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INTRODUCTION*:;;;;;

It is well documented in the literature that foreign direct investment (FDI)plays a positive role in the process of economic growth. Thamos, et al. (2008)argued that foreign affiliates of transnational corporation (TNCs) succeed indeveloping new products and technologies faster than local firms, therebyexerting competitive pressure and forcing local firms to imitate and innovate.This is one of the important reasons why developing countries are eager toattract FDI. Many developing countries including Pakistan faces the problem ofsaving-investment gap and FDI influences the process of economic growth byfilling up this gap, increasing productivity, transferring advanced technology,employment creation and enhancing competition [Kobrin (2005) and Le andAtaullah (2006)]. These benefits have encouraged the developing countries toliberalise their FDI policies in order to attract FDI inflows. In the light ofexpected benefits of FDI, many studies have been carried out to examine theimpacts of FDI on growth. However, theories and empirics appear to providemixed evidence regarding the impact of FDI on economic growth in developingcountries.Like many other developing countries, Pakistan has thrown its doors wideopen to FDI, which is expected to bring huge benefits. However, unlike Chinaand India, Pakistan has not been successful in obtaining substantial andconsistent FDI inflows. Furthermore, the meagre inflows that the country hasreceived have not been utilised appropriately to enhance the economicperformance [Le and Ataullah (2006)]. FDI inflows are still too low and thismight be because the economic reforms went far enough to change the characterand type of FDI. The type of FDI and its structural composition matter as muchfor economic growth [Chakraborty and Nunnenkamp (2008)]. The structure andtype of FDI are hardly considered in previous studies on the FDI-growth nexusin Pakistan.This paper is an attempt to examine the impact of FDI on economicgrowth. The paper contributes to the literature on FDI in three ways. First, wereview the policy measure that the government of Pakistan has undertaken toattract the FDI. Secondly, we examine the impact of FDI on economic growthusing the panel cointegration technique over the period 1981-2008. Finally, weevaluate whether the growth impact of FDI differs between primary, secondaryand services sectors. We apply Granger Causality test on the basis of industryspecific FDI data. The rest of the paper is organised as follows: Section 2discusses the theoretical and empirical literature on the relationship between FDIand economic growth. Overview of FDI inflows in Pakistan is given in Section3. Section 4 describes model, data and methodology. Empirical results areinterpreted in Section 5, while some concluding remarks are provided in thefinal section.

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FDI:-An investment abroad, usually where the company being invested in is controlled by the foreign corporation.

Importance of Foreign Direct Investmentin Pakistan

The Asian currency crisis that erupted in Thailand in July 1997 and has since spreadto other countries, particularly Indonesia, Republic of Korea (Korea), and Malaysia, renewedthe significance of prudential management of foreign capital flows in developing countrieswhere domestic financial markets are not yet fully developed. The crisis poses many challengesto developing countries, including how to best supervise financial institutions, howto efficiently manage foreign exchange reserves/systems, and how to prudentially manageforeign debt and investments. From the viewpoint of foreign resource mobilization, the crisishighlights the urgent need to reexamine the optimal combination of foreign capital, i.e.,proper composition of concessional public loans, commercial loans, portfolio investment,and foreign direct investment. Volatile movements of portfolio investment triggered the Asiancrisis, which was reinforced by panic withdrawals of short-term commercial loans. However,it did not have any relation to foreign direct investment (FDI) due to its high stability.This underscores the importance of FDI in the developing member countries (DMCs), particularlythe group of least developed DMCs where domestic financial markets are fragileand liquidity is limited. Pakistan belongs to this group. The size of its financial market isvery small and its foreign exchange and debt position is precarious. Over the last two years,foreign exchange reserves in Pakistan have remained at less than $1.3 billion, which wasequivalent to only 4-5 weeks of imports of goods.1 Short-term debt has also increased from12% of total debt in the early 1990s to 20% at present.

These developments increase the need for attracting FDI into Pakistan. FDI is asignificant long-term commitment and a part of the host economy itself. In the difficultcircumstances described above, Pakistan’s policy on foreign capital mobilization must attachpriority to (i) official multilateral assistance; (ii) official bilateral assistance; and (iii) FDI,given its very limited absorptive capacity for portfolio investment and commercial bankloans. However, concessional long-term development assistance, both multilateral andbilateral, will become increasingly scarce due to domestic financial constraints in majordonors, such as Japan, and Pakistan’s increased competition with other least developed countriessuch as Bangladesh, Mongolia, Sri Lanka, and Viet Nam. Multilateral developmentorganizations including the Asian Development Bank will focus on poverty alleviation andsoft sectors (i.e., agriculture, rural development, education, environment, poverty, and health),while the hard sectors (manufacturing and large-scale physical infrastructure) are expectedto be invested in by the private sector and foreign investors as well as the Government ofPakistan (GOP).

