Globalization which gave birth to the concept of interdependence of countries and their economies has been defined as the process with which international financial systems, civilizations, and cultures get connected 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. 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 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 one 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 foreign country. Those were 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 variety of other aspects of serious significance to progress.
Since 1990s there has been noteworthy increase in flow of capital investments to developing countries, which motivated discussions in literature concerning determinants of such investment flows. This trend was result of liberal trade policies, variations in economics related fundamentals of emergent countries; development of capital markets and transformations in economic conditions around the globe. This research paper tries to investigate the role of economic fundamentals in driving investment flows. Past research on the economic fundamentals as determinants of foreign direct investment divided economic fundamentals into two broad categories, first was termed as pull factors and second category was known as push factors. The first category of pull factors consisted of economic fundamentals of recipient countries that attract capital flows, in contrast push factors considered those economic fundamentals that related to industrial or developed countries and motivate capital flows. One of the major push factors as cited in the past research was hold back of the economies of the developed countries (Calvo, 1992; Fernandez-Arias, 1996; Haque, 1997; Montiel and Reinhart, 1999). Pull factors consist of Supply of money and local productivity of the recipient country (Calvo et al.,; Lensink and White, 1998). Calvo (1992) argued that push factors contribute more than pull factors in growth of capital transfer. Vita and Kyaw (2008) suggested that variations in domestic yield and productivity of the foreign country were main determinants of portfolio and FDI flows. Dunning (1993) by combining previous research on the determinants of FDI came up with "OLI" model that stated global manufacturing as function of ownership, localization and internationalization. Variety of theories have been developed regarding the determinants of FDI such as industrial organization theory, the pure trade theory, classical theory relating international investment flows, and locational factor theories. Classical theory relating the international investment flow stated that when return on investment crossways countries under autarchy change the investments will shift from lower to higher return providing country. Therefore, this theory assumes foreign direct investment as function of dissimilarity of return on investment. Wilhborg (1978) argued that volatility in the exchange rate would decrease the amount of portfolio investment and that had also been valid for FDI (Black, 1977). According to Kohlhagen (1977) the firms that expect devaluation in the currency of foreign country would defer its investment till the time when exporting becomes profitable. Study also concluded that the higher the exchange rate, the lower the amount of FDI because this phenomena would make exporting relatively less profitable.
1.2 Problem statement
To identify the best determinants of the aggregate inward FDI flow to Pakistan.
1.3 Hypothesis
This particular research primarily focused on testing the following hypothesis:
H1: GDP has positive impact on FDI.
H2: Infrastructure expenditure has positive impact on FDI.
H3: Taxes has negative impact on FDI.
H4: Inflation has negative impact on FDI.
H5: GDP per capita growth has positive impact on FDI.
H6: Exchange rate has positive impact on FDI.
H7: Interest rate has negative impact on FDI.
1.4 Outline of the Study
The first chapter of the research focused on giving basic view of the research and provides information on the overview, issues, purpose and basic theories on the determinants of FDI. In the chapter existing work done by various researchers and past empirical studies have been discussed. The third chapter provides details regarding practically carrying out of the research and describes data collection and analysis procedures. Finally, the last chapter gives details regarding the results of the research.
1.5 Definitions
All the chosen for predicting FDI were variables that had been used in prior research and theories relating FDI.
1.5.1 Net Foreign Direct Investment (FDI)
The net amount of foreign direct investment received by Pakistan measured in current US dollars.
1.5.2 Inflation (I)
The variable represents annual change (%) in the commodities that fall in the category of CPI.
1.5.3 Interest rate (IR)
The variable represents the annual rate of interest (%) offered by banks operating in Pakistan on the deposits by customers.
1.5.4 Exchange rate (ER)
Measured as the rate of converting 1 US $ into Pakistani rupees (1 US $ = Rs.).
1.5.5 Infrastructure expenditure (IE)
Represents the annual amount spent by government of Pakistan on the development of infrastructure in the country. The variable is measured by annual amount of Public Sector Development Program (PSDP) fund and unit of measurement was rupees in million.
1.5.6 Taxes (T)
The variable represents the annual rate of tax (%) applicable on the profits of corporate companies operating in Pakistan.
