ARTICLE ON FOREIGN DIRECT INVESTMENT Presented by Areeba Noman

Foreign direct investment (FDI) is recognized as a mechanism by which a host country can upgrade the competitiveness of its resources and capabilities. FDI has grown in importance in the global economy with FDI stocks now constituting 28 percent of global GDP. However, many mechanisms and dynamics of FDI-assisted development have changed to some extent. There is greater variation in the kinds of FDI, the benefits each offers, and the manner in which each interacts with the host economy. Although some economists remain skeptical of the existence of positive externalities associated with foreign direct investment (FDI), many countries spend large sums attracting foreign investors in the hope of benefiting from knowledge spillovers. The entry of multinationals affects domestic enterprises in the same industry or in upstream or downstream sectors through multiple channels. Some of these channels represent true knowledge spillovers while others have positive or negative effects on domestic producers in other ways. The relative magnitudes of these channels depend on host countrys conditions and the type of FDI inflows. Criticisms on FDI include that during their early stages of development, now-developed countries systematically discriminated against foreign investors. They have used a range of instruments to build up national industry, including: limits on ownership; performance requirements on exports, technology transfer or local procurement; insistence on joint ventures with local firms; and barriers to 'Brownfield investments' through mergers and acquisitions. Only when domestic industry has reached a certain level of sophistication, complexity, and competitiveness do the benefits of nondiscrimination and liberalization of foreign investment appear to outweigh the costs. This report attempts to highlight key benefits and constraints of Foreign Direct Investment on recipient economies. It focuses particularly on Pakistans economy and elucidates the key economic and non economic determinants that encourage and impede the flow of Foreign Direct Investments in Pakistan. It further describes the current state of Foreign Direct Investments in the country and proposes some policy measures for ensuring more conducive investing environment in the country.

ADVANTAGES OF FOREIGN DIRECT INVESTMENT:

1. ECONOMIC DEVELOPMENT: Foreign direct investment plays a pivotal role in the economic growth of the host country. The monetary inflows due to FDI stimulate growth and allow host countries to expand their long run aggregate demand and supply. Foreign inflows can further be used for financing current account deficits as finance flows in form of FDI do not generate repayment of principal and interests (as opposed to external debt). A remarkable inflow of FDI in various industrial units in Pakistan has boosted the economic life of country. In fact, in the 1990s FDI was one of the major external sources

of financing for the developing countries. FDI has also helped several countries in declining economic conditions. During the financial problems of 1997-98 in the Asian countries that the inflow of foreign direct investment remained considerably steady while other forms of cash inflows like debt flows and portfolio equity had suffered major setbacks. Similar observations have been made in Latin America in the 1980s and in Mexico in 1994-95. 2. TRANSFER OF TECHNOLOGIES: Another significant impact of FDI is the transfer of technology into countries via capital inputs. FDI inflows are important in this regard as technology transfers assist in the promotion of the competition within the local input market of a country. This cannot be accomplished only through investments in financial resources or trade in goods and services. 3. HUMAN CAPITAL: FDI provides a number of employment opportunities by aiding the setting up of various industrial units. Host countries can also develop the human capital resources by getting their employees to receive training on the operations of a particular business. 4. JOB OPPORTUNITY: Foreign direct investment helps in the creation of new jobs in a particular country. It also helps in increasing the salaries of the workers. This improves the living standard in the country. It has normally been observed that foreign direct investment allows for the development of the manufacturing sector of the recipient country. While the inflow of advanced technology and skill set in a country has already been discussed, FDI is also observed to allow for increased research activities to be undertaken. 5. EXPORT AND IMPORT: FDI also increases export opportunities for countries and allow them to cash in on their superior technological resources. Products of superior quality are manufactured by various industries due to greater amount of FDI inflows in the country. 6. LINKAGES AND SPILLOVER TO DOMESTIC FIRMS:

Various foreign firms occupy a position in the local market through Joint Ventures and collaboration concerns. The profits gained by these foreign firms boost the local economy as well. 7. INCOME GENERATION:

Foreign direct investment assists in increasing the income that is generated through revenues realized through taxation and plays a crucial role in the context of rise in the productivity of the host countries. It has also been observed that the recipient countries are able to keep their rates of interest at a lower level so that it becomes easier for the business entities to borrow finance at lesser rates of interest. The biggest beneficiaries of these facilities are the small and medium-sized business enterprises. It also creates lucrative opportunities for the investing countries as they are able to explore new markets and have prospects of higher income and profits. Procurement of

properties, buildings, and labor can be obtained at a fraction of the cost in host countries than would be the case within the company's home country. The advantages of foreign direct investment to the investor includes access to a larger market in the host country, ability to tap the potential of a cheap and skilled labor, making use of resources in the host country and pursuing growth goals by diversification and optimizing costs.