The positive developmental role of FDI in general is well documented (see, forexample, Chen 1992). FDI produces a positive effect on economic growth in host countries.

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One convincing argument for that is that FDI consists of a package of capital, technologymanagement, and market access. FDI tends to be directed at those manufacturing sectors.

and key infrastructures that enjoy actual and potential comparative advantage. In thosesectors with comparative advantage, FDI would create economies of scale and linkage effectsand raise productivity. For FDI, repayment is required only if investors make profit andwhen they make profit, they tend to reinvest their profit rather than remit abroad. Anotherbenefit of FDI is a confidence building effect. While the local economic environment determinesthe overall degree of investment confidence in a country, inflows of FDI couldreinforce the confidence, contributing to the creation of a virtuous cycle that affects not onlylocal and foreign investment but also foreign trade and production. This phenomenon wellmatches the directions of historical flows of FDI in the Asian and Pacific region. Initially,FDI had surged into the newly industrialized economies (NIEs) (Hong Kong, China; Korea;Singapore; and Taipei,China) and thereafter moved to ASEAN countries. Recently, it hasbeen changing its direction to People’s Republic of China (PRC), India, and Viet Nam. Thischanging stream of FDI flows suggests that the degree of confidence building, inflows ofFDI, and the pace of economic growth seem to have a positive interrelation in the Asianand Pacific region.

The inflow of FDI into Pakistan is small and concentrated only on a few areas, mostlyin the power sector. In 1997 Pakistan accounted for 0.2% of world FDI, less than one percentof developing country and Asian country FDI, and 18% of South Asian countries’ FDI.2In spite of liberalizing its formerly inward-looking FDI regime, tempering or removal ofobstacles to foreign investors, and according various incentives, Pakistan’s performance inattracting FDI has been lackluster. Why could Pakistan not succeed in attracting sufficientlylarge FDI despite liberalizing its payments and exchange regime as well as inward FDI regime?The present study attempts to find out the answer. Rather, a relatively large inflowof FDI into the power sector since 1995 has created some adverse effects, most importantof which was the large increase in imports of capital goods for construction of power plants,and the ongoing conflict between the government and foreign independent power producers(IPPs) on the power rate the government needs to pay to IPPs under the purchase contract.Another negative effect of FDI concentration on the power sector was that as the remittancesby IPPs began to increase, it severely constrained the balance of payments, given that foreignexchange earnings through exports of goods and services remain low.3 From this undesirablepattern of FDI in Pakistan, very important lessons could be drawn for developing economies:they should be careful in allowing a large amount of FDI to nonforeign-exchangeearningsectors during a short period of time; and FDI should be promoted in the foreignexchange-earning sector at the initial stage and to the domestic-oriented sector at the subsequentstages, or, at least, to both sectors simultaneously.

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Foreign Direct Investment in Pakistan

Issues, Foreign Direct Investment,and Economic Impact of FDI

The success of FDI policies can be judged by the size of the inflows of capital. Pakistanhas been making efforts to attract FDI and such efforts have been intensified with the adventof 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 lasttwo decades. The amount of foreign investment rose from a tiny $10.7 million in 1976/1977to $1296 million in 1995/1996, thus growing at the annual compound growth rate of 25.7percent. However, it declined to $950 million in 1996/1997. With the beginning of the overallliberalization program (1991/1992 onwards) the inflow of foreign investment grew at thecompound 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 comparedto the relatively more buoyant economies of East and Southeast Asia. While FDI flows toall developing countries reached $150 billion in 1997, East and Southeast Asia received thebulk of this share.

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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 investmentcrossed the $1.0 billion mark in 1994/1995. This impressive increase does not reflect the truepicture of the trends in portfolio investment witnessed during the postliberalization period.If the $862.2 million sale of Pakistan Telecommunications Corporation (PTC) vouchers, whichwas 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.]

Structural Pattern of FDI

FDI in Pakistan consists primarily of three elements, namely, cash brought in, capitalequipment brought in, and re-invested earnings. The information provided in Table 3 showsthat the structure of the sources of financing FDI in Pakistan has undergone a noticeablechange. Though all the components of FDI exhibit considerable fluctuations over time, theitem 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) duringthe 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 postreformperiod. In particular, its share jumped to 55.7% in 1994 mainly due to the equipment broughtin for Hubco Power Plant. Re-invested earnings contributed slightly less than one third toFDI 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-investedearnings, 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 ofre-invested earnings in total FDI declined to 23% while those coming from abroad rose to77 percent. It is important to note that the share of re-invested earnings in FDI has beendeclining since 1990, falling from 31% in 1989 to 12% in 1994. There appears to be two reasonsfor such a rapid decline. Firstly, as a result of chronic inflation, the cost of productionhas 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 earningsthat 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 tohigher inflows of new investment. Consequently, the relative share of re-invested earningsin total FDI declined considerably after 1990.

