Foreign Direct Investment and Economic Growth: A Case Study of Pakistan.

Abdul Khaliq Nasar

School of Economics Quaid-i-Azam University Islamabad

Table of Contents: Chapter 1: Introduction Chapter 2: Literature Review Chapter 3: Methodology Chapter 4: Data and Variable Construction Chapter 5: Estimation and Results Chapter 6: Conclusion References; 1 3 7 9 10 16

List of Tables Table 01: Main Regression Table Table 02: Ramsey Reset Test 10

Abstract:
This work investigates that whether the foreign direct investment (FDI) affects the economic growth based on the time series data for the country Pakistan from 1970 to 2010. Ordinary Least Square technique is applied to examine the relationship between FDI and economic growth. A significant positive relationship was found between FDI and economic growth. The interaction of FDI with Human capital has a significant negative impact on the economic growth. Key words: Economic growth, foreign direct investment JEL Classification:
F21; G11; F43

Chapter 01 Introduction
In the various research works much of the attention has been given to determine the impact of FDI on economic growth. In the endogenous growth theories Technology was taken as endogenous and also explained the population growth and income differences among the countries which the exogenous growth theories failed to explain. Investment and savings are one of the main tools of the Solow Model to promote growth. When foreign direct investment is in the form of technological diffusion from the developed to the host country and when the host country has the absorptive capacities then FDI diffusion can promote growth (Borensztein, Gregoria, and Lee, 1998). As various studies have shown different relationship between FDI and economic growth. Some researchers have detected positive while some have detected the negative impact of FDI on the economic growth. It is due to the health of the data. FDI can attract more FDI and have strong impacts on the economic growth when there is political stability i.e. maintaining financial institutions stability and providing the property rights. in the Host country or when the host country has large market size. To get positive impacts of FDI on economic growth it is crucial to maintain an exemplary Judiciary, Financial institutions stability and giving property rights. Here the work encompasses the country Pakistan. A large sample of time series data set from 1970 to 2010 was taken in order to detect the impact of FDI on the economic growth. As the country has faced much political instability during various decades therefore, the magnitude of FDI inflow varies during different time periods. Terrorism and instable regimes has also the negative impact on the FDI inflow and since 2000 the country is involved fighting war
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against terrorism. Beside these tensions the country is also trapped in a curse of corruption. And the corruption has negative impacts on the economic growth as well as the FDI inflows.

Chapter 2
Literature Review
More efficiency is served to find the relationship between FDI and economic growth. For example, Borensztein et al (1997) FDI has a positive overall effect on the Economic Growth however the magnitude is proportional to the level of Human Capital. Thus effect of FDI on the Economic Growth depends on the availability of the Human Capital in the host country. It is also suggested that efficiency matters rather than capital accumulation. The best results of FDI on growth will come from the efficiency rather than from higher capital accumulation. The direct effect of FDI makes a negative contribution to growth in countries having low level of human capital. There is a reverse causality between economic growth and FDI as Gastanaga et al (1998) have shown in their paper that exchange rate distortions in the host country do not exert a significant harmful influence on FDI. By increasing growth rate through different efforts in lower developed countries is not directly associated with FDI. However, indirectly such efforts can influence FDI. For the host country to catch FDI there is also the issue of distance between the host and the home country as Frenkel et al (2004) find that distance and both home and host country characteristics play a significant role in determining the extent of FDI flows. According to them FDI is inversely related to the distance between the host and the home country. As increase distance increases the transportation cost. Economic development as indicated by the GDP growth is the pull factors for the host country e.g. risk and economic growth are crucial for attracting international investment in the host countries. Finally growth in the countries from which FDI activities originate exerts a positive effect on the level of FDI inflow. In the literature we found both a direct and indirect positive relationship between FDI and economic growth

when a country has the absorptive capacities such as Human Capital and large market size as Li and Liu (2005) found that there is a strong complementary relationship between FDI and Economic growth in both developed and developing countries. FDI has a positive relationship with economic growth both directly and indirectly. There is also a strong positive relationship of FDI with Human capital and strong negative relationship with the technology gap on economic growth in the developing countries. To attract FDI host country must have a large market size. In addition human capital and technology absorptive ability are important for inward FDI to positively promote growth in developing countries. Beside these impacts of FDI on economic growth a negative impact of corruption on the FDI was also shown as Cazurra (2008) shows that corruption has a negative impact on FDI because it increases the costs and uncertainty. Pervasive corruption has a larger negative impact on the FDI while, arbitrary corruption has less negative impact on FDI in transition economies. Most of the research has shown a positive impact of FDI on economic growth i.e. FDI promotes economic growth as in the work of Bangvu and Noy (2008) that FDI has a positive and significant effect on the economic growth both directly and through its interactions with labor. This affect is not equally distributed across the countries and sectors. However, in some sectors no evidence was found that FDI enhances economic growth but results will be found if a comprehensive aggregate sectorial data is available. The impact of FDI is also shown in the large economies like China as Lee at al (2009) that when the source country makes investment in China there is a decrease in the relative income between the source and the recipient country. However, there is an increase in the unemployment rate in the source country and decrease in the income disparity. For small source country FDI outflows to China decreases the Export to GDP ratio in the source country. FDI has different positive impacts on different host countries. It can generate more growth in the countries which are more financially

