1

The Determinants of Foreign Direct Investment (FDI) in Pakistan

Joel Alter
Course: ECON 302

ABSTRACT: The purpose of this research is to analyze the determinants of FDI in

Pakistan. After discussing the important determinants of FDI in Pakistan we come to
know that the size of the market, openness, total investment, labor force, indirect taxes,
real exchange rate, military expenditures and developmental expenditures are important
determinants for FDI. The research focuses to show that how the above variables can
make a country conducive for FDI. The study uses OLS to estimate the impact of FDI in
Pakistan. The study uses time series data from 1970-2005. The results of size of the
market, total investment, and developmental expenditures are positively significant.
Indirect taxes and real exchange rate are negatively significant. Military expenditures,
labor force and openness are statistically insignificant. The estimated results show that
FDI is increasing in Pakistan but not as much significantly as it should be, therefore
Pakistan government should make such policies which should attract moreFDI to the
host country.

JEL Classification: G11, F21, F21 C 22

Keywords: Foreign Direct Investment, Stocks, Pakistan

1-Introduction

The purpose of this study is to examine the determinants of FDI in Pakistan.

The empirical studies have been done to analyze the effect of different policy variables
on Foreign Direct Investment in Pakistan. Different researchers in their study have
examined the behavior of FDI in Pakistan. Nishat and Anjum (2004) considered tariff
rate, exchange rate, tax rate, GDP and index of share price as explanatory variables to
analyze their impact on FDI in Pakistan. Nishat and Anjum (2004) found that all the
results are according to the prior expectations and have correct signs except for share
price index. Nishat and Anjum (2004) emphasized the role of these policy variables in
attracting FDI and determining growth both in short and long run in Pakistan and
indicated a positive and significant impact of reforms on FDI in Pakistan. Harko and
Ghumro (1999) worked at the determinants of FDI in Pakistan. Hakro and Ghumro
(1999) took cost related factors, investment related factors, developmental strategy
factors and other risk factors to analyze their impact on FDI. Hakro and Ghumro (1999)
found that investment improving factors-openness is significant in short run, while in
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long-run the dynamics between FDI, openness and macroeconomic factors shows
consistency.

The current study uses market size, openness, total investment, indirect
taxes, real exchange rate, military expenditures and developmental expenditures as
explanatory variables to see their impact in attracting FDI in Pakistan. The expected signs
for market size, openness, total investment, labor force and developmental expenditures
are positive whereas for indirect taxes, military expenditures and exchange rate the
expected signs are negative. The objective of this research is to estimate the results of
these policy variables and to suggest the policy relevance to attract FDI in Pakistan. The
paper is divided into different sections section 2 consists of literature review, section 3
consists of methodology, section 4 consists of description of variables, section 5 consists
of interpretation of estimated results and section 6 consists of conclusion and policy
relevance.

2- LITERATURE REVIEW

Nishat and Anjum (2004) observed that Over the past ten years foreign
direct investment has increased at least twice as rapidly as trade, Nishat and Anjum
(2004) examined that most of the developing countries have introduced the ongoing
process of integration of the world economy and liberalization of the economies which
have increased the competition of inward FDI in these countries. The study analyzed that
market-based economic reform policies initiated by Pakistan government has increased
the FDI in Pakistan since that time. Nishat and Anjum (2004) took the tariff rate,
exchange rate, tax rate, credit to private sector and index of general share price, wages
and per capita GDP to test for relative demand for labor and market size as explanatory
variables to analyze the effect of FDI in Pakistan. The study also takes scrutiny that
which government policies are attracting FDI and which policies deter FDI in Pakistan.
According to Nishat and Anjum (2004), political environment plays an important part in
 3