Sectoral Distribution of FDI:

Having examined the trends and structural pattern of FDI, it is worthwhile to reviewits overall sectoral distribution pattern. The analysis of sectoral distribution of FDI

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may reflect two things: on the one hand, it may reflect the preferential treatment given bythe government to certain sectors while encouraging FDI, and on the other hand, it mayalso indicate the foreign investors’ own preferences.As revealed by the information presented in Tables 4 and 5, a noteworthy changecan be easily observed in the sectoral composition of FDI flow into Pakistan over the last15 years. On the broad sectoral basis, manufacturing industries, mining and quarrying, andcommerce are seen to have traditionally dominated the preferences of the foreign investorsduring 1980-1994 accounting for over 83% of total inflow of FDI. However, like total FDIflows, sectoral shares also exhibit considerable year-to-year fluctuations. For example, thesectoral share of manufacturing industries, though highest, continued to fluctuate violentlyovertime, 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 1987-1993but rose to 35% in 1994. The general decline in manufacturing share is largely substitutedby 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 (naturalgas in particular) during the period. A significant change in the composition of FDI wasalso witnessed during the prereform and postreform periods. Manufacturing and miningand quarrying registered a sharp decline during the postreform period as against theprereform era. On the other hand, commerce, construction, and utilities experienced substantialincrease in total FDI during the postreform period.15 It may be noted that the shareof utilities in total FDI jumped from almost zero in 1993 to 31.7% in 1994. This massiveincrease was entirely due to the inflow of FDI in the power sector with the Hubco Corporationalone accounting for Rs 7 billion out of Rs 7.6 billion in 1994.

Foreign Direct Investment and Economic Growth

Recent theoretical and empirical literature suggests that foreign direct investment (FDI) exerted positive impact on economic growth through the process of technological diffusion. The literature also suggests that the development of the domestic financial system of the host country is an important pre-condition for FDI to have a positive impact on economic growth. A welldeveloped domestic financial sector enhances efficient allocation of financial resources and improves the absorptive capacity of a country with respect to FDI inflows. Particularly, a more developed financial system positively contributes to the process of technological diffusion associated with foreign direct investment. In this study, we examine the link between FDI, domestic financial sector, and economic growth for Pakistan over the period 1972–2005. Empirical analysis is based on the bound testing approach of cointegration advanced by Pesaran, et al. (2001). The results suggest that FDI inflows exerted positive impact on economic growth in the short-run and the long-run if the domestic financial system has achieved a certain minimum-level development. The results further suggest that better domestic financial conditions not only attract foreign companies to invest in Pakistan, but also allow maximising the benefits of foreign investment

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Factors Influencing the Flow of FDI in Pakistan:

Before the Asian crisis, the world had experienced rapid growth in the flow of FDI,which rose from $204.2 billion in 1990 to $400.5 billion in 1997 (see Appendix table).Developing countries have made impressive gains in attracting FDI, the flow rising from$33.7 billion to nearly $150 billion during the same period. The gains owe, to a large extent,to the growing attractiveness of the PRC, which accounted for 30.4% of total FDI todeveloping countries in 1997. The Asian countries have also strengthened their role as thelargest developing-country FDI recipient region with an estimated $87 billion of inflowsin 1997. The East and Southeast Asian countries have attracted $82 billion in FDI in 1997accounting for 21% of the total world flows and 55% of total developing countries’ flows.

Viewed in the background of these developments, the inflow of FDI in Pakistanremains far from encouraging despite numerous incentives offered to foreign investors,particularly after the liberalization program initiated since 1991/1992. Incentives like 100%foreign ownership of capital, foreign investors operating their companies without enlistingin the local stock exchanges, no limit for remittance of profits and dividends abroad,

allowing disinvestment of the originally invested capital at any time, and no prescribed limitsfor remittance of royalties and technical fees abroad by foreign investors are highly competitivewith incentives offered by many other developing countries to prospective foreignin vestors.(i) Political StabilityThis factor is essential to attract foreign direct investment because it creates confidencefor foreign investors (see MIGA 1994). Political turmoil could wipe out overnight eventhe most lucrative investments and endanger the lives of personnel. Many investors havepaid a heavy price for overlooking or ignoring this factor in other parts of the world(Jegathesan 1995). Lack of political stability has been the hallmark of Pakistan during thelast eight years (1988-1996). Three elected governments were dismissed on various chargeswhile four caretaker regimes each remained in power for only 90 days over the last eightyears. Such a frequent change in government accompanied by abrupt changes in policiesand programs are hardly congenial for foreign investors.

