COMPARATIVE STUDY: FOREIGN DIRECT INVESTMENT (FDI) AND THE
RELATIONSHIP WITH GROWTH IN PAKISTAN

Introduction

The enormous development of international production is driven by the economic and technological improvement but more importantly through the liberalization of Foreign Direct Investment (FDI). FDI is defined as "an investment made to acquire lasting interest in enterprises operating outside of the economy of the investor" (IMF ,1993)
FDI can be divided into two forms: "greenfield" investment, which is direct investment in new facilities or the extension of existing facilities and "Mergers & Acquisitions" occur when a transfer of existing assets from local firms to foreign firms takes place.

The proposed research question for this topic is to identify the relationship of FDI and economic growth in Pakistan between the two periods of 1990-1999 and 2000-2009 .The grounds of choosing these particular periods is the events of Karagil war with India and Nuclear bomb testing in is the events of Kargil war with India and nuclear bomb testing in the 90's and the religious extremists and financial crisis from 2000 until today. The aim is to identify how these issues have affected the relationship between FDI and economic growth in the Pakistan region and to compare and contrast the differences of the FDI inflows in the two time periods.

Several factors have detained the development of FDI in Pakistan, namely law and order,lack of proper infrastructure as well as political insability.(Yousaf et al. 2008).
Specifically, net private-capital flows to developing countries climbed up to an unprecedented $1.03 trillion in 2007 which represents 7.5 per cent of developing countries' GDP. In contrast, as a share of Pakistan's GDP, foreign investment inflows form less than 4 percent (Mughal, 2008). Nevertheless, FDI provided a strong base to improve the economic situation in the country. Attractive sectors in Pakistan for FDI are Oil and Gas exploration, telecommunication and Financial Services.

The reasoning behind the selection of this topic is the fact that Pakistan foreign investment has not been studied in depth compare with China or India .A number of articles on this particular topic could be found in national Pakistan sources, however, there is a lack of sources on more generally recognizable journals. A number of factors which make Pakistan an attractive place for foreign investment are: the high quality of Natural Recourses, the fact that 49.9% of the population speak English, and lastly that Pakistan has an important Geographical position in Central and South East Asia along with proper transportation and communication infrastructure.


Theoretical Framework & Literature Review

While the relationship between economic growth and FDI is considered as a well studied subject, within the development economics literature and despite the substantial volume of research on the issue, evidence is still conflicting. When approached both theoretically or empirically the unmistakable explosion of FDI's growth effects still remain controversial.

It is argued that FDI boosts economic growth indirectly where the direct transfer of technology augments the stock of knowledge in the recipient country through new management practices and organizational arrangements as well as labor training and skill acquisition, (De Mello, 1999). In the theoretical context of either endogenous growth models or neo-classical there is a difference in the effect of FDI on the economic growth of the receiving country from their conventional equivalent. The counterpart theory states growth in the framework of an open in contrast to a closed economy and the emergence of externality based growth models. For instance, a study showed that the positive growth effects of FDI have been more likely when FDI is drawn into competitive markets, while negative effects on growth have been more possible when FDI is drawn into heavily protected industries (Encarnation and Wells, 1986).

It was believed that when FDI is included in the model of economic growth the possible impact of FDI on the short-run level of incomes is confined by the traditional growth theories when in fact recent researches strongly suggest an endogenous long run role of FDI in economic growth determination. The neo-classical models state that FDI can only affect short run growth and this is due to diminishing returns of capital in the long run. Alfaro et al (2007) proposed that FDI had a positive effect in countries with adequate developed financial economies, while, Carkovic and Levine (2002) argued this view was not accurate, since FDI did not exert an exogenous impact on growth in financially developed markets.

The rise of endogenous growth models, conflicts with,the neoclassical model and it has made it possible to model FDI as encouraging economic growth through the permanent transfer of knowledge that accompanies it ,even in the long run. For instance, Blomstrom,Lipsey and Zejan (1994) supported that FDI has a positive effect on growth in sufficiently wealthy countries, but there seems to be a certain level of income to have a positive effect on economic growth. Those countries absorb new technologies and that allows them to benefit from technology diffusion thus reaping extra potential advantages of FDI.

According to the majority of studies,factors such as degree of complimentarity and subsitution between domestic investment and FDI as well as other country specific characteristics shape the effect of FDI on growth. Lipsey and & Sj�holm (2004) summarised the evidence of positive spillovers of FDI by different authors. Even though country specifc and industry specific characteristics were vital, their results did not support the conlusion that FDI brings substantial spillover effects on the whole economy.