capturing the brains of foreign investors. It has been seen that due to fluctuations and
inconsistency in governments and their policies in Pakistan the FDI remained low
compared to other developing countries. Nishat and Anjum (2004), empirically identifies
the determinants of growth in foreign direct investment (FDI) in Pakistan over the period
of 1961-2003. The study focuses on the role of these policy variables in attracting FDI
and determining its growth both in short-run and long-run in Pakistan. The study focuses
to analyze how different variables or indicators reflecting trade, fiscal and financial sector
liberalization attract FDI in Pakistan. Nishat and Anjum (2004) used the co-integration
and error correction techniques to identify the variables in explaining the FDI in Pakistan.
The empirical results of the estimation are according to the prior expectations. The
expected sings of the variables were correct and are statistically significant except for
wage rate and share price index which shows the insignificant behavior of stock market
index. It also shows that the stock market is not explaining the growth of FDI inflows in
Pakistan. Thus the estimated results of Nishat and Anjum (2004) research give some
evidence that reducing import tariffs and corporate tax rate would positively affect the
growth of FDI. Moreover, the coefficient of exchange rate is positive implying that when
rupee appreciates, FDI increases as investors see it as a good sign for the economy and
expect high returns. Also the sign of GDP is positive, it means that the size of the market
has increased and GDP is attracting FDI in Pakistan. The study also includes some lagged
dependent variables showed positive signs and statistically significant. It means the short-
run dynamics of inward FDI are influenced by previous development of FDI.

In their research Dar, et al (2004) worked at the determinants of FDI

inflows to Pakistan from 1970-2002. They worked at the long-run relationship between
FDI, economic growth and other sociopolitical determinants. The study analyzed the
impact of these determinants on FDI. The paper considers economic growth (GDP),
exchange rate, interest rate, unemployment, and political instability as the determinants of
FDI in Pakistan. Dar, et al (2004) quoted that Tadesse (2002) said that FDI has strong
relationship with the traditional economic indicators including trade of the host country
with rest of the countries of the world. Dar, et al (2004) quoted Mody (1972) observed
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that sociopolitical determinants including political instability, business environment, law

and order situation, ethnic violations, corruption and infrastructure have found significant
determinants for the inflows of FDI in many countries. This approach is important
because developing countries like Pakistan in particular have fragile economic conditions
along with an unstable political environment since 1972. Dar, et al (2004) used error
correction model based on co integration VAR (2). Almost all the variables are found to
have the theoretically expected signs with the two-way causality relationship. The study
also uses unit root test and Granger causality analysis. By using ECM model the results
show that there is a strong relationship between exchange rate, degree of openness of the
economy and unemployment rate as well as political risk index with FDI. By using co
integration test and causality test the estimated results are positive of macro economic
and sociopolitical factors with FDI. These results show that FDI inflows are dependent on
major macroeconomic factors and important political factors. The econometric model of
the net FDI inflows for Pakistan suggests that there exists a long-run relationship between
FDI and GDP, exchange rate, openness of the economy, discount rate, unemployment
rate and political factors.

Shah and Ahmed (2003), empirically investigates the determinants of FDI

in Pakistan. The study uses time series data from 1960-1999. According to the study FDI
brings the most needed capital fund, advanced production techniques, managerial skills,
advertising and marketing expertise, global links. FDI inflow is taken as endogenous
variable. FDI inflows include purchases of fixed capital assets, import of capital
equipments and foreign exchange for other business transactions. The study examines the
behavior of FDI inflows in context with capital formation and taxation policies of
Pakistan. The exogenous variables are characterized in four ways demand or market size
factors, cost factors, political factors and social factors. The sizes of the market include
GDP and GNP per capita. The cost factors include cost of production labor and capital.
Political factors include political environment of the country which is taken as dummy
variable. Tariff and exchange rate is also taken as explanatory variables. Shah and
Ahmed (2003) used Philips-parron test for unit roots to check out the co integration of the
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variables. The study also uses Jhonson-Juselius test for co- integration by error correction
model ECM to test the significance level of the variables. Using OLS techniques the
expected sign is used for cost of capital is significant and negative. It shows cost affecting
factors determine FDI in Pakistan. Tariff and exchange rate have also expected signs and
have positive effects on inward FDI. The expected sign for GDP and GNP per capita
income is positive it shows that size of the market of Pakistan is increasing and attracting
FDI inflows to Pakistan. The result of political dummy is highly significant and positive
which indicate that a democratic regime is more likely to attract FDI. The study
concludes that statistical results found the selected variables(GDP, GNP per capita,Cost
of Capital, Tariff, Exchange rate, Political instability) to be highly significant in the
long-run with the expected signs.