developed then less financial developed countries as Alfaro et al (2009) that FDI leads to higher growth rates in the financially developed countries as compared to those which are less financially developed. The host country has an absorptive capacity in order to get the positive impact of FDI on economic growth. Also Adams (2009) shows that FDI is positively and significantly correlated to the economic growth. The result shows that contemporaneous FDI is negatively correlated with economic growth while lagged FDI is positively correlated with the economic growth. FDI doesnt have a positive impact on the economic growth. This is due to the low level of development of financial markets in Sub Saharan African countries. Domestic Investment is positively related to economic growth. FDI is negatively and significantly correlated with the Domestic Investment. While lagged FDI is positively related with Domestic Investment. FDI impact depends on the overall structure of the host country. A country is to be cautious and critical in the kind of FDI it attracts; that open door policy to attract all kinds of FDI will not yield the desired level of benefits. Without FDI there is a possibility that a country could be poorer. A countrys advantage from FDI depends on the initial conditions of education level, basic physical infrastructure and appropriate institutions. More recently Saini at al (2010) they in their research article shows that the impact of FDI on economic growth is presented by numerous researchers. As different studies shows that absorptive capacities of the recipient countries has a key role. Here it is shown that FDI has no direct impact on the economic growth. Economic freedom is found to be an important driver in the long run economic growth. Countries that promote economic freedom had gain more from FDI. As in such countries the firms easily absorb and adopt new technology and other benefits associated with the FDI inflows. Security of property rights and market regulations are all important elements of a country absorptive capacity. Property rights and legal structure can be improved by promoting judicial

independence and establishing a trusted legal framework for private businesses. To achieve the better results of FDI on economic growth financial institutions of the country must be organized as Alguacil at al (2010) found that to measure the impact of FDI on economic growth we have to consider internal and external macroeconomic stability as well as the quality of institutions. Secondly the impact of FDI on growth is positive in low income countries as compared to the more developed countries. Policies for attracting FDI are not sufficient if institutional conditions and macroeconomic stability are not improved. FDI and Private investment are in favourable regimes as Morrissey and Udomkerdmongkol (2011) show that private investment and FDI is higher under favorable regimes. Secondly FDI crowds out Private Domestic Investment more incase of good governance whereas the poor governance discourages FDI hence private domestic investment must be higher to compensate. It was also found that FDI crowds out private domestic investment do not imply that FDI is not beneficial. It simply reflects the fact that profitable opportunities are limited.

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Chapter 03
Methodology
The Model: The main explanatory variables which were identified in the various studies include the GDP, Human Capital, Population growth, corruption and Investment. These were taken together with FDI. Keeping the above explanatory variables in mind I have selected the following form of model.
Yt 0 1 X t 2 Et X t 3 Pt X t 5 X t 1 t

In the above model on the right hand side Yt is the dependent variable which is the real GDP. On the left hand side there is a set of explanatory variables. Xt is the variable showing FDI and EtXt is the interaction term of FDI and total secondary enrollment. The interaction term of FDI and Human Capital taken in the model is to determine the absorptive effect of foreign investment through Human Capital on the real GDP. Here in the model the total secondary enrollment is proxy of Human Capital as data on the Human Capital is not easily available therefore, I proxy the Total Secondary Enrollment as a Human Capital. Human Capital can increase as the level of education increases and when the technical education is provided to the population of the country so, as to absorb the foreign direct investment. It was used by many researchers as (Li and Liu 2005) had taken the secondary enrollment as a proxy for Human Capital. Pt is Public investment. It is taken as an interaction term with FDI. A lag value of FDI is also taken in the above model. All the variables taken in the model are real. The above model is estimated through a method

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Ordinary Least Square (OLS). This method is used because of its simplicity. I applied Ramsey Reset test to check the specification of the model. This test tells us that whether the model is correctly specified or not. According to this test when the probability after conducting the test is more than 0.1 than it can be concluded that the model is correctly specified. And I found the probability greater than 0.1 so, I concluded that the model I selected is correctly specified.