(ii) Law and OrderAn unsatisfactory law and order situation keeps prospective foreign investors on thesidelines. Safety of capital and the security for the personnel engaged in the projects areessential ingredients that govern foreign investment. Unfortunately, Pakistan’s law and ordersituation has remained far from satisfactory in the major growth poles of the country. Karachi,the largest industrial and commercial center and the only commercial port of the country,has been disturbed in varying degrees since 1989. In recent years the law and order situationhas also deteriorated in the Punjab province. Notwithstanding attractive incentivesoffered to foreign investors, this factor has discouraged them to set up their businesses inPakistan.17

In a recent survey, the International Asset Management Company (IAMC), an affiliateof the British-based Morgan Stanley Asset Management, found that the business environmentin Pakistan has deteriorated considerably. The IAMC surveyed 115 leading listed and

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unlisted companies including multinationals operating in Karachi. The sector covered forthe survey included automobiles, banks, chemicals, insurance, energy, textile and apparel,financial services and electrical goods. Some 74% of investors answered that they had noinvestment plan for 1996/1997, while in 1995/1996 some 56% of those had not invested inPakistan. The key reason for the negative sentiment of businessmen was the deterioratinglaw and order situation in Karachi. Three out of four businessmen interviewed blamedpolitical instability as the major constraint facing business today and over 59% of the 115respondents were not pleased with government policies.

(iii) Economic StrengthInvestors would not want to invest in a country where the economic fundamentalsare so weak that it is unpredictable what the government would do next to prop up a saggingeconomy. In countries of high economic strength, the investor is assured of a growingof high economic strength, economy, and of increased opportunities for business, as moregovernment development projects and private sector investments put purchasing power in the hands of the people. Increased purchasing power means increased positive multipliereffects on the economy and a source for stability. Furthermore, foreign investors are unlikelyto increase their participation in economies that are expected to remain affected by foreignexchange scarcities for several years into the future (UNCTAD 1985).As compared with the decade of the 1980s, Pakistan’s macroeconomic imbalancesworsened in the 1990s, along with the slowdown of economic activity. Annual average GDPgrowth slowed from 6.4% in the 1980s, to 3-4% in the 1990s. In particular, large-scalemanufacturing has slowed down to 2-3% as against almost 8.0% during the 1980s.The large fiscal deficit has emerged as a major source of macroeconomic imbalancesin Pakistan. Slippages on both the revenue and expenditure sides contributed to mountingfinancial imbalances. The rate of inflation has averaged 11% during the 1990s as againstan average rate of 7.3% in the 1980s. Pakistan’s external sector also remained under pressureduring the 1990s as compared with the 1980s. The current account deficit averaged4.4% of GDP as against 3.9% during the 1980s. Pakistan’s foreign exchange reserves havealso fluctuated in an unpredictable manner in the 1990s. Thus, attractive incentives notwithstanding,the large macroeconomic imbalances and slowing down of economic activity musthave discouraged FDI in Pakistan.

iv) Government Economic PoliciesPakistan’s track record in maintaining consistent economic policies has been poor.The abrupt changes in policies with a change in government as well as a change in policywithin the tenure of a government have been quite common. Pressures to raise revenues(for fiscal consideration), and other conflicting objectives have generally led to inconsistenciesin investment and industrialization policies, and an ad hoc and changing incentive system.Revenue measures are not in harmony with the industrial policies. Several instances ofchange in policy stance in recent years can be identified. For example, the process ofprivatization slowed down considerably with the change in government. As against theprivatization of 63 units in two years (1991/1992 and 1992/1993), only 20 units were privatizedin three years (1993/1994 to 1995/1996). Similarly, with the change in government adrastic change was made in the Lahore–Islamabad motorway project. Another exampleconcerns the concessions given to the petroleum and power sectors in terms of duty-freeimports of machinery. Resource crunch forced the government to withdraw this concessionby imposing a 10% regulatory duty in October 1995. It took several months to get the petroleum

