The effects of foreign private investment on economic growth in Pakistan.
Shabbir, Tayyeb ; Mahmood, Azhar
1. INTRODUCTION
Studying the impact of foreign financial flows such as foreign
private investment and aid on economic growth or domestic savings of a
country has been a topic of considerable academic as well as practical
interest. In fact, considering the expected decline during the 1990s in
the supply of commercial flows particularly to the developing countries,
the question of the impact of foreign capital on economic growth and
other important macro variables such as saving and investment assumes a
renewed significance.
The various forms of foreign capital inflows are being increasingly
viewed as a potentially significant source of capital to supplement
domestic investment. According to the latest World Development Report,
in 1988, Direct Foreign Investment surpassed all other forms of lending
as a source of foreign capital to developing countries (1) [World Bank
(1991), p. 95].
In theoretical terms, there has been no consensus on the role of
foreign capital in promoting economic growth in developing countries.
[See Mosley (1980) for an historical review of the important literature
on this issue.] In short, whereas early writers such as Chenery and
Strout (1966) were able to show that foreign capital exerted a
favourable effect on growth, their results may be sensitive to the
assumption that foreign inflows fully augment resources available for
capital formation and that the incremental capital-output ratio is
independent of such inflows.
However, later work by the so-called "Displacement
Theorists" questioned both these assumptions. [For instance, see
Griffin (1970); Leff (1969) and Weisskopf (1972).] Foreign capital may
in fact substitute for domestic saving on two accounts: (a) foreign
capital inflows could lead to government becoming less enthusiastic
about its revenue generation efforts, the nation could increase its
consumption expenditure and/or liberalise imports and (b) to the extent
that saving is determined by available investment opportunities, by
crowding out domestic investment, foreign private investment could cause
domestic savings to fall. Besides, foreign capital may lead to
inefficiencies due to inappropriate technology and management styles.
Thus, it is conceivable that foreign capital could adversely affect
economic growth.
In terms of the existing empirical evidence, single equation
estimates of the saving equation have found a negative relationship
between foreign capital and domestic saving [Fry (1984); Griffin and
Enos (1970) and Weisskopf (1972)].
Similarly, single equation estimates of foreign capital's
effect on growth rate report favourable impact [Dowling and Hiemenz
(1983); Stoneman (1975) and Papanek (1973)].
Obviously, the above results become suspect if one believes that
saving and growth are embedded in a simultaneous system. There have been
few studies that specify saving and growth in the context of a system of
simultaneous equations [one exception is Gupta (1975)]. However, there
are no such studies for Pakistan. Additionally, in terms of the
literature on foreign private investment and/or other foreign capital
inflows, very rarely has the analysis been conducted so as to
concentrate on a single country; most studies tend to pool data across
countries and time to lessen the degrees of freedom constraint. However,
this procedure is valid only if certain restrictive assumptions on
temporal and/or spatial constancy of model structure are made. It is
perhaps most meaningful to bite the bullet and concentrate on time
series analysis of each country individually.
Taking our own advice, in this study, we specify and estimate a
two-equation simultaneous model of rate of real economic growth and
saving ratio using annual time series data on Pakistan for 1959-60 to
1987-88. Here we plan to explore the answers to the following two
propositions:
Proposition I = Net foreign private investment (FPI) promotes
economic growth as measured by annual rate of growth of real GNP.
Proposition II = FPI displaces savings of a country as measured by
its National saving to GNP ratio.
The rest of the paper is organised as follows:
Section 2 presents the specification for a simultaneous equation
model of economic growth and saving ratio. Section 3 describes the data
while the next section reports and discusses the empirical results.
Finally, Section 5 contains some concluding remarks and notes some
policy implications of our results.
2. MODEL SPECIFICATION
Consider the following simultaneous equation model of the rate of
growth of real GNP (GR) and the ratio of National Saving to GNP i.e. so
(Note: The time subscript is being omitted for convenience).
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] ... (1)
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] ... (2)
The above model specifies the relationships (2) amongst two
endogenous variables, GR and S, and four exogenous variables: DISB, FPI,
XM and RINT. (These variables have been defined in the next section).
The a priori expected signs of the parameters are noted below each of
the equations. In light of the controversy amongst economists, the signs
of FPI and DISB coefficients cannot be determined a priori and thus are
an empirical question. The XM variable in the GR equation is posited to
have a positive effect since it is often maintained that growth in
exports (or generally, 'openness of economy') can stimulate
economic growth [for instance, see Balassa (1978) and Tyler (1981)].
Again, the RINT or the real rate of interest variable is the standard
variable used in the specifications of the saving equation to represent
the 'reward for saving'.