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Chapter 04
Data and Variable Construction
The Data: The Time Series data is about Pakistan covering the period from 1970 to 2010. This data set is mainly obtained from the source World Bank WDI data base and State Bank of Pakistan. Data of the variable real GDP, Total Secondary Enrollment, Public Investment, Foreign direct investment (FDI), GDP Deflator, Official Exchange Rate and Total Investment were obtained from the above sources. The data of the variable Human Capital was not available then it was proxy by total Secondary Enrollment. Variable Construction: All the variables used in model are taken in US dollar except the variable total secondary enrollment. As the data of Public investment was taken from the source State Bank of Pakistan. It was in million rupees. Latter I converted the data of public investment into million US dollar simply dividing it by the Official Exchange Rates. All the data is in constant 2000 US dollar. Real GDP data was obtained from the nominal GDP dividing nominal GDP by the GDP deflator and multiplying it with 100. Similarly data of FDI was also obtained from the State Bank of Pakistan, it was in million rupees and before introducing it into the model it was converted into constant 2000 US million dollars by dividing the FDI with official exchange rates and then by GDP deflator constant 2000 and multiplying it with 100.

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Chapter 05:
Estimations and Results
In this section the estimation results are discussed. The results are presented in the given tables. Table 01: Main Regression table.
Dependent Variable: GDP Method: Least Squares Date: 12/20/11 Time: 19:21 Sample(adjusted): 1973 2009 Included observations: 37 after adjusting endpoints Variable C FDI ENROLL*FDI PUBINVST*FDI FDI(-1) R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat Coefficient 2.88E+10 160.7489 -1.22E-05 -9.50E-09 20.70642 0.828442 0.806997 1.21E+10 4.72E+21 -908.9747 0.953886 Std. Error 4.89E+09 32.63940 3.02E-06 1.66E-09 5.012944 t-Statistic 5.886215 4.924996 -4.020759 -5.738778 4.130591 Prob. 0.0000 0.0000 0.0003 0.0000 0.0002 5.54E+10 2.77E+10 49.40404 49.62173 38.63146 0.000000

Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

As the model was specified keeping GDP as dependent variable. I have to find the impact of FDI on the GDP. A regression line was run and as a result of this regression the above table results are obtained. First I observed the coefficients and t-statistics of the model. I observed that all the t-statistics of the model are statistically significant. But when I observed the coefficients it was not as I was expecting. The coefficient of FDI was statistically significant and has a positive sign. This shows the positive impact of FDI on the economic growth. The coefficient of the interaction term Enroll*FDI is negative. This shows that its combine effect on GDP is negative.

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This result was not according to the theory. As theory suggests that Human Capital that is proxy by Enrollment has appositive effect on the GDP. When it is higher than the host country can easily absorb the FDI thus then FDI will have a positive impact on the economic growth in the long run. When a regression of GDP as dependent variable was run keeping Enrollment as independent variable then a coefficient with a high positive value was obtained. It was according to the theory that enrollment or the Human Capital has a positive impact on the economic growth. Then I checked the Durbin-Watson statistics and R- square of the model. After observing the Rsquare I concluded that there is no multicollinearity in the model. But I obtained too low value of the Durbin Watson Statistics. In normal conditions it is almost or near to two. But here it is less then two so there is an auto-correlation problem in the model. The low statistics of the Durbin Watson statistics is due to the less number of explanatory variables on the right hand side of the model. I then applied Cochrane- Orkut Iteration test to remove the auto-correlation problem from the model. When I run a regression including AR (1) then I obtained the results with statistically insignificant t-statistics. R-square and the probability were too high. It created the problem of multicollinearity. Then I dropped the AR (1) from the model. I applied Histogram Normality test and obtained the above given graph. I observed the Skewness, Kurtosis, Jarque-Bera and probability. As the probability is greater then 0.1 it suggests that the residual are normally distributed.

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Table 02: Ramsey Reset test.

Ramsey RESET Test: F-statistic Log likelihood ratio Test Equation: Dependent Variable: GDP Method: Least Squares Date: 12/20/11 Time: 23:46 Sample: 1973 2009 Included observations: 37 Variable C FDI ENROLL*FDI PUBINVST*FDI FDI(-1) ESGDP10^2 FITTED^2 FITTED^3 R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat Coefficient 2.01E+10 121.5447 -7.17E-06 -8.54E-09 24.10747 -4.49E-12 1.65E-11 -1.37E-22 0.911046 0.889574 9.19E+09 2.45E+21 -896.8240 1.169827 Std. Error 2.38E+10 551.8261 4.03E-05 3.40E-08 75.36308 1.73E-11 2.50E-11 1.39E-22 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic) t-Statistic 0.844998 0.220259 -0.177727 -0.251014 0.319884 -0.258904 0.659172 -0.985685 Prob. 0.4050 0.8272 0.8602 0.8036 0.7513 0.7975 0.5150 0.3324 5.54E+10 2.77E+10 48.90940 49.25771 42.42997 0.000000 1.972860 4.719924 Probability Probability 0.157284 0.094424