1.5.7 Gross domestic product (GDP)
Represents the total value of goods and services (at factor cost) produced in Pakistan measured in Rs. Million.
1.5.8 GDP per capita growth rate (GDPG)
The variable represents the annual rate of growth (%) in the gross domestic product per capita, of Pakistan.
CHAPTER 2:
LITERATURE REVIEW
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 implied that the determinants of Foreign Direct Investment differed on the basis of country investment and location of investment. The purpose of this research was to find out the impact of Labor cost (Wage), Inflation (I),Interest rate (IR), Exchange rate (ER), Infrastructure expenditure (IE), Taxes (T), GDP and GDP per capita growth (GDPG) on Foreign Direct Investment (FDI) inflow in Pakistan. The study hypothesized positive relationship between GDP, GDP per capita growth, Infrastructure expenditure and Exchange rate with FDI whereas Wage, Inflation, Taxes and Interest rate related negatively with FDI.
Pursuing similar objectives Kok and Ersoy (2009) conducted study that made attempt to investigate the best determinants of FDI in developing countries. Study hypothesized and concluded that GDP, inflation, Trade, GDP per capita growth, Gross fixed capital formation and communication (telephone) were positively related with FDI whereas inflation and total debt/ GDP had negative relationship. Barrel and Pain (1996) in their empirical studies found that FDI and both the acceleration and level of GNP were positively related. In addition unit labor cost and relative capital cost also had positive relationship with outward direct investment. Research suggested that in short run funds availability affected investment timing. Research of Barrel and Pain et al. related to this particular thesis because it tried to identify probable impact of factor prices and demand across countries, as well as exchange rate expectations in determining the total level of foreign direct investment (FDI) by United States companies. According to Janeba (2002) investment costs and government credibility had significant impact on the level of inward foreign direct investment; research suggested that MNCs would prefer to invest in politically stable countries. The research also concluded that when any politically unstable country has cost advantage over other countries MNC will invest efficient amount in that particular country and will hold excess capacity elsewhere. According to the conventional wisdom lack of commitment from the government discouraged foreign direct investment in emerging countries. The research work done by Harvey (1990) focused on the macroeconomic determinants of FDI in addition to variables relating to different industry groups and tried to identify the impact of these variables on the inward FDI flow of the recipient country. Research suggested that Exchange rate and Sales had significant impact on the foreign direct investment, whereas taxes did not have any significant role in explaining foreign direct investment.
Following bit different framework research conducted by Rolfe, Ricks, Pointer and McCarthy (1993) made an attempt to check investors' investment decision on the basis of various investment incentives provided by countries in the Caribbean region. The study demonstrated that all inducements do not evenly plea to all investors. The investment characteristics would determine which incentives firm manager will prefer. According to the study incentives chosen by firms exporting their products vary from those firms that sale product in local markets, companies opening operations in new state had different inducement preferences than firms involved in growing or purchasing prevailing operations, incentive choices occasionally differ by state of investment, incentives vary reliant upon the products made, large financiers select different motivations than those preferred by smaller companies and incentive inclinations can fluctuate on yearly basis. In short the research concluded that incentive preferences can be represented as a function of the investment type, countries involved, the market positioning of the investing companies, type of products produced by the investing company, amount of the capital invested, and investment time.
Terpstra and Yu (1988) tried to examine the impact of firm-specific advantages and locational factors on the foreign investment made by advertising agencies of U.S. Study focused on determining role of market size of recipient country, geographic nearness of recipient country, size of the investing firm, experience of investing firm in international operations, oligopolistic response and existence of homemade country clienteles overseas on FDI. The research depicted that U.S. advertising agencies prefer to invest in those foreign countries having large market size, did not discriminated countries on the basis of their geographic location, inclined to enter foreign market with bigger firm size, tended international expansion with increasing understanding of international operations, reacted oligopolistically while making foreign investment and followed client firms belonging to home country while going abroad. Additionally research found that oligopolistic reaction had stronger impact in 1984 compared to 1972, intensity of competition had significant impact on oligopolistic reaction and top agencies witnessed stronger impact of oligopolistic reaction.