3. DATA DESCRIPTION
In this paper we have used time series data for the period 1959-60
to 1987-88. The names of relevant variables and their definitions are
given below where the respective source of data is being noted in the
parentheses.
Variable's Name Definition (Source)
GR Annual growth rate of Gross National Product (GNP) at constant
market prices of 1959-60. (Source: Pakistan Economic Survey
1989-90).
S National Savings as a ratio of GNP. (Source: Pakistan Economic
Survey 1988-89, PIDE's Statistical Paper Series No.4, and
Annual Report, State Bank of Pakistan 1987-88).
FPI Net Foreign Private Investment into Pakistan as a ratio of GNP
where the former is the sum of cash brought in, capital
equipment brought in and reinvested earnings. (Source: Foreign
liabilities and Assets and Foreign Investment in Pakistan, (3)
State Bank of Pakistan, Statistic Department, Various issues).
DISB Total disbursements including Grants during a year as a ratio
of GNP. (Source: Pakistan Economic Survey, 1989-90).
XM Exports of goods and services as a ratio of GNP. (Source:
Pakistan Economic Survey, 1989-90).
RINT Real rate of interest, computed by subtracting growth rate
of consumer price index from the nominal interest rate on
twelve month time deposits. (Source: Pakistan Economic Surve,
1988-89, the PIDE Econometric Model of Pakistan's Economy
(1959-60 to 1978-79), Annual Report, State Bank of Pakistan,
1987-88.)
GPC GNP per capita. (Source: Pakistan Economic Survey, 1989-90).
REM Workers' Remittances as a ratio of GNP. (Source: Pakistan
Economic Survey, 1989-90).
4. EMPIRICAL RESULTS/DISCUSSION
The simultaneous equation model given by Equations (1) and (2) is
exactly identified (4) and is estimated by 2SLS. These estimates are
presented in Table 1 whose columns 2 and 4 contain estimates that
correspond exactly to Equations (1) and (2) which are for GR and S
respectively. The remaining two columns i.e. colunm 1 for the GR panel
and the column 3 for the S panel pertain to a specification which is
only a slight variation on the model in the text since here we exclude
the DISB or the disbursement variable. Incidentally, before we start
discussing the results one may be reminded that except for RINT, all the
variables in the model are ratios of GNP.
The results for the GR equation (columns 1 and 2) show that the
coefficient estimate of net foreign private investment (FPI), the
variable of central interest in this study, is positive and
statistically significant at 90 percent level for one-tailed t test for
25 degrees of freedom (column 1) and almost significant at the same
level in column 2. Further, the results show that the remaining three
variables i.e. disbursements of grants and external loans (DISB), saving
(S) and exports (XM) too have a positive impact on GR. However, with the
probable exception of the coefficient of S, the significance levels of
the coefficient estimates are not very high. In our view, this issue of
the lack of significance is related to the problem of insufficiently
long time series whenever we restrict ourselves to a single developing
country most of them having come into being only after the Second World
War. Lack of sufficiently long time series is also partly responsible
for the relatively low [R.sup.2] for the GR equation. However, this is a
common problem in studies of this kind. For instance, Mosley (1980)
laments that 'depending on the sample of LDCs which is chosen and
whether or not the independent variables are lagged, between 4 and 25
percent of growth in LDCs is explained by domestic savings and capital
flows from abroad. (5) [In this regard also see Rana and Dowling (1988)
and a recent study by Otani and Villanveva (1990).]
In terms of the saving equation, the evidence favours the
'Displacement Hypothesis'--that net inflow of foreign private
investment and even financial flows by way of disbursements of grants
and loans leads to a lessening of the country's saving ratio. (6)
Besides our main variables of interest, FPI and DISB, the other
variables which have been entered primarily as controls are RINT and GR.
While RINT, as a measure of the real interest rate, is positive and
significant at the 95 percent level, the coefficient estimate for GR is
positive but not significant. (7)
While these results are consistent with those obtained by Fry
(1984); Weisskopf (1973) and Griffin and Enos (1970) for saving and
Dowling and Hiemenz (1983), Stoneman (1975) and Papanek (1973) for
growth, unlike these single equation results which are susceptible to
simultaneity bias, ours are perhaps more robust since they have been
obtained using a simultaneous equation model.
5. CONCLUDING REMARKS
The main conclusions of this study and their relevant policy
implications are being noted below:
1. It is found that both net foreign private investment (FPI) and
disbursements of grants and external loans (DISB) has a positive impact
on the rate of growth of real GNP (GR) in Pakistan. (However, the
coefficient estimate of the DISB variable is not significant.)