Wang and Swain (1996) worked at the determinants of FDI in transforming

economies like Hungry and China. The study throws some light on some important
factors which determine foreign capital inflow into Hungry and China during the period
1978-92. The study uses time series analysis. The study builds one-equation model, the
specification and the test of alternative hypotheses. The research uses size of the market,
cost of the capital, labor cost, tariff barriers, exchange rates, import volumes and
economic growth in OECD countries and also the political stability as explanatory
variables and using one-equation model. FDI is taken as the endogenous variable. Time
series data from 1978-92 for Hungry and China are fitted into the one-equation model
and are estimated by Ordinary Least Square Method (OLS). Wang and Swain (1996)
found the signs of the estimated results are according to the prior expectations in the case
of Hungry the signs of the size of market variables GDP, Tariff, Wage Rate Growth Rate
of OECD, two cost-of-capital variables are statistically significant. The sign of political
dummy is negative which indicates the effect of previous communist regime in Hungry
before 1989. It shows that foreign investor prefer stable political system. The sign of
GDP is positive which shows that size of the Hungarian economy is significant and
attracts FDI. The sign of the two cost-of-capitals is significant and suggests that foreign
investors can finance some of their projects through the local financial market. The signs
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of tariff and wage rate are statistically insignificant. It shows that tariff rates are
meaningless. Though wage rate is not high in Hungry as compare to Eastern Europe but it
is attracting foreign investors in Hungry. The signs of imports and exports are statistically
insignificant. It shows that trade policy of Hungry is not attracting FDI. Similarly, the
estimated results in the case of China have expected results. Most of the variables are
found to be statistically significant. The sign of the GDP is positive and for both cost of
the capital is negative. The result also shows positive correlation between FDI and low
labor cost. The result shows negative relation between FDI and tariff barriers.

Majeed and Syed (2006), worked at the determinants of FDI in developing

countries. They selected seven developing countries of south Asia including Pakistan and
observed the trend of FDI in these countries. The study uses the panel data from 1970-
2004. The study uses GDP, trade openness, real exchange rate, labor force, health
expenditures, external debts, military expenditures, domestic investment as the
determinants of FDI in the above mentioned countries. The study uses all these variables
as independent or explanatory variables and FDI as dependent or endogenous variable.
Majeed and Syed (2006), quoted that Khan (1997) observed that over the past 50 years
Pakistan is unable to attract Foreign Direct Investment because of unstable political
conditions, inconsistency in macroeconomic variables, poor economic policies,
uncomfortable political environment; infrastructure facilities are below the international
standards, lack of educated and skilled labor force and etc. Due to these factors the
Pakistani environment for foreign investors is not catchy. Majeed and Syed (2006), in
their research used econometric models for panel data known as fixed effect model or
country specific model. The result shows that the effect of GDP trade openness, real
exchange rate, and labor force and health expenditures on FDI is positive and significant.
So these variables are attracting FDI to developing countries of south Asia including
Pakistan. The study shows the effect of military expenditures and external debts are
negative and significant, it means that most of the country’s expenditures are made on
non-developmental projects or on non-productive resources. The external debts are not
used properly or on the progressive projects. It shows country’s inability to attract FDI.
 7

Majeed and Syed (2006) observed that the relationship between FDI and domestic
investment is insignificant; it shows the poor performance of domestic investment in
south Asian countries. This shows that local investors are not investing in the host
countries. The effect of taxes is negative and insignificant on FDI, it depicts that lack of
fiscal incentives to the foreign investors and it is a hurdle for FDI in south Asian
countries. The study suggest that in order to attract Foreign Direct Investment the host
country should adopt the policies which attain macroeconomic stability and friendly
business environment. Stable exchange rate policy should be introduced to attract foreign
investment. The study concludes that the government should invest on productive sector
more in order to capture the mind of foreign investors to invest in the host country.