Another study tried to examine determinants of FDI by using macroeconomic variables but more emphasis was given to various ratios relating to capital and labor, also employed "The Heckscher-Ohlin Theory" acknowledged that nations sell to other countries that merchandise that heavily employ country's comparatively plentiful factors and bring in that merchandise that make use of its inadequate factors in high quantity. Results indicated that countries like U.S. imported goods whose production required higher capital to labor ratio than the goods exported and when the endowment ratio of capital/labor increased the ratio of capital for each worker in import-competing production to capital for each worker in export production declined. Gopinath and Echeverria (2004) studied the association between foreign investment (FDI) and trade in mutual framework, that is, source or investing country's exports and foreign investment to investment recipient country were examined through gravity-model methodology. Results suggested that physical distance had negative impact on trade-FDI ratio, this caused nations to switch from export to FDI based manufacturing. Research also found GDP per capita to affect trade-FDI ratio positively and institutional quality strongly encouraged FDI, additionally FDI was also encouraged by regional trading agreements.
The empirical study conducted by Goldberg and Kolstad (1995) stated that exchange rate instability contributed to production internationalization without depressing economic activity in the home country. Furthermore, exchange rate instability motivated the portion of investment activity situated in foreign state. Research also suggested that exchange rate instability did not have statistically dissimilar effects on capital investment shares when distinguished between varieties of periods where real or financial variations dictated exchange rate movement. Yin (1999) made an attempt to study the impact of tax inducements on the arrangement of a local business with respect to price, productivity, revenue, and entrance/exit, by taking into consideration technology relocation through FDI. The study concluded that if the host country's government provided higher tax relief to foreign companies, total yield increased and decrease in price index was experienced that encouraged more foreign businesses to move in the industry while certain present host businesses departure. Research also suggested that government had to be cautious in decreasing rate of taxes to attract FDI.
Vita and Kyaw (2008) used empirically controllable structural VAR model for identifying determining factors of investment flows and variance decomposition and impulse response analyses to examine the time-based dynamic effects of variations in both pull and push motivators on FDI and portfolio investments. Study suggested that variation in real variables representing economic activity for example domestic productivity and foreign output possessed more power in explaining variability in investment flows to developing nations. This research developed structural VAR model to test relative importance of the determinants of disaggregated investment flows to developing countries. The study investigated the degree to which deviations in FDI and portfolio investments were caused by variety of pull and push factors through various period horizons.
Studying the impact of FDI on various facets of local economies, containing global trade, employment, gross fixed capital formation, output, balance of payments (BoP) and overall welfare Hejazi and Pauly (2003) found that FDI was encouraged by marketplace admittance and factor price disparity, and by trade within organization. According to the research prediction of whether increase in outward flow of foreign direct investment will boost or reduce investing countries GFCF is not possible. Therefore, assessment of this type of increase relative to expansion of inward flow of foreign direct investment was considered as a deceptive pointer for the strategy makers. Since the impact of foreign direct investment flow on local GFCF relies on the fundamental incentives for capital investment and merely not on the increase in outward foreign direct investment with respect to inward foreign direct investment, the outcome were of significance to all of the nations. The implications of results stated that quick progress in outward foreign direct investment, comparative to inward progress, should not be taken as a negative growth, but might be source of success. Chen (1996) suggested that capacity of the market share to expand affected inward flow of FDI but labor cost did not affect FDI. Similarly foreign investing companies had utilized the natural and energy resources of Western region of China despite of low allocative efficiency in this area. Interregional railway networks were significant in location preference of foreign investors'. Besides that, foreign investors were reluctant in locating near state-of-the-art local Chinese businesses in the eastern as well as middle provinces. These results were significant because the choice of FDI location appeared to have been motivated by the presence of good transport connections, high-tech filtering and, to some level by the capacity of the market share to expand. The choice of FDI location did not appear to have been persuaded by taking into account labor cost variances.
According to the neoclassical model of growth, growth rate of labor as well as technological development were considered as exogenous and 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). Papanek (1973) indicated statistically significant negative effect of various sorts of investment on domestic savings. Grounded on a sample of 85 emerging countries, research concluded that foreign investment displaced national savings. Precisely, the research exhibited all types of foreign investment either in shape of aid or individual investment compressed the domestic savings. As a result the economy of the FDI recipient country went into state of higher dependency on foreign investment for development.
