Total Investment, FDI and Growth Relationship in Pakistan

Presented by: Irfan Ullah Tarar Supervised by: Dr. Nisar Ahmed

Agenda
Introduction Review of Literature Theoretical Framework Data and Methodology

Empirical Results
Conclusion and Policy Implications

Introduction
The FDI can be defined as: an investment made by a resident of one economy in another economy and it is of a long-term nature or of lasting interest, (UNCTAD, 2009)

Importance of FDI Inflows

Promote Economic growth Augment capital formation Source of Human capital development Diffused technology and spillovers promote competition Encourage Financial development Source

of bridging gap of LDCs(Source of external finance)

saving-investment

in

Impact of FDI inflows on Total Investment

Complementary Effect (Crowding-in) Substitution Effect (Crowding-out) Neutral Effect (One-to-One Effect)

Complementary Effect (Crowding-in Effect)

The TNCs can promote competition with domestic firms Diffused modern technologies and positive spillovers

through FDI to domestic firms

Complement domestic firms production activities

Substitution Effect (Crowding-out Effect)

The TNCs have comparative advantage over domestic

firms in managerial skills, financial resources, production efficiency and technology

FDI inflows substitute domestic firms production activity,

it also leads to Crowding-out Effect

Trends of FDI, Total Investment and GDP Growth in Pakistan

FDI inflows during 1970s and 1980s are low After restructuring of the economy in 1990s, FDI inflows

have moderate increase in 1990s and exponential growth during 2003-2007

The FDI inflows and Gross Fixed Capital Formation ( Total

Investment) have almost the similar trends during the study period 1974-2009
The GDP Growth Rate fluctuates between 1.01% and

10.2% during the study period 1974-2009

1000

2000

3000

4000

5000

6000

Source: UNCTAD(2011)
1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

FDI Inflows ($ million)

FDI Inflows($Million )

10

12

14

16

18

20

Source: UNCTAD(2011)
1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 FDI Inflows (As a Percentage of GFCF)

FDI Inflows (As a Percentage of GFCF)

Goss Fixed Capital Formation ($ Million)

40000 35000

30000

25000

20000

Goss Fixed Capital Formation ($ Million)

15000

10000

5000

Source: World Development Indicators (2011)

10

12

Source: World Development Indicators (2011)

1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

GDP Growth Rate (Annual %)

GDP Growth Rate (annual %)

Objectives of the Study

To test the short-run and long-run relationship among total

investment, FDI and economic growth in Pakistan

To check the crowding-in or crowding-out effect of FDI on

total investment in Pakistan

To analyze the causal relationship among total investment,

FDI and economic growth

To provide policy implications based on empirical results

Literature Review
Van Loo (1977) examined the direct and indirect effects of

foreign direct investment on total investment in Canada for the time period 1948-1966. The OLS and 2SLS techniques were used to estimate the results. The coefficient of FDI was 1.3981 which confirmed the evidence of complementary effects ( crowding-in effect)
Lipsey and Kravis (1987) used cross- sectional and time

series data and found that the growth rate was more closely related to capital formation.

Continued
De Long and Summers (1991,1992) used a cross-national

data from the 1950s to 1980s, and found a strong positive causal relationship between capital investment and economic growth.
Aitken and Hanson (1997) analyzed panel data on Mexican

manufacturing plants and found evidence of beneficial spillovers from multinational enterprises to the Mexican economy.

Continued
Borensztein et al., (1998) analyzed the relationship between

FDI and economic growth for a panel of 69 developing countries. The minimum threshold of human capital was necessary for positive effects of FDI on economic growth. The study also found the supportive evidence of crowdingin effect of FDI on domestic investment.
Agosin and Mayer (2000) developed

total investment model to analyze crowding-in or crowding-out effect of FDI inflows for a panel of three developing regions (Asia, Africa and Latin America) and found crowding-in effect in Asia, but less so in Africa, and strong crowding-out in Latin America.