Harko and Ghumro (1999), in their research worked at the determinants of

Foreign Direct Investment and policy analysis in the case of Pakistan. The study uses cost
related factors, investment environment factors, development strategy factors and some
risk involving factors of current FDI flows to Pakistan economy. The study shows that
FDI inflows have been impressive and progressive in past recent years. FDI has increased
from $ 322 million in 2000-01 to $ 3.52 billion in 2005-06 and expected to be $ 6 billion
in 2006-07. Previously the net inflows of FDI in Pakistan were very low in 80’s and 90’s
due to the heavy debts. Harko and Ghumro (1999) quoted that Aggarwal (1997)
explained that economic reforms in a host country confers great freedom on TNCs in
their choice to internalize or not, it also affect the market conditions. The study uses time
series data from 1971-2005 and obverse the impact of independent variables on
dependent variable. The study takes FDI as dependent variable and wage rate, output
growth, openness, employment/labor force, human capital, capital formation, interest
rate, savings, inflation, export, import as independent or explanatory variables. The study
uses Vector Auto Regressive (VAR) model and VEC model for the purpose of
estimation. Harko and Ghumro (1999), in their research build hypothesis on the bases of
existing literature according to which the cost related factors, investment factors,
macroeconomic factors, influence positively FDI in Pakistan. The estimated results are
according to the expectations. The signs are statistically significant. The cost relating
factors wage and interest rates positively determine FDI. This means that these factors are
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favorable for investment in Pakistan. Openness of the economy shows positive relation
with FDI in Pakistan. The study concludes that social and political factors are highly
significant and have negative effect on FDI. It means the political environment is not
favoring or attracting foreign investors to Pakistan. The study emphasis on the policies to
make a stable political environment in Pakistan. Such policies should be made that attract
FDI in Pakistan. One of the major determinants that deter FDI in Pakistan is political
instability.
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3- METHODOLOGY

In this section a framework analysis has been formulated to determine the

effects of different variables on foreign direct investment in Pakistan. Ordinary Least
Square method (OLS) has been used to analysis the effect of various explanatory
variables on dependent variable (FDI). The study uses time series data from 1970-2005.
Real GDP, Indirect taxes, Total Investment, Openness, Labor Force, Real Exchange Rate,
Military Expenditures, Developmental Expenditures has been used as explanatory
variables and FDI is used as a dependent variable. The data of Real GDP, Total
Investment and Openness has been collected from Pakistan Statistical Division, FBS
(National accounts). Data of Labor Force, Military Expenditures, Developmental
Expenditures, and Indirect Taxes has been collected from, 50 years of Pakistan in
statistics. And the data of FDI and Real Exchange Rate has been collected from UN
Statistical Division. The study uses simple regression model.

Justification of FDI determinants and their expected signs: The justification of the
determinants of FDI in Pakistan has been made in the following lines.

Market Size: According to the economic theory market size of an economy is positively
related to the Foreign Direct Investment because most of the economies use production
benefits policies for foreign investors, Majeed and Syed (2006) quoted, Root (1979). A
large market size attracts foreign investors to invest in the host country. Real GDP is used
as a proxy to estimate the effect of market size of Pakistan on Foreign Direct Investment
(FDI). Therefore we expect a positive sign of market size in terms of FDI.

Openness: The ratio of (import + export) has been used as proxy for openness. We
expect a positive sign of Openness with respect to FDI according to the economic theory.
 9

In case of market seeking investment the trade restriction can have a positive sign with
FDI. Due to the liberalization of the economy the expected sign of Openness is positive.

Total Investment: Total Investment includes investment from abroad and domestically.
The expected sign of total investment with respect to FDI is positive. Foreign investors
seek to invest in those countries whose total investment is increasing significantly.
Therefore we expect a direct relationship between FDI and total investment.

Indirect Taxes: Indirect Taxes have a negative impact on FDI. So it shows that FDI and
indirect taxes have negative relationship. Foreign investor deters to invest in those
countries that have high rate of indirect taxes. So we expect a negative sign of indirect
taxes in case of FDI.

Labor Force: Another determinant of Foreign Direct Investment is the labor force
participation rate. Labor force means the availability of labor as being particularly
imported for labor-intensive, efficiency seeking Foreign Direct Investment-rather than the
cost of labor. So economic theory suggest positive relationship between FDI and labor
force. So we expect a positive sign of labor force.