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sector concession restored but the regulatory duty was reimposed in the 1996/1997federal budget. The serious disagreement in 1998 between the GOP and IPPs on the purchaseof electricity by the WAPDA aggravated investors’ confidence.The investment approval requirement has been removed but other regulations institutingthe need for other administrative approvals, however, are still in place. Numerouspermits and clearances from different government agencies at national, regional and locallevels still apply to investors.Incentives/concessions to foreign investment apart, private investors continue to facea plethora of federal, provincial, and local taxes and regulations. Federal levies includecustom duties, sales tax, withholding tax at import stage, and excise duty. At the provinciallevel there are stamp duties, professional taxes, boiler inspection fees, and weight andmeasures fees. In addition, local government taxes are levied, including a local metropolitantax, and the Octroi. At the federal and provincial levels, labor taxes have to be paid separately in compliance with labor laws, such as the contributions to the Workers Welfare Fund, SocialSecurity, worker’s children’s education, and workers participation in profit and group insurance.In particular, a 5% withholding tax at the import stage as well as restrictions thatthese firms cannot borrow more than their equity capital have caused serious cash flowproblems.

Government BureaucracyThis could perhaps be the biggest “burden” in any investment environment. It doesnot matter how efficient the government thinks its investment policy is; what is critical isthe perception of businessmen, especially those already in the country. Do businessmen feelthat they have the support of government officials in their efforts to set up and operateefficient business units, or do they feel that they have to fight the government to get projectsoff the ground?The general perception of businessmen in Pakistan is that there exists a large gapbetween the policies and their implementation (Shirouzu 1993). The implementation ofpolicies has been slow and the bureaucracy has not responded to the initiatives with conviction.18 Such perception about the slow implementation of policies is not at all conduciveto attracting FDI.

(vi) Local Business EnvironmentThis covers many factors, including the availability of local lawyers, secretarial services,accountants, architects and building contractors, local consultants, etc.—all requiredboth before and during the life of a project. Also, there is the question of the availabilityof ancillary and supporting industries, their quality, and their cost. Another question wouldbe the availability of suitable joint venture partners, and whether there are lists of potentialpartners that the investors can choose from. All these conditions are not satisfactoryin Pakistan.

(vii) InfrastructureThe availability, reliability, and cost of infrastructure facilities (power, telecommunications,and water supplies) are important ingredients for a business environmentconducive to foreign investment. Pakistan compares unfavorably in infrastructure facilitieswith other developing countries that have attracted higher levels of foreign investment.Pakistan has only 18% of paved roads in good condition as against 50% in Thailand, 31%

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in Philippines, and 30% in Indonesia. Pakistan’s extensive but poorly managed railway system does not make good for this disadvantage. Telecommunication is another bottleneck:there are only 10 telephones per 1,000 persons in Pakistan compared with 31 and 112 inThailand and Malaysia, respectively. Pakistan’s amount of electricity produced per capitais higher than Indonesia’s (435 kWh as against 233 kWh), but is only a fourth of Malaysia’sand one half of Thailand.19 In most cases the urban infrastructure is grossly inadequate.Only 50% of population have access to safe drinking water as against 81, 72, and 78% forPhilippines, Thailand, and Malaysia, respectively.20

Karachi Port is six times more expensive than Dubai port (Jebal Ali), three times moreexpensive than Colombo port, and twice as expensive as Bombay port. While other portsoffer goods container terminal facilities, Karachi port cannot even offer priority berthingfor container vessels. There are frequent delays and cancellations of berthing and sailingdue to obsolete tugs and pilot boats at Karachi port. Moreover, due to the lack of maintenancethe berths are unsafe. Karachi port cannot even provide proper container handlingequipment and there is a shortage of space and bad planning, resulting in high cost to theconsignees. Large vessels cannot come to the port because of the lack of dredging of shippingchannels. Moreover, congestion in the hazardous cargo results in containers being detainedlonger in the barge. All these have made Karachi port much more expensive than ports ofneighboring countries (see Table 6 for itemwise costs at Karachi port and other ports of neighboringcountries). Such infrastructure deficiencies have discouraged the flow of FDI inPakistan.

(viii ) Labor ForceA technically trained, educated, and disciplined labor force along with a country’slabor laws are critical factors in attracting foreign investors. Pakistan has an acute shortageof technically trained and educated labor, especially in middle managerial positions andin engineering, which may have discouraged foreign investors. In particular, Pakistan is ata more serious, disadvantaged position in terms of education and health compared withother developing countries that have attracted FDI at much higher levels. Pakistan’s adultilliteracy rate is 62% as against 17% for Malaysia, 16% for Indonesia, 5% for Philippines,and 6% for Thailand. Only 80% of primary school age boys are enrolled in school (49% forgirls); the lowest rate for the four reference countries is 93% for Malaysia. Pakistan’s expenditureon education accounts for only 1.1% of total expenditure as against 10% forIndonesia, 15.9% for Philippines, 21.1% for Thailand, and 20.3% for Malaysia (World Bank1997). It also has by far the worst indicators of public health among the five countries. Withthe general level of education and health care being low, foreign investors may not findthe workforce they need.Besides poor education and health indicators, Pakistan’s labor laws are complicatedand overprotective, discouraging job creation, inhibiting business expansion, and frighteningaway much needed productive investment. Such labor laws have created unnecessary labordisputes posing problems for management and causing productivity losses, which havealso discouraged foreign investment.

