In the past two decades, foreign direct investment inflows have increased steadily in both emerging and developed economies because of free-market approaches. According to the World Bank, “foreign direct investment (FDI) is the net inflows of investment to acquire a lasting management interest (10 percent or more of voting stock) in an enterprise operating in an economy other than that of the investor” (World Bank, 2014). The FDI accounts for “the sum of equity capital, reinvestment of earnings, other long-term capital, and short-term capital as indicated in the balance of payments” (World Bank, 2014). These elements capture net inflows, which are new investments in the country without any removed investments. FDI inflow comes from foreign investment, and it is compared to GDP.
This essay focuses on foreign direct investment net inflows (percentage of GDP) in Pakistan for the last few years. It also presents the benefits and costs of FDI alongside its theoretical perspectives.
Pakistan is located in South Asia. The World Bank classifies the country as lower middle income. By the year 2012, Pakistan had a GDP of $225.1 billion with a population of 179.2 million people. Today, the country’s FDI inflow is $846.7 million as indicated by the Heritage Foundation (Heritage Foundation, 2014).
Pakistan’s FDI policies
In some cases, a country can hardly notice the impacts of FDI, but they can also be definite. While several factors influence outcomes of FDI in a country, well-developed and implemented FDI policies could help investors facilitate investments and maximize the outcomes in such countries. FDI offers many benefits to the host country. These include technology transfer and trade balance, as well as several externalities, which relate to a good reputation as an investment destination and clustering. On the other hand, FDI could also result in unwanted outcomes, such as anti-competitiveness and exploitation of limited resources.
Pakistan has developed its FDI policy to attract foreign investors. Foreign investors can invest in some sectors through direct foreign investment. Unlike in the past when investors could only focus on the manufacturing sector, today, the country has opened up its economy and markets for investments (Khalid, Ullah and Shah, 2012).
FDI Inflows Trend in Pakistan
Based on the World Bank data of 2012, the rate of FDI in Pakistan was 0.4 (World Bank, 2014). In order to understand the trend of FDI in Pakistan, the historical graph provides a clear account of past records of FDI as a percentage of GDP. The graph offers insights into changes in FDI inflows in Pakistan in the recent past.
There is a strong relationship between a country’s economic growth and FDI. Rising FDI or large investments are necessary for a country to achieve high rates of economic growth.
Today, the amount of FDI inflows into Pakistan has declined steadily to 0.4%. The FDI inflows trend has declined since 2008 after reaching a peak of 3.9% (the highest ever) in 2007 (Kazmi, 1998). Pakistan’s FDI inflows rate was also below the global rate of 2.1% in 2012 (World Bank, 2014). Therefore, it is imperative for researchers and economists to understand factors that are responsible for the steady decline of FDI inflows in Pakistan.
Theories of FDI
Elements of the host country’s internal environment have critical roles in promoting inflows of foreign investments. A country with natural resources attracts investors. In addition, investors or multinational companies (MNCs) also search for cheap labor, available markets, favorable economic, legal systems, and infrastructures. However, an investor cannot underestimate the importance of political stability and political ideologies.
Political stability acts as an incentive for MNCs. The unfavorable political situation in Pakistan has affected FDI inflows in the country. One major challenge for foreign investors is the frequent change in FDI policies, which results from the country’s instability. Consequently, foreign investors are unable to predict the next move of the government. Moreover, there are also religious extremists in Pakistan, who are responsible for major cases of political instability.
In Pakistan, subsequent governments have defined their policies based on diverse political ideologies. This implies that there is a discontinuity in the development of long-lasting FDI policies. All governments in Pakistan have their own policies. Consequently, the country has experienced poor FDI inflows (Khalid et al., 2012). Such results can only indicate that Pakistan has an extreme regime with a radical stance against any form of FDI. Thus, they have failed to embrace the free market economy, which has resulted in an investment surge globally.
Eclectic Paradigm or the OLI Model
An eclectic paradigm is a critical tool for understanding FDI determinants. It provides captures all fundamental aspects, which a multinational firm may consider when planning a foreign investment and expansion for future growth. However, the paradigm tends to generalize aspects of FDI. Hence, it can only provide a clear explanation for a few aspects of international investments (Stefanović, 2008).
The paradigm can explain ownership advantages or competitiveness to investors. Therefore, it can identify competitive advantages, which any MNC can derive by expanding its operations internationally. Location factor determines the interest of MNC to invest in another country. Finally, the internationalization factor identifies possible reasons, which explain the choice of FDI rather than partnership or other forms of contracts and ventures.
The theory of eclectic paradigm assumes that firms, which seek to expand in other countries, possess certain assets and resources that can give them a competitive advantage in such locations. The intangible resources of a firm are useful in creating a competitive advantage in highly competitive international markets. These resources could be advanced technologies, skilled workforce, reputable brand name, high standards of management capabilities and logistics among others.
Such resources will allow a firm to conduct FDI and differentiate itself in the global market as MNC. This could result in a competitive advantage to the firm and a monopoly in the market. Such advantages make firms seek foreign investments and result in increased market share, revenue growth, and profitability. These outcomes could compensate for heavy investments required in Greenfield ventures. However, domestic firms have a cost advantage because they do not incur such costs of foreign investment.