Balasubramanyam et al. (1996) argues that FDI plays different role in the growth process due to the differing trade policy regimes .In order for the the contribution of FDI to economic growth to be enhanced its based on the interaction with the level of human capital in the host country.( Borensztein et al. ,1998).Nair-Reichert and Weinhold (2001) attempted to examined the relationship between FDI and growth in developing countries and they found that there is no casual link between FDI and growth.
Yousaf et al (2008) deems that developing countries that show an increasing growth in GDP, attract more foreign FDI and also that the government should provide friendly policies to promote FDI. In addition this study suggests that FDI is an important agent for innovation and technology in the host country and eventually contributes in the growth of a country like Pakistan.

The positive or negative relationship of FDI on growth is inconclusive, due to the conflicting studies of different authors.

Utilizing the literature review and the growth theories discussed above, for this particular thesis one of the three possible types of causal relationship exists and will be proved:

  1. Growth-driven FDI (when the growth of the host country attracts FDI)

  2. FDI-led growth (when the FDI improves the rate of growth of the host country)

  3. Two- way causal link between them (or possibly no causality at all).

Methodology

It is vital at this point to explain the methodology that will be used in order to explore the relationship between FDI and economic growth in Pakistan during 1990-1999 and 2000-2009. This thesis will be following a deductive reasoning, a theory testing approach, aiming at identifying a positive or a negative relationship and the type of the relationship between FDI and growth. Attention will be focused on econometric techniques used to analyze the relationship of FDI and economic growth as well as simple calculations like average and percentages of FDI inflow

Time series data will be utilized in order to prove a positive or a negative relationship in the two periods between FDI and economic growth. The data will be collected from different data sets such as, International financial statistics (IFS), Statistical Year Book of International Trade, 50 Years of Pakistan and lastly the Economic Survey of Pakistan.

This study aims at testing the existence of a causal relationship between FDI and economic growth.An appropriate regression analysis will be used and the variables that will be included in this econometric model are the following: Gross Domestic Product (GDP), Capital Stock, Total Factor Productivity of Growth in output, Total Exports and Imports to GDP as well as Domestic Investment.

The econometric techniques that will be employed using the annual time series data of the variables, will deal with the estimation of a set of simultaneous equations that establish the mutual interdependence among them.


Conclusion

FDI has become an important growth factor in the globalization of the world economy. Generally existing literature have provided conflicting predictions concerning the growth effects of FDI. This thesis will empirically analyze the relationship of FDI and economic growth in Pakistan, relying on annual time series data over the two periods 1990-1999 and 2000-2009.During the last few years the role of FDI has become more and more important for Pakistan and other developing countries. Indeed, the reason for this project is the optimistic view that Pakistan could be a hub of foreign investment .The vision is to complete a number of studies on FDI exploring the stimulation of change, the potential and the benefits of Pakistan in recent years as a foreign investment country the importance of FDI on the growth of the country.


References:

IMF (1993), Balance of Payments Manual: Fifth Edition (BPM5), Washington: International Monetary Fund.

Yousaf, M. et al (2008). Economic Evaluation of Foreign Direct Investment in Pakistan, Pakistan Economic and Social Review, Volume 46, No.1, pp. 37-56

Mughal, M. (2008). Boon or bane-role of FDI in the economic growth of Pakistan, Munich Personal RePEc Archive (MPRA) Paper No. 16468

De Mello, L., Jr. (1999). "Foreign Direct Investment-Led Growth: Evidence from Time Series and Panel Data," Oxford Economic Papers 51 (1), January

Encarnation D. J. and L. T. Wells, Jr. (1986) "Evaluating foreign investment," in T. H. Moran et al. Investing in development: new roles for foreign capital? Washington, DC: Overseas Development Council.

Alfaro, Laura, Chanda Areendam, Sebnem Kalemli-Ozcan, and Sayek Selin. (2003). FDI and Economic Growth: The Role of Local Financial Markets. Journal of International Economics 61, no.1 (October): 512-33

Carkovic, M. and Levine, R. (2002). "Does Foreign Direct Investment Accelerate Economic Growth?". University of Minnesota. Working Paper.

Blomstrom, M., Lipsey, R.E. and Zejan, M. (1994). "What Explains Growth in Developing countries?". NBER Discussion Paper 1924.

Lipsey, Robert & Sj�holm, Fredrik, 2004. "Host Country Impacts Of Inward Fdi: Why Such Different Answers?," EIJS Working Paper Series 192, The European Institute of Japanese Studies.

Balasubramanyam, V. N., Mohammed Salisu and Dabid Sapsford. (1996). Foreign Direct Investment and Growth in EP and IS countries. Economic Journal 106, no.434 (January): 92-105.

Borensztein, E., De Gregorio, J., and Lee, J. W., 1998. How does foreign direct investment affect economic growth? Journal of International Economics, 45, 115-135

Nair-Reichert, Usha & Weinhold, Diana, 2001. " Causality Tests for Cross-Country Panels: A New Look at FDI and Economic Growth in Developing Countries," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 63(2), pages 153-71, May

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