(ix) Quality of LifeQuality of life along with cultural and social taboos is critical to attract foreign investors.These factors are less conducive to foreign investors in Pakistan who are accustomedto liberal lifestyles. This is in fact, one of the largest hidden handicaps Pakistan possessagainst NIEs and ASEAN countries (Shirouzu 1993). Foreign investors find better conditions

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in Indonesia and Malaysia (both Muslim countries) in the ASEAN region in terms ofsocial life and quality of life.

E. Economic Effects of FDIFDI has emerged as not only a major source of much needed capital but is alsoconsidered to be a major channel for the access to advanced technologies and intangiblessuch as organizational and managerial skills, and marketing networks by developing countries.Globally, FDI has grown rapidly in recent years, faster than international trade.Developed countries were the key force behind the record FDI flows but developing countriesalso experienced a spectacular rise in the flows, reaching as high as $150 billion in 1997.How far have the inflows of FDI affected the level of economic activity in the host countries?This question has been extensively investigated in recent years.22

The inflow of FDI can “crowd in” or “crowd out” domestic investment and its effecton saving is ambiguous. FDI has a positive overall effect on economic growth but themagnitude of this effect depends on the stock of human capital available in the host economy.A high positive correlation between aggregate inflows of FDI and the host countries’aggregate exports has been found, while the inflow of FDI tends to increase the hostcountry’s imports.23

Views, however, diverge regarding the effect of FDI on balance of payments. Criticsargue that while the initial impact of an inflow of FDI on the host country's balance ofpayments is positive, the medium-term impact is often negative, as the investors increaseimports of intermediate goods and services and begin to repatriate profit. On the other hand,it is argued that the impact of FDI on the balance of payments depends on the exchangerate regime. Under flexible exchange rates, any disturbance to the balance between supplyand demand for foreign exchange is corrected by a movement in the exchange rate. Inthe case of a fixed exchange rate regime, a net increase in the demand for foreign exchangeby the FDI project will result in a reduced surplus or increased deficit in the balance ofpayments. Empirical evidence suggests that an inflow of FDI has a bigger positive impacton host country exports than on host country imports. Hence, the balance of paymentsproblems, if they do occur, are likely to be small (WTO 1996).The inflow of FDI in Pakistan is not only a recent phenomenon but it also does notform a high percentage of GDP or domestic fixed investment. As shown in Table 7, FDIas percentage of GDP remained less than one percent until 1994/1995 but rose to 1.69% in1995/1996, due to large FDI in the power sector. FDI as a percentage of gross fixed investmentaveraged 3.5% during 1984/1985 to 1995/1996. Thus, given its low share in GDP andfixed investment, FDI is not expected to have a significant impact on various sectors of theeconomy.

Concentrated FDI in the Power Sectorand its Balance of Payments Implications:If it is not the “engine of growth”, infrastructure is certainly the “wheels” of economicactivity. Empirically a strong positive association exists between the availability ofcertain infrastructure—power, telecommunications, paved roads, and access to safe water—and per capita GDP.29 The generally poor performance of state-owned monopolies, combinedwith the rapid globalization of world economies, has brought into sharp focus the economiccosts of inadequate infrastructure and has prompted a growing number of developingcountries to take active steps to promote competition, encourage the private sector including

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foreign investment in infrastructure. Between 1993 and 1995 the estimated private participationin infrastructure rose from $17 billion to $35 billion in developing countries (see IFC1996).In the last decade and a half, growth of population, per capita income, and rapidurbanization have generated a great deal of demand for transport, power, telecommunications,and water in Pakistan. The supply of these services, on the other hand, has notexpanded sufficiently fast to prevent the emergence of gross shortage. Among variousinfrastructure constraints, power has emerged as the most serious bottleneck constraining the economy’s long-term growth and development possibilities. The rationing of electricity(load-shedding) to metropolitan and industrial areas has become a common feature inPakistan since the early 1980s and has given rise to social costs (the frustration of householdusers) as well as economic costs in terms of lost manufacturing output. The Task Forceon Energy (1994) noted the loss of industrial output due to load shedding in the neighborhoodof Rs 12 billion. Stone (1995), in a survey of 200 industrial enterprises in Pakistan foundthat these firms lost an average of 21 workdays a year to electric power shortages alone.30

Removing Pakistan’s power shortages required a large amount of capital and strongincentives that were beyond the resources and institutional capabilities of the public sector.From 1994 to 1996, efforts to rectify power shortages were focused on encouraging domesticand foreign private investors to participate in the generation of electricity. The policy washighly welcomed by foreign investors, mostly from the US and the UK. Two to three yearsafter the initiation of the policy, there are now serious apprehensions about overcapacityand balance of payments implications.