The product life cycle may force a firm to seek foreign investments. In this case, a firm believes that it cannot adequately exploit its resources, technical expertise, research and development, financial resources, technologies, and managerial capabilities at home. Therefore, firms can overcome such limits by seeking investment opportunities in other countries. Foreign investment goes beyond capital. Firms also bring along their technical expertise, technologies, managerial skills, and other intangible resources, which have served them in their domestic markets.
Conversely, internationalization ensures that firms utilize and leverage their intangible assets to create a competitive advantage in their domestic markets (Stefanović, 2008).
Countries offer several advantages to firms when it comes to their geographical locations. For instance, there are locations with readily available cheap labor, markets, favorable financial policies or freedom, the justice system, intellectual property rights, and tax regimes among others. In the recent past, the location factor has grown to account for a country’s knowledge of institutions (Stefanović, 2008).
There are country-specific factors, which multinationals must consider when choosing a location for investment. Although governments aim to attract many foreign investors, there must be favorable location conditions, which should enhance a firm’s overall competitive advantage in such locations. The country has a seaport, which should favor it. However, Karachi Port has poor infrastructures, it is prone to delays, cancellation, and cannot handle many large container vessels. Moreover, the port is extremely expensive relative to its neighboring ports in Dubai and India. This may only limit several chances of FDI investments in the country.
This explains why firms seek investments outside their home countries rather than use joint ventures and franchises. Internationalization ensures that companies utilize their intangible resources effectively in locations other than home countries. In this case, competitive advantage is a major focus for a firm that seeks international investment opportunities. Global market conditions for business might be poor relative to the domestic market. Thus, it is imperative for MNCs to develop their competitive advantage through foreign investments instead of partnerships with other firms. However, firms that seek international investments must understand market failures and the potential costs of such investments.
For instance, Pakistan has several cases of “corruption, a lack of business freedom, trade freedom, limited transparency and accountability and a lack of open market regimes could deter foreign investments” (Heritage Foundation, 2014). In other words, these factors can limit any competitive advantage that a firm may achieve in Pakistan. Under such conditions, a firm must internalize its competitive advantage when undertaking FDI because of several market risks and possible failures. Costs are major concerns for any business in a failed market. As a result, a firm may seek joint ventures, acquire an existing firm, or establish a new subsidiary, but the option must reduce high costs.
A choice of a location for international operations should also act as an incentive for companies and help them in creating a competitive advantage. A firm must identify and differentiate its own competitive advantages against any possible advantages it might gain from the location. For instance, in Pakistan, any firm will have to interact with bureaucratic and corrupt governments of Pakistan. Such institutions may limit chances of attracting huge volumes of FDI inflows.
While a firm can overcome some of the limitations in a location, there are some limitations, which may only drive away foreign investments as they create unfavourable business environments. For instance, political instability in Pakistan is not simple to overcome with a firm’s competitive advantages. Since firms, which seek to expand their operations to foreign countries, already have some competitive advantages and internalisation favours, the major factor is finding a suitable location, which can favour business in a given foreign country.
FDI Benefits and Costs
While the essay has already mentioned some few benefits associated with FDI, this part presents additional benefits and costs associated with FDI to the host country.
Resource transfer effects
This will result from managerial capabilities, technology skills, and capital. These are resources, which may only come from FDII.
Any form of foreign investment results into a creation of new jobs in the host country.
Balance of payment effects
Generally, countries prefer account surplus, and FDI may help the host country achieve this by substituting imports and using a foreign partner for exporting products.
FDI on competition and economic growth
Foreign investments create competition and enhance efficiency and product quality in the host country. This will lead to high rates of productivity, which may spur economic growth.
Negative effects on competition
On the contrary, MNCs may also force budding firms in the host country to lose market share as they create fierce competition.
Unfavorable effects on the balance of payments
This may result when a firm returns huge profits (outflows) to its home country and imports substantial equipment for its investment in the host country.
A possible loss of National Sovereignty and Autonomy
In some cases, foreign investors may only focus on critical industries, which a country considers vital for national security. In addition, dependence on foreign investments may lead to a possible loss of economic independence for the host country.
FDI inflows are responsible for rapid economic growth in a country. However, in Pakistan, the rate of FDI inflows has declined from 2008 to the present. Although it has huge potentials and a desire to be a free-market economy, Pakistan faces several challenges. Political instability and ideologies as every successive government has its agendas, poor policy implementation, religious extremists, and poor infrastructures could be responsible for the decline of FDI inflows in the country. Thus, Pakistan must create favorable investment conditions to attract foreign investors.
Heritage Foundation 2014, 2014 Index of Economic Freedom: Pakistan. Web.
Kazmi, S 1998, Declining Foreign Investment in Pakistan. Web.
Khalid, S, Ullah, H and Shah, M 2012, ‘Declining Trends of Foreign Direct Investment in Pakistan (Causes and measures)’, Journal of Basic and Applied Scientific Research, vol. 2, no. 5, pp. 5148-5263.
Stefanović, S 2008, ‘Analytical Framework of FDI Determinants: Implementation of the OLI Model’, Economics and Organization, vol. 5, no. 3, pp. 239-249.
World Bank 2014, Foreign direct investment, net inflows (% of GDP). Web.