The empirical studies of Cushman (1985) based on U.S. bilateral FDI outflow and inflow data concluded that exchange rate variability had positive relation with both set of flows. Connor (1983) conducted research focusing on inward as well as outward flow of FDI. The study divided country specific advantages into three categories FDI Probability, FDI Propensity and FDI Penetration and their impact on FDI. Research done by Larudee and Koechlin (1999) focused on the wage or labor costs and productivity in terms of production costs as the determinants of FDI. This research used "sweatshop labor argument" that relied indirectly on assumption of simplistic trade model that assumed all of the national firms to have access to similar technology. But in contrary MNE and abundant theory acquired higher labor efficiency due to the firm related advantages MNE possess. The discrepancy between investing and recipient country in average manufacturing wage was identified as independent determinant of FDI flows.
CHAPTER 3:
PROPOSED METHODOLOGY
3.1 Method of Data Collection
The secondary data necessarily required to perform the research was gathered from the official sites of The World Bank and The State Bank of Pakistan. Additionally, some of the required data was abstracted from the book Statistical Supplement and Yearly Book both being published under the supervision of State Bank of Pakistan.
3.2 Sample Size
The data used for the purpose of research consisted of 30 years annual data of the variables used in research. Data of all the variables belonged to period starting from fiscal year 1980 to fiscal year 2010.
3.3 Research Model developed
In order to test the hypothesis of the research multiple regression model was developed. The model established was similar to the research model used by Kyrkilis and Pantelidis (2003).
FDI= α + β0GDP + β1GDPG - β2I + β3ER + β4IE - β5T - β6IR + µ
Where
FDI = Net amount of Foreign Direct Investment received by Pakistan
I = Inflation rate
IR = Interest rate
ER = Exchange rate
IE = Infrastructure expenditure
T = Tax rate
GDP = Gross domestic product
GDPG = GDP per capita growth rate
µ = Error term.
3.4 Statistical Technique
In order to test the hypothesis developed of the research the statistical technique of multiple regression analysis was applied. This technique was applied because both the dependent variable and independent variables were scale and under this situation the prediction power of regression analysis is stronger as compared with the other statistical techniques available.
CHAPTER 4:
RESULTS
4.1 Findings and Interpretation of the results
The results drawn by applying Multiple Regression analysis were as follows:
Table: 4.1Model Summary
The model summary table elucidated what amount of variance in the dependent variable is explained by the independent variables. The value of R-square is .996 which means that approximately 99.6 % of the variance of SQFDI is accounted for by the model and only .04 % of the variance remains unexplained. Independent variables were square of Infrastructure Expenditure (PSDP Fund), Interest Rate (IR), Inflation (I) and Exchange Rate (ER) and the dependent variable was Square of Net Foreign Direct Investment (SQFDI).
Table: 4.2ANOVA
The Anova table elucidated the model fit, sig. value of .000 suggested F-test to be significant, and therefore the model was statistically significant. When the sig. value in the Anova table is less than .05 the model fit is good and regression could be applied on the data.
Table: 4.3 Coefficients
The co-efficients table showed the significance of individual independent variable in explaining the dependent variable. In final model square of Infrastructure Expenditure (PSDP Fund), Interest Rate (IR), Inflation (I) and Exchange Rate (ER) were the statistically significant variables. The effect of Inflation (b = -8.806E16, p = .035) was statistically significant had negative coefficient demonstrating that larger the value of inflation rate, the lower the Foreign Direct Investment. The value of beta indicated that 1 unit increase in inflation would decrease FDI by - 8.806E16 units. Similarly, the effect of Interest Rate (b = 2.047E17, p = .003) was significant and its coefficient was positive indicating that the greater the value of interest rate, the higher the amount of FDI received. The value of beta indicated that 1 unit increase in interest rate will increase FDI by 2.047E17 units. Next, the effect of Exchange Rate (b = -5.646E16, p = .000) was also statistically significant, exchange rate had negative coefficient demonstrating that larger the value of exchange rate, the lower the amount of FDI. The value of beta indicated that 1 unit increase in exchange rate will decrease FDI by -5.646E16 units. Finally, the effect of Infrastructure Expenditure (b = 1.654E8, p = .000) was statistically significant too, Infrastructure Expenditure had positive coefficient indicating that the greater the amount spent by government as infrastructure expenditure, the higher the amount of FDI received. The value of beta indicated that 1 unit increase in amount of infrastructure expenditure can lead to an increase of 1.654E8 units in FDI.