The policy scene of FDI in Pakistan:Pakistan’s investment regime is as open as in any other developing country, and the country hasan investment incentive structure more generous than most.17 The welcome to foreign investorsis longstanding. A notable milestone was the signing with Germany in 1959 of the first bilateralinvestment treaty (BIT) in the world. The early 1970s were marred by nationalization, which wasprevalent in the region, including India and Sri Lanka.18 Although foreign enterprises wereexempted,19

new equity inflows collapsed.20 A process of policy liberalization ensued from themid-1970s onward.By the mid-1990s, restrictions to entry, ownership, admission, and repatriation had been greatlyrelaxed or eliminated. Investor guarantees, property protections and national treatment arestipulated in the constitution and relevant laws. 21 Incentives for foreign investors include avariety of credit facilities, concessional customs duties, tax holidays, a favorable visa policy, and

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special investment zones. It is easier to do business in Pakistan than in any of the neighboringcountries of South Asia.22

The privatization program and incentive packages have not been without controversy (i.e.,surrounding the transparency of the deals, job losses and/or profit repatriations). 23 Theprivatization process was set back in 2006 when the Supreme Court, citing irregularities,annulled the divestment of Pakistan Steel Mills.24

A major dispute is looming in the minerals sector, which is governed at the provincial level,unlike oil and gas, which is regulated at the federal level. The authorities in Balochistan Provincehave threatened to cancel the mining licence of the Reko Diq copper and gold mine held by aconsortium led by the Canadian Barrick Gold Corporation and the Chilean mining companyAntofagasta. The exploration license grants exclusive rights to explore and, subject to certaininvestment requirements, also to develop, mine and sell minerals discovered within the licensearea. The exploration has found significant deposits, and provincial authorities are unhappy withthe terms of the development project (involving new FDI inflows of US$ 3.2 billion). Thefederal government (i.e. the Prime Minister) has intervened between the provincial authoritiesand the mining companies. In the interim, the dispute is a blemish on the country’s otherwisewelcoming attitude toward FDI.

Although the weight of terrorism on investment decisions is unclear,25 a recent survey rankspolitical risk as a major investor concern in developing countries and places Pakistan among thefive most risky investment destinations.26 In order to provide insurance cover against terrorism, aPolitical Risk Guarantee Facility was created by the Asian Development Bank in 2002. Thefacility is counter guaranteed and indemnified by the Pakistani Government. The liabilitycoverage (up to US$ 175 million) may be increased through commercial reinsurancearrangements. There have so far been no terrorist incidents targeting FDI in Pakistan.27

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The United States Congress is also considering a new US$ 300 million enterprise fund to provideupfront risk capital to spur IFDI in Pakistan. This fund would be financed from within theforeign aid allocation. Such facilities are not entirely new. The U.S. Overseas Private InvestmentCorporation and MIGA provide risk insurance for Afghanistan. The United States has also set upenterprise funds for the transition economies of Eastern and Central Europe, and countries of theformer Soviet Union.

Country Wise FDI Inflows ($ Million)

Country 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-102009-10(Jul-Apr)

2010-11(Jul-Apr)

USA 92.7 326.4 211.5 238.4 325.9 516.7 913.1 1,309.3 869.9 468.3 390.5 173.0

UK 90.5 30.3 219.4 64.6 181.5 244.0 860.1 460.2 263.4 294.6 214.0 165.9

U.A.E 5.2 21.5 119.7 134.6 367.5 1,424.5 661.5 589.2 178.1 242.7 182.7 246.4

Japan 9.1 6.4 14.1 15.1 45.2 57.0 64.4 131.2 74.3 26.8 21.4 2.4

Hong Kong 3.6 2.8 5.6 6.3 32.3 24.0 32.6 339.8 156.1 9.9 (56.6) 110.1

Switzerland 3.6 7.4 3.1 205.3 137.5 170.6 174.7 169.3 227.3 170.6 126.0 36.6

Saudi Arabia 56.6 1.3 43.5 7.2 18.4 277.8 103.5 46.2 (92.3) (133.8) (86.3) 5.9

Germany 15.5 11.2 3.7 7.0 13.1 28.6 78.9 69.6 76.9 53.0 46.7 17.5

Korea (South) 3.7 0.4 0.2 1.0 1.4 1.6 1.5 1.2 2.3 2.3 2.0 1.8

Norway

41.9

0.1 0.3 146.6 31.4 252.6 25.1 274.9 101.1 0.4 0.5 (48.3)