Continued
Weinhold and Nair(2001) used causality tests for cross-

country panel of 24 developing countries to look at dynamic relationship between FDI and economic growth from 1971-1995 and found that there was a quite heterogeneous effect of FDI on economic growth across countries.
Chakraborty and Basu (2001) applied co-integration and

Error- Correction approaches to study long-run and shortrun relationships between GDP and FDI in India for the period 1974-1996. It was found that GDP in India had no Granger causality by FDI, but causality from GDP to FDI was present.

Continued
Misun and Tomsik (2002) used total investment model of

Agosin and Mayer (2000) to analyze crowding-in or crowding-out for a panel of three countries; Czech Republic, Hungary and Poland for time period 1990-2000. The evidence of crowding-in was found in Hungary and Czeck Republic and crowding-out in Poland.
Kim and Seo (2003) analyzed the relationship among

inward FDI, economic growth and domestic investment for Korea over the time period 1985-1999. The VAR methodology was used to estimate the results and found no evidence of crowding-out effect of inward FDI on domestic investment.

Continued
Backer and Sleuwaegen (2003) analyzed firms entry and

exit in Belgian manufacturing sector in the presence of FDI and import competition and found the evidence of crowding-out of domestic firms.
Choe (2003) examined the causal relationship among

economic growth, FDI and gross domestic investment (GDI) for a panel of 80 countries over the period of 19711995. There was a bidirectional causality between FDI and economic growth and the effects of economic growth were stronger than FDI when the outliers were excluded for 80 countries from 1971-1995. In case of economic growth and GDI, the causality ran in only one direction from economic growth to GDI.

Continued
Hansen and Rand (2006) analyzed the causal link between

FDI and economic growth for a panel of 31 developing countries from Asia, Latin America and Africa over the period of 1970-2000. The VAR methodology was used in their study. The results supported the strong causal link from foreign direct investment to economic growth in the long run. It was also concluded that a higher ratio of FDI in gross capital formation had positive effects on the level of GDP and hence on economic growth in the long-run.

Continued
Chowdhury

and Mavrotas (2006) analyzed the causal relationship between FDI and economic in a panel of Chile, Malaysia and Thailand for the period of 1969-2000. The TodaYamamoto test for causality analysis was used and found that GDP Granger caused FDI in Chile and bidirectional causality in Malaysia and Thailand.

Yang(2007) used panel data for 110 countries from 1973 to

2002 to analyze the relationship between FDI and growth and found the effect of FDI on growth was different over time and across regions.

Continued
Ozturk and Kalyoncu (2007) investigated the impact of FDI

on economic growth for Turkey ad Pakistan over the period of 1975 to 2004 and found that it was GDP that caused FDI in the case of Pakistan, while there was a bi-directional causality between the two variables for Turkey.
Sarkar (2007) used panel data of 51 less developed

countries for the period of 1981 to 2002 and time series data from 1972-2002 and found mixed relationships between FDI and economic growth across panel.

Continued
Tang et al., (2008) used quarterly data from 1981:1 to

2003:4 and analyzed the relationship among the FDI inflows, domestic investment and economic growth in China. The study found that FDI inflows complemented domestic investment. The GDP and domestic investment had bidirectional causality relationship and FDI inflows had unidirectional causality with domestic investment and GDP

Theoretical Framework and Model Specification

A model of total investment in the presence of FDI by MNEs

in the host country which is developed by Agosin and Mayer (2000) is used in this study.
The model is based on the following identity:

It = If,t + Id,t
Where,

(1)

It = Total investment in time period t Id,t = Domestic investment in time period t If,t = Investment by MNEs in host country in time period t

Continued
Domestic investment: An accelerator model of investment is as:

Id,t = + 1GDPGt

(2)

Where, GDPGt is GDP Growth Rate in time period t. And Investment by MNEs: If,t = f(FDIt) (3)