DISADVANTAGES OF FOREIGN DIRECT INVESTMENT:

Despite being integral for an effective international economic system, the benefits of FDI do not accrue automatically and evenly across countries, sectors and local communities. The state of FDI and its impact on a country are significantly dependent upon national policies and overall international investment scenario. In order to reap the full benefits of FDI for development by of developing countries, the local investment architecture should be feasible. The host country needs to establish a transparent, broad and effective policy environment for investment and to build the human and institutional capacities to implement them. FDI forms a major part of investment in most countries. It may be directed towards employing relatively cheap labor, or to produce goods near to markets, particularly if trade barriers hinder exports. FDI may involve additions to a country's capital, but is sometimes locally financed, so that what is imported is techniques and management skills. FDI is often criticized in both home and host countries particularly because multinational location improves the bargaining power of businesses in dealing with both government and trades unions. Moreover, in home countries trade unions criticize FDI as exporting jobs; in host countries there are complaints that it is hard for local firms to compete with the knowledge and financial resources of multinational companies. Problems also arise due to competition over scarce resources and limited skilled manpower, strategic motives by the affiliates of Multinational Corporations (MNCs) or the high technological gap between local and foreign firms. There are also other costs associated with inflow of FDI such as restrictive business practices by foreign firms, profit repatriation and forgone tax in the case of tax holidays.

CHANGING TRENDS IN FOREIGN DIRECT INVESTMENT:

Traditionally, it had been observed that a majority of foreign direct investment is made in the form of fixtures, machinery, equipment and buildings. This was accomplished primarily through mergers & acquisitions. Within the past decade, however, the foreign investment patterns have changed significantly. This can be attributed to the dramatic increase in the access to technology and internet. Majority of the technology based companies that were setup during this period had small operations with their primary product being intellectual property rights such as a software program. These companies had grown out of research & development projects often affiliated with major universities or government sponsorship they did not require huge capital investments. A high tech venture tends to require significant development time. In the case of software and other intellectual property type products, the product is constantly changing even before it hits the marketplace. This makes the investment decision more complicated. When you invest in fixtures and machinery, you know what the real and book value of your investment will be. When you invest in a

high tech venture, there is always an element of uncertainty. While large, mostly foreign, companies still dominate the investment market, the risk associated with such high tech ventures acts as a deterrent for outright acquisition of smaller companies by the dominant giants. The manufacturer usually wants to get closer to its foreign market or wants to circumvent some trade barrier by making a direct foreign investment. The major risk here is that you do not sell enough of the product that you manufactured. However, you have added additional capacity and in the case of multinational corporations this capacity can be used in a variety of ways. Hence efforts are now towards rather unconventional routes of attracting FDI including Licensing and Technology Transfer, Reciprocal Distribution Agreement, Joint venture and other hybrid strategic alliances and Portfolio Investment. For most of the latter part of the 20th century when FDI became an issue, a companys portfolio investments were not considered a direct investment if the amount of stock and/or capital was not enough to garner a significant voting interest amongst shareholders or owners. However, two or three companies with "soft" investments in another company could find some mutual interests and use their shareholder power effectively for management control. This is another form of strategic alliance, sometimes called "shadow alliances". So, while most company portfolio investments do not strictly qualify as a direct foreign investment, there are instances within a certain context that they are in fact a real direct investment.

FOREIGN DIRECT INVESTMENT TRENDS IN PAKISTAN:

Pakistan is a key determinant of the viability of the growth and development projects in South Asia and is considered very important strategically due to its impact on the entire Asian region. Pakistan was among the first few countries in the region to open up its market in early nineties when Pakistan was able to attract considerable foreign investment after it initiated the process of privatization. Investors can now invest in a majority of Pakistani industries. Initially, foreign investment was particularly encouraged in industrial projects involving advanced technology and heavy capital outlay like engineering, basic chemicals, petrochemicals, electronics, and other capital goods industries. In last five years foreign investment came in large volume, both as FDI and as portfolio funds, and the increasing trend is predicted to be maintained in the following periods. It is to be noted that this trend was observed despite the issues pertaining to law and order situation and terrorism. According to one statistic, seventy-four per cent of the foreign investors already operating in Pakistan are interested in going ahead with new investments over the next two years. This interest in Pakistan can be primarily accredited to the vast, untapped natural resources that foreign companies are keen toexploit. The FDI trend over the past six years shows an increase in FDI by more than 900%. This is a clear indication of the success of the proactive approach of the government. The Government of Pakistan has strived to provide attractive environment to foreign investors by employing incentives and policies like the deregulation policy. In Pakistan foreign investors are permitted to hold 100% of the equity in not only industrial projects but also in the service, infrastructure and social sectors (subject

to certain conditions) on re-partible basis. Government sanction is not required for setting up an industry in terms of field of activity, location and size except in case of four sectors relating to national security. Pakistan has concluded agreements with 51 countries, including nearly all the developed economies, to avoid double taxation on income earned by foreign investors. It has also enacted an extensive set of investment incentives including credit facilities, fiscal incentives, and visa policy. Special industrial zones (SIZs) have been set up to attract foreign investment in exportoriented industries where the government ensures necessary infrastructure and utility services in the SIZs. Pakistanis working abroad are also eligible to invest in SIZs apart from foreign investors.

CURRENT TRENDS:
Foreign Investment Inflows in Pakistan ($ Million)

Year 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 Jul-Feb-10 Total

Greenfield Investment 357 622 750 1,161 1,981 4,873.20 5,019.60 3,719.90 1,319.30 19,803.00

Privatization Proceeds 128 176 199 363 1,540 266 133.2 2,805.20

Total FDI 485 798 949 1,524.00 3,521.00 5,139.60 5,152.80 3,179.90 1,319.30 22,068.60

Private Portfolio Investment -10 22 -28 153 351 1,820 19.3 -510.3 343.5 2,160.50