Exchange Rate: The coefficient of exchange rate is ambiguous in many studies. Its sign
is expected to be positive when the foreign investors consider it as lower cost of capital
and negative if the foreign investors are considering high returns on their investments. An
economy whose currency is depreciating will not attract FDI, Majeed and Syed (2006)
quoted, Akhtar (2000). The use of real exchange rate as compare to nominal exchange
rate on the bases of methodological ground affected by inflationary impacts, Majeed and
Syed (2006) quoted, Ragazzi (1973). In imports oriented countries foreign investors like
to invest more. When their will be trade barriers on imports such kind of ventures become
more desirables. So TNCs find it attractive to produce locally. Taking under
consideration all these facts we expect a negative sign of real exchange with FDI in case
of Pakistan.
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Military Expenditures: Defense expenditures are used as a proxy for military

expenditures. Large expenditures made on defense create uncertainty about the future. A
country whose military expenditures are high will deter FDI. Foreign investor avoids
investing in those countries that have high military expenditures. We expect a negative
sign of military expenditures with respect to FDI.

Developmental Expenditures: Foreign investors like to invest in those countries that

have high developmental expenditures. Because such expenditures provide good
infrastructure for investment. So we expect a positive sign of developmental expenditures
in terms of FDI.

^ ^ ^ ^ ^ ^ ^ ^
FDI=α +β1 RGDP+β2 OP+β3 INDIR+β4 LF+β5 RER+β6 T INVES+β7 ME+β8
^
DEX+ ui

FDI=Foreign Direct Investment

RGDP= Real Gross domestic product,

OP=Openness measured by (import+export)

INDIR=Indirect Taxes

LF=labor force

RER=real exchange rate

T INVES=Total Investment

ME=military expenditures

DEX=Developmental Expenditures
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4-Description of variables:

Foreign Direct Investment is the net inflows towards the host region
and economy. It also includes inflows of foreign investment to the host country. FDI data
has been collected from UN Statistical Division from 1970-2005 in US million $,
according to the World Bank estimates. The data is in 1999-2000 base year.

GDP (MP) is the sum of gross value added by all domestic producers in
an economy. GDP (MP) data has been collected from, Pakistan Statistical Division, FBS,
in million rupees. Data has been converted into 1999-2000 base year. After that GDP
deflator has been used and than GDP (MP) is divided by GDP deflator and it is converted
into Real GDP. The research uses Real GDP as an explanatory variable.

Openness is the ratio of export plus import. Export is the value of all
those goods and services which have been produced with in the host country and send
abroad in different countries. It shows the economic growth of a country. Import is the
value of goods and services which have been imported from abroad. The data of export
and import has been collected from, Pakistan Statistical Year Book; 2006. The data is in
1999-2000 base year. Export and Import data is in local currency million rupees.

Total Investment includes all the investments which have been made from
abroad and all the domestic investments to the host country. The data of total investment
has been collected from Pakistan Statistical Division; FBS. Data is from year 1970-2005
and is in 1999-2000 base year. The data of total investment is in local currency million
rupees. Total investment is used as an independent variable to see its impact on Foreign
Direct Investment (FDI).
 Indirect taxes are the taxes made on the consumption of the people of the
host country. Indirect taxes include taxes made on custom duties, federal excise duties,
sales taxes and etc. The data of indirect taxes has been collected from; 50 years of
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Pakistan in statistics. The data of indirect taxes is from year 1970-2005. The data is in
1999-2000 base year. It is in local currency million rupees.

Labor Force includes all the employed labor force and unemployed labor
force of the country. Labor force is the supply of labor to the labor market. It shows the
skill level of the labor force of the country. The data of labor force has been collected
from; 50 years of Pakistan in statistics, population and labor force. The study uses data
from year 1970-2005 in 1999-2000 base year.

Real exchange rates are the exchange rates determined by the stock exchange
market. It shows that the currency of the host country is appreciating or depreciating. It
also shows the efficiency of the stock market of the host country. The data of nominal
exchange rate has been collected and than with the help of USA’s CPI and Pakistan’s CPI
it has been converted into real exchange rate. The data has been collected from; UN
Statistical Division. The study uses data of real exchange rate from year 1970-2005 in
1999-2000 base year. The data of real exchange rate is in US $.

Military expenditures are the expenditures made on the armed forces of the
country. It does not include any developmental expenditure. Military expenditures show
that how much budget of the host country has been made on the armed forces. The data
of military expenditure has been collected from; 50 years of Pakistan in statistics, public
finance. The study uses data from year 1970-2005 in 1999-2000 base year. The data is in
million rupees.

