Dr. SALMAN AHMADTHE DETERMINANTS OF FDI

A CASE STUDY OF PAKISTAN

PROF. Department of Management Studies, University of Central (FY81—FY09)  

 
 

Punjab, LAHORE
ABSTRACT
This paper analyzes the determinants of Foreign Direct
Investment (FDI) in developing countries like Pakistan and
examines why some countries like Pakistan have been relatively
unsuccessful in attracting FDI despite policy reforms. This Study
applies Auto Regressive distributed Lag (ARDL) Co-integration
technique given by Pesaran. The study found GDP as a significant
variable affecting low FDI inflows. The reason for small inflows
is that Pakistan has small GDP and it is not growing at a higher
rate showing a small size of market compared to India and China.
The paper considers other variables like corruption, globalization,
etc., but found them statistically insignificant taking into account
Pakistan’s data for about 30 years.
ABSTRACT
This study investigates the econometrically empirical
evidence of the relationship between FDI and GDP in an
ARDL framework for Pakistan. This study also examines
causal linkages between the variables by applying the
augmented Granger causality test of Toda-
Yamamoto(1995). The results using data on Pakistan’s real
GDP and FDI for the period 1980-81 to 2008-09 show
cointegration between FDI and GDP when FDI is taken as
the dependent variable. Furthermore, unidirectional
Granger causality running from real GDP to real FDI has
been found in bivariate causality framework.
IMPORTANCE
FDI is crucial to a developing country like Pakistan as it
provides the needed capital for investment. In addition,
FDI brings with it employment, managerial skills and
technology, and thus accelerates growth and development.
The role of FDI as a source of capital has become
increasingly important as IMF has started putting
conditions and forced structural adjustments for loans.
INVESTMENT POLICY 1997
1. Previously only manufacturing sector was open to
foreign investors. Now agriculture, services, infrastructure,
and social sectors are also open for foreign investors on
repatriable basis.
2. Manufacturing sector has been prioritized in four
categories, namely
a) Value added or export industries, the units which export
80 percent or more of their products in any one year or have
minimum value addition of 40 percent of production value
is treated as value added or export industries respectively.
Investment Policy
b) High-tech, this includes information technology, solar
technology, aerospace, defence production, etc.
c) Priority industries, this includes engineering/capital
goods industries, chemicals, and others.
d) Agro-based industries, this includes production of
quality/hybrid seeds, edible oil extracting/refining,
livestock/poultry feeds, milk processing, etc.
3. Revision of labor laws in favor of industrialists.
LITERATURE REVIEW
The size-of-market hypothesis is based on the assumption that an
inadequate market size has retarded the specialization of
productive factors. The argument holds that the size of the market
has been insufficient to absorb efficiently the technology which
the direct investor desires to introduce. Based on this and related
assumptions that differences exist among nations in the level of
technology; and that some nations are more able to mobilize
financial capital than others, the size –of-market hypothesis is
that foreign investment will take place as soon as the market is
large enough to permit the capturing of economies of scale.

Literature review
Bandra and White (1968) found market size to be a
significant determinant of U.S. FDI. Schmitz and Bieri
(1972) found the one-period lagged GNP of the EEC to be
a significant variable in a FDI demand function. Lunn
(1980) also found the one-period-lagged GNP of the EEC
to be a significant explanatory variable for U.S. direct
investment in Europe. For developing countries, Root and
Ahmad(1979), Torrisi(1985), Schneider and Frey (1985),
Petrochilas(1989), and Wheeler and Mody(1992) all find
market size to be significant. For Pakistan, Muhammad
Hanif
Literature Review
Akhtar(2000) has used data from 1972 to 1996 and multivariate
regression analysis to reveal that market size, relative interest
rates and exchange rates are the major determinants of FDI in
Pakistan. Zahir Shah and Qazi Masood Ahmad(2003) used
cointegration technique to find that in the error correction model,
tariff, per capita GNP and dummy for democracy were significant
variables. Dar, et all (2004) have used the data for 1970-2002 to
check causality and long-term relationship between FDI,
Economic Growth and other socio-political determinants. They
found economic growth, exchange rate, interest rates,
unemployment, and political instability as having theoretically
expected signs with two-way causality relationships.
HYPOTHESIS
Three principal hypotheses have been proposed as to the
motivation of foreign investment: size of market in the
receiving area, economic growth, and tariff
discrimination. These hypotheses are tested using the co-
integration technique to determine their relative
importance. The empirical data used in these tests relate to
direct investment in Pakistan for the 1980-2009 period.
ARDL APPROACH
The prosed ARDL approach to cointegration is developed
by Pesaran and Pesaran(1997), Peasaran and Shin(1995,
1998) and further advanced by Pesaran et al. (2001). It is a
unification of autoregressive models and distributed lag
models. In an ARDL model, a time series is a function of
its lagged values and current and lagged values of one or
more explanatory variables.
The traditional cointegration technique perform better
only for large sample but this is more appropriate for 30
observations.
MODEL
The measure of the size of market is the level of GDP
shown by Y. The second category of hypotheses, the
growth hypothesis, are fundamentally based on the
relation between the level of aggregate demand and the
total investment needed to satisfy this demand. Two
variants of growth variables are used. The percentage rate
of growth of Pakistan GDP is designated G1; and dY
represents the absolute change in the Pak GDP.
Model
The investment demand function incorporating the size-of-market,
growth, and tariff-induced burden as arguments may be specified as:
I = A0 + A1 Y+ A2 T+ A3 G -------------(1)
Where:
I = the annual book value of Direct foreign investment in Pakistan (in
millions of dollars)
Y = Pak Real GDP (1999-2000 constant factor cost in millions of
rupees)
T= Tariff revenue as a ratio of total tax revenue
G = the general specification for the two variations of the growth
hypotheses: Growth rate Gr, and change in real GDP dY
DATA