China 0.3 3.0 14.3 0.4 1.7 712.0 13.7 (101.4) (3.6) (6.5) 9.3

Others 76.6 173.9 108.6 369.3 521.9 1,512.2 2,005.2 1,964.2 1,019.6 894.0 511.5

Total including Pvt. Proceeds

322.4 484.7 798.0 949.0 1,523.9 3,521.0 5,139.6 5,409.8 3,719.9 2,150.8 1,728.4 1,232.1

Privatisation Proceeds

- 127.4 176.0 198.8 363.0 1540.3 266.4 133.2 0.0 0.0 0.0 0.0

FDI Excluding Pvt. Proceeds

322.4 357.3 622.0 750.2 1,160.9 1,980.7 4,873.2 5,276.6 3,719.9 2,150.8 1,728.4 1,232.1

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Sector Wise FDI Inflows ($ Millions)

Sector 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-102009-10(Jul-Apr)

2010-11(Jul-Apr)

Oil & Gas 80.7 268.2 186.8 202.4 193.8 312.7 545.1 634.8 775.0 740.6 604.7 412.9

Financial Business (34.9) 3.6 207.4 242.1 269.4 329.2 930.3 1,864.9 707.4 163.0 133.0 165.3

Textiles 4.6 18.5 26.1 35.4 39.3 47.0 59.4 30.1 36.9 27.8 20.8 20.3

Trade 13.2 34.2 39.1 35.6 52.1 118.0 172.1 175.9 166.6 117.0 78.7 44.4

Construction 12.5 12.8 17.6 32.0 42.7 89.5 157.1 89.0 93.4 101.6 86.3 52.7

Power 39.9 36.4 32.8 (14.2) 73.4 320.6 193.4 70.3 130.6 (120.6) (7.9) 132.2

Chemical 20.3 10.6 86.1 15.3 51.0 62.9 46.1 79.3 74.3 112.1 80.4 33.3

Transport 45.2 21.4 87.4 8.8 10.6 18.4 30.2 74.2 93.2 132.0 104.3 61.4

Communication(IT&Telecom)

NA 12.8 24.3 221.9 517.6 1,937.7 1,898.7 1,626.8 879.1 291.0 222.6 (11.2)

Others 140.9 66.2 90.4 170.1 274.0 285.0 1,107.2 764.5 763.4 586.3 401.9 320.8

Total including Pvt. Proceeds

322.4 484.7 798.0 949.4 1,523.9 3,521.0 5,139.6 5,409.8 3,719.9 2,150.8 1,724.8 1,232.1

Privatisation Proceeds

- 127.4 176.0 198.8 363.0 1,540.3 266.4 133.2 0.0 0.0 0.0 0.0

FDI Excluding Pvt. Proceeds

322.4 357.3 622.0 750.6 1160.9 1980.7 4873.2 5,276.6 3,719.9 2,150.8 1,724.8 1,232.1

CONCLUSIONSSince the introduction of reforms related to trade and payments system,there has been a substantial increase in the FDI flows Pakistan. However, thecomposition and types of FDI has changed considerably. The primary industrieshave attracted varying FDI. In the manufacturing industries, there is still localmarket-seeking FDI, while services sector has enjoyed a rising share of FDI inrecent years.We assessed the growth implication of FDI in Pakistan using sectorspecificFDI and output data, and applying panel cointegration technique overthe period of 1981-2008. We found that FDI and real GDP were cointegratedand the DOLS estimates suggested that at the aggregate level, FDI is positivelyrelated to real output. Whereas , in the long-run an evidence of uni-directionalcausality between FDI and real GDP is observed and in the short-run there existsbi-directional causality. At the sectoral level, we found uni-directional causalityrunning from FDI to real GDP in the primary sector. For manufacturing sector,an evidence of uni-directional causality running from GDP to FDI is found. Anevidence of uni-directional causality running from FDI to output is also foundfor the services sector. These results suggest that FDI promotes output in theprimary and services sectors. Thus, policymakers should increasingly focus onattracting FDI in these sectors in order to attain short-term growth. In themanufacturing sector, the inflow of FDI is relatively small; especially the textile

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sector has received meager FDI inflows. This means that Pakistan has receivedlittle export-oriented FDI. Hence, there is limited role of FDI in exportpromotion. Finally, by analy sing the sectoral effects of FDI on the domesticeconomy, this study provides significant information to policy-makers informulating investment policies in Pakistan.