of better quality and more reliable services in all areas of

infrastructure are key ingredients of a business environment conducive to foreign

investment. In most infrastructure services, Pakistan is highly deficient as compared

with many developing countries that have attracted higher levels of foreign investment.

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If Pakistan wants to catch up gradually with the development of the economies of East

and Southeast Asia, it will have to investment more in the areas of education and

physical infrastructure. On the education front, the government should identify the

nature of skills critical to sustained industrial growth, and formulate strategies, policies,

and programs that could facilitate the enhancement of these skills.

In telecoms, the government should expedite the privatization of PTC. In the

railway and road sector, government must engage the private sector in leases,

concessions, and buildoperate-transfer (BOT) type contracts. The high cargo handling

costs at the Karachi port need to be controlled. Dredging of shipping channels to

accommodate large vessels, lowering labor costs, upgrading port handling equipment,

and improving documentary procedures need urgent attention.

Confidence-building Measure

The close partnership between the private and public sector is essential to build

confidence. In this respect, it is recommended that a forum be established where the

private and public sectors could sit together to discuss business promotion-related

issues. The forum must be composed of the prime minister, all the presidents of the

national chambers, top businessmen/industrialists, top bankers, as well as heads of

overseas chambers of commerce and relevant ministries' secretaries and ministers. The

forum may meet regularly to review the economic situation of the country. The problem

faced by the business community can be discussed and decisions could be taken

immediately. This kind of partnership between the government and private sector will

help restore market confidence.

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BIBLOGRAPY

Articles

1) Foreign direct investment in Pakistan: Policy, issues and operational implications.

By: Ashfaque H. Khan and Yun-Hwan Kim

2) Impact of Foreign direct investment on economic growth in Pakistan

By:Nuzhat Falki

Websites

www.adb.org/Documents/EDRC/Reports

eprints.hec.gov.pk

www.sbp.org.pk

www.pakboi.gov.pk/forign-invest.htm

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http://www.adb.org/Documents/EDRC/Reports

http://www.pakboi.gov.pk/forign-invest.htm

http://www.sbp.org.pk/

The Impact of Foreign Direct Investment on Pakistan Economy Final Project

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