FDI
Real inflows of FDI are the annual inflows of FDI for the period 1980-81 to 2008-09. Real
value of the dependent variable is obtained by deflating the nominal values with GDP deflator at
constant prices of 1999-2000.
 
GDP
Real GDP is used as a proxy to estimate the impact of existing market size in Pakistan on FDI.
The data for this variable, being in millions of rupees at constant prices of 1999-2000, was
converted into dollars using each year’s exchange rate of rupee per dollar.
Economic Growth
A high level of economic growth is a strong indication of market opportunities. The growth of
the host market is deemed to be significant for expansionary direct investment. We have used
two types of measures for growth. Real Growth rate of GDP is used to test the proposition that
a growing Pakistani market attracts FDI.
 
 
 DATA
Exchange Rate
An economy with a depreciating currency attracts more
FDI as exporting from abroad becomes expensive, while it
becomes cheaper to produce locally. Hence, exports by the
home country are replaced through local production in the
host country. Real exchange rate is used as a variable. It is
the nominal exchange rate (rupees per US dollar) adjusted
for relative changes in consumer price index (CPI) based
on 2000 prices.
Globalization
Data
When one shifts to consider price linked determinants of foreign
investment, direct influences on domestic prices should be
distinguished from direct influences on international prices.
Emphasis is placed on international price patterns to avoid domestic
price change due to change in tariffs. It is said that foreign
investment is undertaken to avoid obstacles to trade. An implication
of this hypothesis is that trade liberalization as a result of WTO will
allow goods to move more freely and thereby reduce the volume of
international investment flow needed. We use government revenues
from taxes on international trade, mainly import and customs duties.
These revenues are divided by the total tax to compute the relative
tax burden borne by the international sector.
EMPIRICAL FINDINGS
To investigate the nature of any long-run relationship
between FDI and the variables suggested in our model, we
proceed to examine whether the series are cointegrated.
Unless series are cointegrated, there is no equilibrium
relationship between variables and inference is worthless.
Empirical Findings
Unit Root Test
The results of four different unit root tests, augmented
Dickey-fuller(ADF), Phillips-Perron, Dickey-Fuller
Generalised Least Square (DF-GLS), and Ng-Perron tests
are employed for unit roots to find out whether the variables
are integrated of the same order. Johansen-Juselius test for
cointegration is employed followed by Error Correction
Model to find short-run relationship of the variables. If not,
then we use ARDL approach to test for long run
relationship. Results of the ADF and Phillips-Perron tests
are presented in Table 1.
Variables Augmented Dickey-Fuller Test Phillps-Perron Test (PP)
(ADF)
Intercept Intercept & Intercept Intercept &
Trend Trend
Lx1 -1.5341 -2.6657 -1.4808 -2.7374
(0.5020) (0.2569) (0.5283) (0.2304)
DLx1 -5.4522 -5.4533
(0.0001) (0.0001)
Lx2 -0.5813 -5.7460 -1.2030 -1.7989
(0.8566) (0.0005) (0.6587) (0.6781)
DLx2 -3.9483
(0.0055)
Lx3 -3.6020 -3.8615 -3.5532
(0.0123) (0.0278) (0.0138)
DLx3 -7.0140
( 0.0000)
Lx4 -1.3640 -4.4203 -2.3650 -4.4033
(0.5845) (0.0080) (0.1602) (0.0083)
DLx4
Lx5 -3.6009 -1.5749 -1.6416
(0.0136) (0.4818) (0.7499)
DLx5 -5.8639
(0.0003)
 TABLE 2