Developmental expenditures are the expenditures made on the developmental

projects of the host country. It shows the level of infrastructure of the country. Its data
has been collected from; 50 years of Pakistan in statistics. The data of developmental
expenditure is from year 1970-2005 in 1999-2000 base year. It is in million rupees.

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5-Estimated results and their interpretation

OLS method has been used to determine the results. Regression has been run
on the explanatory variables against the dependent variables to calculate the results. The
value of R-square is very high. It turns out to be 98%. This shows the explanatory power
of the mode. So 98% of the variation is explained by the explanatory variables. The value
of Durbin-Watson is turn out to be 2.142 which is in the acceptable range.

Real GDP is used as proxy for the size of the market. Real GDP is used as
lead variable. It turns out to be highly significant. The estimated result of the RGDP is
according to the prior expectation. It shows the growing size of the market of Pakistan
economy. The size of the Pakistan market is attracting FDI in Pakistan to a significant
level. Real GDP is a strong indicator of a country’s economic growth. The study shows a
stable economic environment that attracts foreign investors to the host country. The size
of the Pakistan market is providing opportunities for the foreign investors to invest in
Pakistan and is offering a higher demand and absorptive capacity in the economy. The
estimated result of the Real GDP is strongly attracting Foreign Direct Investment in
Pakistan. So we can conclude on the basis of these results that Pakistan’s size of the
market is leading towards success in attracting the Foreign Direct Investment to the host
country.

The ratio of (import + export) is used as proxy for openness. It shows the level of
trade liberalization of the country. It turns out to be statistically insignificant at 10% level
of significance. The MNCs like to invest in the country that has sound trade policies and
has less trade barriers. The liberalization in the trade policy provides benefits to MNCs to
import raw material, equipments and plant machinery and also export promotion
facilities. The research shows that trade policies of Pakistan is not facilitating MNCs. It
shows that openness of the Pakistan economy is not attracting Foreign Direct Investment
in Pakistan. So we can say that liberalization of Pakistan economy in trade policies is
insignificant for attracting FDI to Pakistan.
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Variable Coefficients

C -1951.640

RGDP 0.001009*

T INVES 0.015573**

INDIR -0.022280**

OP -0.002889

LF 8.953050

RER -65.58119**

ME 0.016177

DEX 0.045718**

R-square 0.981827

Durbin-Watson stat 2.142762

ESTIMATED RESULTS

Dependent Variable: FDI (net inflows to Pakistan)

• * 1 % level of significance
• ** 5 % level of significance
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The sign of the total investment is according to the prior expectations. It turns
out to be statistically significant at 5% level of significance with positive sign. Total
investment is an important indicator in determining the behavior of FDI. It shows the
investment facilities and environment of a country. Foreign investors will seek to invest
in that country whose total investment is increasing. The estimated result shows that total
investment is attracting FDI at significant level. Total investment has a huge impact in
attracting FDI in Pakistan. It means that MNCs are attracting in Pakistan for the purpose
of investment. Pakistan with its high total investment is attracting FDI to great extent.

Foreign investors will avoid investing in those countries that have high indirect
taxes. The estimated sign of indirect tax is according to the prior expectations. The
estimated result of indirect tax is significant at 5% level of significance. It shows the
fiscal incentives given to foreign investors. It means that the history of indirect taxes is
not attracting FDI in Pakistan. Because more the custom duties, excise duties and sales
taxes less will be the FDI. The result shows that Pakistan’s indirect tax system is not
suitable for FDI in Pakistan. Pakistan government is not giving fiscal incentives to the
foreign investors.

The estimated result of labor force is not according to the prior expectations.
The result of labor force is statistically insignificant at 10% level of significance. Foreign
investor seeks to invest in the country whose labor force is skilled, productive, efficient
and hard working. The estimated result shows the low level of skilled workers in
Pakistan. The study shows that Pakistan’s labor force is not highly skilled, productive and
efficient. The estimated result shows that labor force of Pakistan is not determining and
attracting FDI in Pakistan due to its low skilled level. Labor force of Pakistan is not
leading towards success in attracting FDI in future.