After obtaining the negative coefficient of the interaction term enroll*FDI I applied a Ramsey Reset Test to check the specifications of the model I made. As this test tells us that whether the model is correctly specified or not. After applying the test I obtained the results and observed the probability. Ramsey reset test suggests that when the probability is greater than 0.1 then the model is correctly specified. I obtained the probability greater than 0.1 and I concluded that the model which I constructed is correctly specified.

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Figure 01: Histogram Normality Test.

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Series: Residuals Sample 1973 2009 Observations 37

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Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability -1.39E-06 -2.35E+09 2.58E+10 -1.88E+10 1.15E+10 0.451639 2.412971 1.789128 0.408786

0 -2.0E+10 -1.0E+10 0.00000

1.0E+10 2.0E+10 3.0E+10

I then applied Cochrane- Orkut Iteration test to remove the auto-correlation problem from the model. When I run a regression including AR (1) then I obtained the results with statistically insignificant t-statistics. R-square and the probability were too high. It created the problem of multicollinearity. Then I dropped the AR (1) from the model. I applied Histogram Normality test and obtained the above given graph. I observed the Skewness, Kurtosis, Jarque-Bera and probability. As the probability is greater then 0.1 it suggests that the residual are normally distributed.

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Figure 02: Cusum Stability test.

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10

-10

-20 80 85 90 CUSUM 95 00 05

5% Signif icance

Figure 03: Cusum of Squares Stability Test.

1. 6

1. 2

0. 8

0. 4

0. 0

-0. 4 80 85 90 95 00 05

CUSUM of Squares

5% Signif icance

I applied the Cusum test and Cusum of squares. As from the figures the line falls in between the significance level. The Cusum is normal but there is a problem in the Cusum of squares. As
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when the Cusum is normal and the problem is in Cusum of squares then the problem is due to a shock. Beyond the observation 85 the shock starts and it is up to the 00. As here the line crosses the significance level. Research work of the researcher had showed that there is a reverse causality between FDI and economic growth. As (Hansen and Rand 2006) showed that economic growth can cause the FDI inflow. Countries which experience high economic growth can attract more FDI inflows thus there also exists a reverse causality between FDI and Economic growth. Beside this uncertainty and the regimes also affect the economic growth. Because of the unavailability of the data on uncertainty I can not included its impact in the model in order to judge its impact on FDI and economic growth.

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Chapter 6:
Conclusions:
It can be concluded that in this research work it was tried to show the relationship between FDI and economic growth. As various studies had showed both positive and negative impacts of FDI on the economic growth. Here, a significant positive impact of FDI on the economic growth was seen. FDI has strong positive impact on the economic growth when there is availability of the Human Capital in the host country. The availability of the Human capital then strongly absorbs the FDI inflow thus giving an economic growth in the Log Run. But the coefficient sign of the interaction term of FDI with enrollment was not according to my expectations. It was due to the less availability of the data. Also corruption, no better financial institutions and uncertainty or instable regimes have different negative impacts on the FDI inflow and economic growth. There is also a reverse causality between FDI and economic growth. Sometimes the strong economic growth can attract FDI inflows. The host country has to promote financial institutions and to setup an exemplary judicial system in order to catch foreign direct investment. Also it has to arm the population with technical education in to order to cope the FDI which is in the form of technology diffusion. Then the fact of strong positive relationship between foreign direct investment and the economic growth can not be denied.

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References:
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Li, X., and Liu, X. (2005). Foreign Direct Investment and Economic Growth: An Increasingly Endogenous Relationship. World Development 33 (3), 393-407. Mah, S. J. (2010). Foreign direct Investment inflows and economic growth of China. Journal of Policy Modeling 32, 155-158. Morrissey, O., and Udomkerdmongkol, M. (2011). Governance, Private Investment and Foreign Direct Investment in Developing countries. World Development xx(x), xxx-xxx. Saini, A. W. N. W., Baharumshah, Z. A., and Law, H. S. (2010). Foreign direct Investment, economic freedom and economic growth: International evidence. Economic Modeling 27, 1079-1089. Vu, B. T., and Noy, I. (2009). Sectoral analysis of foreign direct investment and growth in the developed countries. Journal of International Financial Markets, Institutions & Money 19, 402414.

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