Variables Dickey-Fuller Generalized Least Square Test (DF-GLS)

Intercept Intercept & Trend
Lx1 -1.4648 -2.7436
DLx1 -5.4416
Lx2 0.4390 -2.7736
DLx2 -2.8076
Lx3 -3.6663
DLx3
Lx4 -1.3228 -4.4877
DLx4
Lx5 -2.0992
DLx5
 TABLE 3

Variables MZA MZT MSB MPT

Lx1 with Constant -4.2439 -1.2814 0.3019 5.9959
Lx1 Constant &trend -9.4247 -2.1667 0.2299 9.6849
DLx1 with Constant -15.8455 -2.7426 0.1730 1.8092
DLx1 Constant &trend
Lx2 Constant -0.1183 -0.0773 0.6531 26.9766
Lx2 Constant &trend -5094.22 -50.4682 0.0099 0.0182
DLx2 Constant
DLx2 Constant &trend
Lx3 Constant -12.7850 -2.3322 0.1824 2.6382
Lx3Constant &trend
DLx3 Constant
DLx3 Constant &trend
Lx4 Constant -3.4389 -1.1992 0.3487 7.0644
Lx4 Constant &trend -13.5126 -2.5984 0.1923 6.7481
DLx4 Constant -10.2511 -2.2596 0.2204 2.4064
DLx4 Constant &trend
Lx5 Constant -51.2715 -5.0072 0.0976 0.6158
Lx5 Constant &trend
DLx5 Constant
DLx5 Constant &trend
1% level of significance with constant -13.8000 -2.5800 0.1740 1.7800
5% level of significance with constant -8.100 -1.9800 0.2330 3.1700
10% level of significance with constant -5.7000 -1.6200 0.2750 4.4500
1% level of significance with constant & Trend -23.8 -3.42 0.143 4.03
5% level of significance with constant & Trend -17.3 -2.9 0.168 5.48
10% level of significance with constant & Trend -14.20 -2.62 0.185 6.67
 TABLE 4
ORDER OF INTEGRATION

variables ADF PP DF- NG-

GLS PERRON

Interc In Inte In Inter In Intercept In

ept te rcep te cept te te
rc t rc rc rc
e e e e
pt pt pt pt
& & & &
tr tr tr tr
e e e e
n n n n
d d d d

LX1 I(1) I(1) I(1) I(

0)

LX2 I( I(1) I(1) I(

0) 0)

LX3 I(1) I(0) I(0) I(

0)

LX4 I( I( I( I(
0) 0) 0) 0)