16

The estimated result of real exchange rate is according to the prior expectations.
The result of real exchange rate is statistically significant at 5% level of significance.
Depreciation of the currency tends to increase the prices of goods and services imported
from abroad and decrease the price of exports. It shows that country is in deficit and has
burden of foreign debts. The study shows that Pakistan rupee is depreciating, which
means that the value of imports is increasing and the value of exports is decreasing. It
shows the macroeconomic instability of a country and also shows that the foreign debts
of Pakistan are increasing. It decreases FDI in host country. The foreign investors avoid
investing in that country whose currency is depreciating. So the history of Pakistan’s real
exchange rate is not determining and attracting FDI in Pakistan.

Defense expenditures are used as proxy for military expenditures. Foreign

investors avoid investing in that country that has high military expenditures. The
estimated result of military expenditure is not according to the prior expectation. The
result of military expenditure is statistically insignificant. More the military expenditures
a country has less will be the Foreign Direct Investment in that country because it
indicates that a country is making less expenditure on economic development. So it will
attract less FDI. The study on the basis of estimated results explains that Pakistan
government is making less expenditure on economic development and it has high non-
developmental expenditures and macroeconomic instability. Due to these facts the
foreign investors are not attracting towards Pakistan. Pakistan is making to much non-
developmental expenditures that are not showing a positive behavior of FDI for the
purpose of investment in Pakistan.

Developmental expenditures mean how much a country is investing for the

improvement of its infrastructure, for its economic development and macroeconomic
stability. The estimated result of developmental expenditure is according to the prior
expectations. The estimated result of developmental expenditure is statistically significant
at 5% level of significance with positive sign. Foreign investors seek to invest in that
country that has high developmental expenditures; because it shows that the country is
expending more on its developmental projects to facilitate the foreign investors and also
17

to attract the foreign investors. It means that developmental expenditures made by the
government are attracting FDI in Pakistan.

6-Conclusion and policy relevance

The research uses FDI as dependent variable and Real GDP, Openness, Total
Investment, Indirect Taxes, Labor Force, Real Exchange Rate Military Expenditures,
Developmental Expenditures as independent variables. The regression has been run using
OLS method. The estimated results of size of market, total investment, indirect taxes, real
exchange rate and developmental expenditures are statistically significant and openness,
labor force and military expenditures turn out to be insignificant with respect to Foreign
Direct Investment in case of Pakistan.

Thus the study suggests that size of the market (RGDP) is a positively attracting
FDI in Pakistan. Openness is negative and insignificant in attracting FDI in Pakistan, so
in order to attract FDI Pakistan government has to remove the trade barriers and should
liberalize the trade policies of the economy to significant level. Total investment is
positively attracting FDI in Pakistan positively and significantly. Indirect taxes turn out to
be negative and significant; it shows the lack of fiscal incentives to the foreign investors.
Thus the study suggests that more tax incentives should be given to the foreign investors
in order to attract FDI. Such policies should be made which give more tax incentives to
the foreign investors to attract the brains of foreign investors in order to invest in
Pakistan. Labor force is positive and insignificant in case of Pakistan which suggests the
low level of skilled workers, therefore the study concludes that Pakistan government
should made such policies and should introduce new techniques in labor force that
enhance their skills and productivity in order to attract FDI. Real exchange rate is
negative and significant. The study suggests that the stock exchange market of Pakistan
has to play its role and has to work efficiently in order to capture FDI in Pakistan.
Pakistan government is expending more than 70% of its budget on military. It shows that
Pakistan is not sending too much on economic development. The study suggests that
Pakistan has to decrease its non-developmental expenditures in order to attract FDI.
18

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http://www.pide.org.pk/ Topic: “The Pakistan Development Review”, Volume 47,

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 THE DETERMINANTS OF FDI IN PAKISTAN

Joel Alter

09-12132

(A student of economics in FCC UNIV)

Email Address: joelalter85@yahoo.com
Cell number: 0343-4007711

RESEARCH METHODOLOGY

ECON 302

SEC A

INSTRUCTOR DR. SHABIB HADIER SYED

FORMAN CHRISTIAN COLLEGE AND UNIVERSITY