Empirical Model Developed
FDI = 1.654E8 Infrastructure Expenditure + 2.047E17 Interest Rate - 5.646E16 Exchange Rate - 8.806E16 Inflation
4.2 Hypothesis Assessment Summary
Table: 4.4 Hypothesis Assessment Summary
Hypothesis
β
Sig.
E.C
H1: GDP has positive impact on FDI
-5.349E10
.887
Reject
H2: Infrastructure expenditure has positive impact on FDI
1.654E8
.000
Accept
H3: Taxes has negative impact on FDI
-6.989E15
.943
Reject
H4: Inflation has negative impact on FDI
-8.806E16
.035
Accept
H5:GDP per capita growth has positive impact on FDI
-2.050E17
.248
Reject
H6: Exchange rate has positive impact on FDI
-5.646E16
.000
Reject
H7: Interest rate has negative impact on FDI
2.047E17
.003
Reject
CHAPTER 5:
DISCUSSION, CONCLUSION, IMPLICATIONS AND FUTURE RESEARCH
5.1 Conclusion
Foreign direct invest being the most important factor in the development of developing countries likewise Pakistan. From recent years there has been great fight going on among LDC's from all over the world to attract higher amount of FDI to fuel their economic growth. This research was intended to find out the impact of macroeconomic variables including GDP, GDP per capita growth rate, Interest rate, Inflation rate, Wage rate, Exchange rate, Tax rate and Infrastructure expenditure (PSDP fund) on the inflow of Foreign Direct Investment in Pakistan. The relationship between labor cost (Wage) and FDI could not be established because insufficient data was available on the annual wage rate in the country. GDP, GDP per capita growth rate and Tax rate were statistically insignificant in contributing in the final model. The most significant variables in the model were Inflation rate and Exchange rate; both had negative relation with FDI inflow having beta of -8.806 and -5.646 respectively. Interest rate and Infrastructure expenditure (PSDP fund) were positively related with FDI inflow having beta of 2.047 and 1.654 respectively.
5.2 Discussion
According to results derived from the research inflation had negative impact on FDI as found by (Kok and Erosy, 2003). Contradictory to the studies of Kok and Erosy et al. and Asiedu (2002) that found positive impact of GDP per capita growth rate on inward flow of FDI but in case of Pakistan GDP per capita growth rate proved insignificant. Results regarding the impact of infrastructure on FDI were similar to those established by Asiedu (2002) but the impact of tax rate was conflicting. The results regarding the impact of exchange rate on FDI were consistent with those found by (Cushman, 1985). Terpstra and Yu (1988) and Weinstein (1977) found positive impact of GDP on FDI but according to the results of this study GDP was statistically insignificant in explaining variation in FDI. Finally, the results regarding the impact of interest rate on FDI were consistent with those found by (Fernandez-Arias, 1996).
5.3 Implications and Recommendations
Pakistan belongs to category of countries those currently face huge deficit of resources to finance its major growth projects and to manage the government operations smoothly. This research paper made attempt to explore those factors that in particular have direct impact on the inward FDI flow of the country. Results of the research show that exchange rate and inflation were negatively related with FDI and had statistically significant impact on the FDI received by the country. Therefore, the government of Pakistan should try to control variations in exchange rate and inflation rate and keep both at minimum possible level in order to assist increase in inflow flow of FDI. Similarly, infrastructure expenditure and interest rate were found to be positively related with inflow of FDI, keeping this in mind government should increase its spending on the development of infrastructure within the country. Following these strategies the government would be able to attract higher amount of FDI.
5.4 Future Research
Generally speaking determinants of foreign direct investment could consist of variety of factors other than some macroeconomic variables discussed in this particular research paper. The most common of those that previously have been studied were political factors including political stability, level of corruption, structure of the industry, market openness and variety of other factors impact the foreign direct investment received by any specific country. But talking in the Asian scenario cheap labor has been one of the major determinants of the inward FDI flow but unfortunately data regarding labor cost (wage) could not be collected and the impact of labor cost on FDI in case of Pakistan remained unidentified. Therefore, great deal of research could be done in order to identify those variables that have an impact on FDI.
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