Continued
Total Investment: I = + 1GDPG + FDI (4) Here , FDI is used for FDI inflows by MNEs The more general form of total investment: I = + 1GDPG + 2FDI The econometric model of Total Investment: It = + 1GDPGt + 2FDIt + t (5)

(6)

Continued
There are three possible outcomes: (i) Crowding-in: if, (ii) Crowding-out: if, (iii) No Effect(Neutral Effect) if, 2<0 2>0

2=0

Hypothesis
The FDI inflows does not effect Total Investment The GDP Growth Rate does not effect Total Investment

There is no causal relationship between Total Investment

and FDI inflows

There is no causal relationship between Total Investment

and GDP Growth Rate

There is no causal relationship between FDI inflows and

GDP Growth Rate

Data and Methodology

Data description and sources
Variables Description LRGFCF Natural log of real gross fixed capital formation ($ million)

LRFDI

Natural log of real foreign direct investment inflows ($ million)

GDPG

Growth rate of GDP (%)

Sources of Data:
Online World Development Indicators (2011)

Online World Investment Report (UNCTAD,2011)

Methodology
1. Unit root test (ADF-test and PP-test) 2. Cointegration ( Bound test Approach) 3. Error Correction Model in ARDL(p,q,r) Framework 4. Diagnostic Tests and Stability Analysis 5. Granger Causality tests

The ARDL(p,q,r) Model

The General Form of Unrestricted ECM model in ARDL(p,q,r) formulation:

(7)

Here, is the first difference operator The coefficients of first part such as:i,i, and i, represent the short run dynamics The coefficients 1,2, and 3 represent the long run relationships between the variables And t is used for white noise error term in the model

The Bound Test for Cointegration

It is the most suitable technique for small samples
It is applicable whether the variables are I(0), I(1) or mixed There is no need for pre-testing for unit roots Only a single reduced form equation is used for long run

relationships
Different variables have different optimal lags

Continued
The bound test (F-test) is used to test the existence of long run relationship between the variables. Null Hypothesis: H0 :1=2=3=0

Alternative Hypothesis:
Ha :10 , or 2 0, or 3 0

Continued
There are three possible outcomes:
1.

If F-stat> upper bound (cointegration) If F-stat< lower bound (no cointgration) If F-stat lies between upper and lower bound (inconclusive)

2.

3.

The Long Run ARDL(p,q,r) Model

If cointegration found in the general form of unrestricted

ECM model in ARDL(p,q,r) formulation, then the following long-run ARDL(p,q,r) model will be estimated:
(8)

The ECM Model

The following ECM model in ARDL(p,q,r) formulation is

used to estimate short-run relationships between total investment, FDI and economic growth.

(9)

The Empirical Results

Descriptive Statistics:
Variable(s)
Maximum Minimum Mean Std. Deviation

LRGFCF
5.5798 4.7677 5.2763 .23810

LRFDI
3.8741 -.80829 1.7487 1.0412

GDPG
10.2157 1.0144 5.0974 2.1106

Skewness
Kurtosis - 3 Coef of

-.71770
-.75562 .045126

-.18917
.25636 .59538

.16247
-.38687 .41406

Variation

Correlation Matrix
LRGFCF LRFDI GDPG

LRGFCF

1.0000

.12066

.51243

LRFDI

.12066

1.000

-.12379

GDPG

.51243

-.12379

1.0000

Unit Root Tests

ADF-Test (intercept and no trend) PP-Test (intercept and no trend) Variable At level At 1stdifference Critical Values At level At 1stdifference

LRGFCF GDPG LRFDI

-2.43 -2.57 -1.34

-3.44** -5.67*** -2.85*

1% 5% 10%

-3.63 -2.59 -2.94 -4.30*** -2.61 -2.64*

-3.08** -11.04*** -7.7***

Note: (***) significant at 1% level (**) significant at 5% level (*) significant at 10% level

The Bound Test for Cointegration (F-test)

Dependent variable F-Statistics lag
F-critical value*

Conclusion

I(0)

I(1)

