Globalization which gave birth to the concept of interdependence of countries and their economies is defined as the process through which regional economies, societies, and cultures have become integrated with the assistance of global network of trade, communication and transportation. This allowed the investors to invest or transfer their capital where ever they wanted which introduced the concept of Foreign Direct Investment.
FDI defined: FDI is simply defined as physical investment made by company(s) or individual(s) from one country to another. Foreign Direct Investment is generally classified in two categories:
Direct Investment: Investment made by foreign corporation(s) or individual(s) with the aim of acquiring control over the development of a firm’s long term strategy. These investments are primarily part of sectors termed as productive sectors, e.g. industrial, financial or services.
Portfolio Investment: Investment done through capital markets which may comprise of acquiring bonds, shares and other financial instruments with the aim of acquiring short or medium term profitability due to the yield or capital gains of the purchased assets.
Issues: Since the recent financial crisis in Asia and Latin America, developing as well as newly industrialized countries have been advised to rely mainly on FDI for economic development and to supplement national savings by capital inflows. Developing countries in particular are in need of investment for their development and the investment amount in majority of cases is greater than the capital internally available. Therefore, FDI has emerged as most important source of generating capital required for development of emerging countries. Currently Foreign Direct Investment has become on of the major sources of economic development, modernization, employment, income growth, capital generation and a channel for the transfer and access to advance technologies as well as organizational and managerial skills. Recognizing this fact, developing countries try their level best to attract as much as of FDI as they can. But attracting FDI is not that much simple, it requires huge efforts on the part of policy makers and government. Variety of factors is considered by an investor before making investment in a particular country. Those are labeled as determinants of FDI, and may vary from country to country. Pakistan is currently facing a huge shortfall of capital to finance its major development projects and to run the government operations smoothly. The country requires capital to fulfill the growing needs in defense, infrastructure, education and many other areas of critical importance to development.
Objective: The objective of this research is to identify the major determinants of Inward FDI flow to Pakistan.
Users: This research will be useful for the national policymakers and government of Pakistan; it will allow them to improve the weak points in the economy which discourage the FDI inflows to the country.
A lot of research has already been conducted in the field of identifying the best determinants of Foreign Direct Investment by various researchers. Most of the research work conducted implies that the determinants of Foreign Direct Investment vary from country to country and similarly from location to location.
According to the neoclassical growth model, labor growth and technological progress are considered as exogenous, inward Foreign Direct Investment(FDI) will lead to increase in the investment rate and which will ultimately lead to increase in the growth of per capita income but the growth effect will not last in the long run(Hsiao and Hsiao, 2006). New growth theory in 1980’s endogenizes technological progress and states that FDI which results in technology transfer and spillovers will have long-lasting growth effect in the recipient country. The discussion on the impact of FDI on the host country’s economy is still continuing, as perceived from the modern surveys of the collected works (De Mello, 1997, 1999: Fan, 2002: Lim, 2001). Neoclassical growth theory model states that, FDI does not have any affect on the long-term growth rate of the host country. If we consider the assumptions of the neoclassical growth theory which are, constant economies of scale, declining marginal products of inputs, positive substitution elasticity of inputs and perfect competition it can be understood much easily (Sass, 2003). Within the framework of the neoclassical models (Solow, 1956), the diminishing returns in the physical capital was considered to constrain the impact of FDI on the growth rate of output. As a result, FDI could only apply a level effect on the output per capita, but not a rate effect. In other words, FDI was not able to alter the growth rate of output in the long run (Calyo and Robles, 2003). According to the framework given by the new theory of Economic Growth, nevertheless, FDI will have affect on the level of per capita output as well as its growth rate. This particular literature developed variety of hypotheses that described the reason why FDI would possibly improve the growth rate of per capita income in the recipient country (Calyo and Robles, 2003) et al. FDI would encourage economic growth through its effect on technological progress as hypothesized by Findlay (1978).
The empirical studies conducted by Blomstrom (1992) and Borensztein (1988) concluded that FDI and economic growth are positively correlated. Levine and Renelt (1992) and De long and Summers (1991) determined in their studies that the rate of economic growth is determined by rate of capital formation. According to Streeten and Sanjaya (1977), FDI had a net positive effect on the national economic welfare. The empirical study of Sun (1998) showed that, FDI has meaningfully encouraged economic growth in China by contributing to domestic capital formation, creating new employments and increasing exports. FDI dislodges domestic savings (Papanek, 1973; Cohen, 1993; Reinhart and Talvi, 1998). Papanek (1973) showed significant negative impacts of different types of capital on national savings. Grounded on a sample of 85 emerging countries, Papanek found that foreign capital displaced domestic savings. Precisely, he exhibited that foreign aid, private investment and other capital crowded out national savings, and a reduction in domestic savings could lead to further increase on the dependency on foreign capital (Baharumshah and Thanoon, 2006). Morck and Yeung (1991) postulated and concluded that FDI generates wealth when a growing firm possesses intangible assets, such as superior production and management skills, marketing expertise, patents and consumer goodwill.
Determinants of FDI:
FDI influences the income, prices, production, employment, economic growth, development and general welfare of the recipient country (UNCTAD, 2006). The studies conducted by Asiedu (2002) and Edwards (1990) concluded that the openness to trade and FDI are positively related. Recep Kok and Bernur Acikgoz Ersoy (2009) hypothesized and concluded that GDP, inflation, Trade, Gross capital formation, GDP per capita growth and communication (telephone) are positively related with FDI.
The determinants of FDI can be divided in two main categories, pull and push factors. The push factors are defined as exogenous, and are related to economic developments in those countries which are mainly industrial countries that impact the supply of capital flows to the emerging countries. The lower level of a country’s interest rate or reduction in the international interest rates is cited as the most important push factors. The pull factors are related to a specific country, and are termed as endogenous or in other words these factors are related to the economic development of the host country which has an impact over the demand for capital flows. The most common example of pull factors are money supply and domestic productivity or GDP (Calvo, 1992; Lensink and White, 1998).
The empirical studies of Fernandez-Arias (1996) concluded that the decline in the international interest rates was the major factor underlying the capital flows to emerging countries. Chuhan (1998) conducted research to find out the determinant factors of huge capital flows to developing countries in the period of 1988-1992 and concluded that the role of push factors in explaining the capital flows was more important as compared to the pull factors which were at least as vital especially in case of Asian countries. Hartman (1984) conducted research to study the impact of taxes on the level of FDI by using annual data of three variables the after-tax return of the foreign investor, the overall after-tax rate of return on the capital and the ratio of tax rate on the U.S. capital owned by foreign investors to that on U.S. capital owned by U.S. investors, the data used belonged to the period of 1965 to 1979. Hartman at al (1984) concluded that the rate of tax affects the FDI inflow, irrespective of the source of funding.
Stephen Golub (1995) commented on the “sweatshop labor argument” which says “production repositioning is expected from high-wage to low-wage countries” that, if the argument was right than Bangladesh and Botswana would rule the trade, the argument further states that wage is not the only factor determining the FDI flows. The empirical studies of Cushman (1985, 1988) based U.S. bilateral FDI outflow and inflow data concluded that exchange rate variability had positive relation with set of flows. Bailey and Taylas (1991), in their study conducted by using quarterly data on aggregate real direct investment inflows for 1976:1,-1986:1 concluded that there is no adverse impact of exchange rate variability over FDI flows.