LX5 I(0) I(1) I(0) I(

0)
Table 5.
Variable Addition Test (OLS case)
******************************************************************************
Dependent variable is DLX1
List of the variables added to the regression:
LX1 LX2 LX3 LX4 LX5
27 observations used for estimation from 1983 to 2009
******************************************************************************
Regressor Coefficient Standard Error T-Ratio[Prob]
INPT -5.4185 7.5902 -.71388[.486]
DLX1(-1) -.40578 .20182 -2.0106[.062]
DLX2(-1) -1.5150 2.6953 -.56209[.582]
DLX3(-1) .19199 .15940 1.2044[.246]
DLX4(-1) .061084 .11301 .54054[.596]
DLX5(-1) .62421 2.5742 .24248[.811]
LX1 .76126 .16750 4.5449[.000]
LX2 .51600 .67575 .76360[.456]
LX3 .41967 .19957 2.1028[.052]
LX4 -.018261 .17693 -.10321[.919]
LX5 3.6916 1.2624 2.9244[.010]
Joint test of zero restrictions on the coefficients of additional variables:
Lagrange Multiplier Statistic CHSQ( 5)= 18.5838[.002]
Likelihood Ratio Statistic CHSQ( 5)= 31.4733[.000]
F Statistic F( 5, 16)= 7.0659[.001]
TABLE 6
Autoregressive Distributed Lag Estimates
ARDL(2,0,2,0,1) selected based on Schwarz Bayesian Criterion
*******************************************************************************
Dependent variable is LX1
27 observations used for estimation from 1983 to 2009
*******************************************************************************
Regressor Coefficient Standard Error T-Ratio[Prob]
LX1(-1) .60745 .15191 3.9987[.001]
LX1(-2) -.36779 .19193 -1.9163[.072]
LX2 -1.8355 .61472 -2.9859[.008]
LX3 .18677 .18721 .99770[.332]
LX3(-1) -.0090175 .19288 -.046752[.963]
LX3(-2) .57923 .18267 3.1710[.006]
LX4 .16931 .14080 1.2025[.246]
LX5 -7.8992 1.5840 -4.9867[.000]
LX5(-1) 5.7617 1.1193 5.1474[.000]
INPT 19.9557 6.7968 2.9361[.009]
************************************************************************
R-Squared .90367 R-Bar-Squared .85267
S.E. of Regression .31023 F-stat. F( 9, 17) 17.7199[.000]
Mean of Dependent Variable 1.9084 S.D. of Dependent Variable .80826
Residual Sum of Squares 1.6362 Equation Log-likelihood -.46442
Akaike Info. Criterion -10.4644 Schwarz Bayesian Criterion -16.9436
DW-statistic 2.2851
************************************************************************
 Diagnostic Tests
**************************************
**********************************
* Test Statistics * LM Version *
F Version *
**************************************
**************************************
***
* * *
*
* A:Serial Correlation*CHSQ( 1)=
3.3806[.066]*F( 1, 16)= 2.2901[.150]*
* * *
*
* B:Functional Form *CHSQ( 1)=
1.3124[.252]*F( 1, 16)= .81743[.379]*
* * *
*
* C:Normality *CHSQ( 2)= .
72179[.697]* Not applicable *
* * *
*
* D:Heteroscedasticity*CHSQ( 1)=
3.2248[.073]*F( 1, 25)= 3.3910[.077]*
CAUSALITY TEST
TODA-YAMAMOTO AUGMENTED GRANGER CAUSALITY
TEST
The causal linkage among FDI, GDP, Growth rate, Trade
restrictions are being tested by following the Granger causality
procedures adopted by Toda and Yamamoto (1995) and interpreted
and further expanded by Rambaldi and Doran(1996) and Zapata
and Rambaldi(1997). Toda – Yamamoto Augmented Granger
causality Test applied modified WALD test for restrictions on the
parameters of a Seemingly Unrelated Regression (SUR). The
following system of equations is being estimated to investigate the
augmented Granger causality test.
 
Causality Test
FDIt = α1 + ∑ β FDI t-i + ∑ γ GDP t-i + u1
GDPt = α2 + ∑β FDIt-I + ∑ γ GDP t-i + u2
The above system of two equations is estimated by SURE method.
To explore that GDP does not Granger cause FDI, the null hypothesis
will be
Ho : γ = 0. Likewise, the other null hypothesis for second equation is
Ho: β =0, that is, the FDI does not Granger cause GDP. This was
carried out by means of a Wald test with the null hypothesis that the
values of the estimated coefficients β and γ are zero. The results of
the Toda-Yamamoto test of augmented Granger causality are given in
the table 7.
 Table 7.
TODA-YAMAMOTA GRANGER CAUSALITY TEST

Equation Null hypothesis value d.f. Prob.

Equation 1 GDP does not 4.006 1 0.045
Granger cause Reject Ho
FDI
Equation 2 FDI does not 1.2795 1 0.258
Granger cause Cannot reject
GDP
SUMMARY
The results of ARDL approach to co-integration show
cointegration between FDI and GDP when GDP, Foreign
exchange rate, Indirect Taxes are taken as Independent
variables.
CONCLUSIONS
To date, most of the analysis of the determinants of
foreign direct investment has been descriptive in form;
there has been little work directed to statistically
evaluating these determinants. In order to provide a more
comprehensive empirical estimate of the determinants of
foreign direct investment, this article used the ARDL
cointegration technique and data for the 1980-2009 to test
the size of market, growth, and tariff changes as
explanations of why direct investment has been coming
recently in large amounts.
CONCLUSIONS
The study’s empirical tests lead to the conclusions that
only the size-of-market hypothesis can be supported
statistically. Negative findings were discovered for all
variants of growth and tariff related imports; these
hypotheses were rejected as not statistically significant .
The results suggest that when dealing with policy
problems relating to foreign direct investment, it is
important to focus on the receiving country’s size of
market as a major determinant of foreign direct
investment flows.
THANKS