F(LRGFCF/LRFDI,GDPG)
F(LRFDI/LRGFCF,GDPG) F(GDPG/LRGFCF,LRFDI)

F(3,19)= 7.67 F(3,19)=1.82 F(3,19)=7.5

3.793

4.855

Cointegration

3.793

4.855

No Cointegration

3.793

4.855

Cointegration

Note:(*) The critical value bounds are taken from Table CI(iii) of Pesaran et al.(2001)

The Long-Run Results

ARDL(1,0,1) selected based on Schwarz Bayesian Criterion

Regressor

Coefficient Standard Error T-Ratio [Prob]

LRFDI GDPG C

0.037111 0.17081 4.3337

0.046303 0.031800* 0.21185*

.80148[.430] 5.3714[.000] 20.4570[.000]

Note: (*) Significant at 1% level

The ECM Results

Error Correction Representation for ARDL (1,0,1) selected based on Schwarz Bayesian Criterion

Regressor

Coefficient

Standard Error

T-Ratio [Prob] .81550[.421] 3.9695[.000] 4.2547[.000]

dLRFDI dGDPG dC ecm(-1)

012587 .026148 1.4699 -.33918

.015435 .0065873* .34548* .068235*

-4.9707[.000]

Note: (*) significant at 1% level

Diagnostic Tests
Test Statistics LM Version F Version

A:Serial Correlation B:Functional Form C:Normality D:Heteroscedasticity

CHSQ(1)= .43836[.508] CHSQ(1)= 1.9263[.165] CHSQ(2)= .62771[.731] CHSQ(1)= 1.9058[.167]

F( 1, 27)= .36349[.552] F( 1, 27)= 1.6738[.207] Not applicable F( 1, 31)= 1.9000[.178]

R2 =.90457 R-bar Squared=.89093 DW-statistic=1.9885

Durbin's h-statistic= .035971[.971]

Stability Tests
Cumulative Sum of Recursive Residuals

( CUSUM)

Cumulative Sum of Square of Recursive Residuals

(CUSUMSQ)

Continued
CUSUM(Cumulative Sum of Recursive Residuals)
Plot of Cumulative Sum of Recursive Residuals

15

10

-5

-10

-15 1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

20092009

The straight lines represent critical bounds at 5% significance level

Continued
Cumulative Sum of Square of Recursive Residuals(CUSUMSQ)

Plot of Cumulative Sum of Squares of Recursive Residuals

1.5

1.0

0.5

0.0

-0.5 1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

20092009

The straight lines represent critical bounds at 5% significance level

Granger Causality Test

Null hypothesis No of observations F-Statistic Probability

LRFDI does not Granger Cause LRGFCF LRGFCF does not Granger Cause LRFDI

36

3.49253 2.76752

0.02975 0.06186

GDPG does not Granger Cause LRGFCF LRGFCF does not Granger Cause GDPG

4.81224
36 0.23480

0.00852
0.87129

GDPG does not Granger Cause LRFDI LRFDI does not Granger Cause GDPG

36

0.93278 2.25115

0.43893 0.10614

Conclusion
The FDI inflows are statistically insignificant determinant

of total investment in the short-run as well as in the longrun during the study period 1974-2009. The GDPG is highly significant determinant of total investment for both short-run and long-run. The speed of adjustment (ECM coefficient) after disequilibrium is moderate which is about -0.339 Bidirectional Granger causality exists between LRFDI and LRGFCF (LRFDI LRGFCF) Unidirectional Granger causality between GDPG and LRGFCF (GDPG LRGFCF) No Granger causality between LRFDI and GDPG

Policy Implications
GDP growth rate has statistically significant positive effect

on total investment, therefore policy makers should adopt those measures which will help to improve GDP growth rate in Pakistan
The statistically insignificant effect of FDI inflows on total

investment may be due to small share of FDI inflows to Gross Fixed Capital Formation
Need to attract FDI inflows in real sector
Need to overcome those factors which are responsible for

low FDI inflows in Pakistan