2. In the saving equation, the coefficient estimates for both FPI
and DISB are negative lending support to the "Displacement
Hypothesis" i.e. foreign financial inflows may discourage domestic
public and/or private saving behaviour and resource mobilisation
efforts.
3. By specifying a simultaneous model of GR and S, we are able to
control for a possible simultaneity bias which many of the earlier
single equation studies of growth or saving were susceptical to.
What are the policy implications of the above results? First, on
the grounds of empirical evidence, foreign private investment should be
encouraged since it enhances country's rate of economic growth.
However, these foreign financial inflows tend to discourage the saving
ratio at home. Since we find that saving is positively affected by
marginal changes in real interest rate, an optimal policy may be to
encourage foreign investment for its favourable impact on growth and at
the same time rationalise the domestic credit structure and interest
rate policy to mitigate FPI's negative impact on saving and
resource mobilisation effort.
Comments on "The Effects of Foreign Private Investment on
Economic Growth in Pakistan"
I. FRAMEWORK OF ANALYSIS
The analytical framework adopted in the paper concentrates on
testing, through regression, two hypotheses about foreign private
investment (FPI): first, that it promotes economic growth; and second,
that it displaces savings. This was justified by the authors by
referring to the findings of some of the earlier studies which failed to
reach any consensus on the role of foreign capital.
In my opinion, the very basis on which the hypotheses were formed
is incorrect. Firstly, almost all the studies quoted in the paper are
those dealing with foreign capital inflows in the form of loans or
disbursements, rather than FPI. Secondly, the FPI, bulk of which is
usually in the form of direct foreign investment, is distinctly
different from loans in terms of its nature and impact. The loans foster
economic dependence through debt servicing liability, and have import
raising impact in general. The FPI, on the contrary, involves dividend
and has an export generating and technology transfer impact. Even the
attitude of the developing countries regarding the two is different:
dependency in the former case, and sharing of power in the latter.
It is strange that the authors treat FPI like foreign loans and
form hypotheses about FPI by generalising the findings in respect of
foreign loans. In fact, if one surveys the literature on FPI, one hardly
finds any evidence of disagreement on its role in economic growth. As an
example, three such references are quoted below:
(i) Pearson Report (1969). (1)
"In our judgement available facts do suggest that direct
foreign investment has added substantially to the real national income
of the developing countries" [p.104].
(ii) The classic study on foreign private investment by Reuber
(1973), (2) based on data for 109 countries, concludes; "The
results rather clearly indicate a positive association between the stock
of private direct investment per capita and GNP per capita" [p.
136].
(iii) More recently, Cynthia Day Wallace (1988) (3) concludes:
"... the evidence does appear to indicate a positive ratio between
direct (foreign) investment density and the economic development of the
host country".
In the light of such evidence, undertaking a study on FPI in terms
of simply testing the hypotheses through regression, as proposed by the
authors, neither has any utility nor contributes anything to the
literature on the topic. The appropriate framework for undertaking such
a study is the one based on micro analysis on the impact of FPI on
production, employment, exports and balance of payments, tax revenues,
and transfer of technology (see, for example, Reuber's (1973)
framework of analysis on the subject). (4) These are the issues which a
developing host country, like, Pakistan, would be interested to have
some knowledge about.
II. SURVEY OF RELEVANT LITERATURE
It is strange that none of the studies reviewed in the paper
specifically pertains to FPI. Almost all of them deal with foreign
capital inflows in general. There is much to be quoted on the subject
from the experience of the newly industrialised countries (NICs) in
South East Asia and Latin America who benefitted a great deal from
direct foreign investment. There is even no mention of the emerging NICs
in the Far East, namely, Malaysia, Indonesia, Thailand, and the
Philippines, who indicate a rich profile in terms of FPI. It may be
noted that in 1989, the FPI, compared to Pakistan's level of $177
million, was 4 times larger for Indonesia, 5 times for Philippines, 7
times for Thailand, and 10 times for Malaysia.
III. EMPIRICAL USEFULNESS
Even if the proposed hypotheses had to be tested through regression
at all, it has been done in a purely mechanical way, without looking at
the meaningfulness of the results. All the discussion about single vs.
simultaneous equation model, structural vs. reduced-form coefficients,
and two-way vs. one-way simultaneity proved to be interesting only from
an econometric point of view, as the results yielded by the model were
technically too weak to be of any use. All the coefficients of the
growth equation in Table 2 with which the authors compare the
reduced-form coefficients, are statistically insignificant. One also
wonders how the authors could justify their findings of FPI displacing
domestic savings, in the light of the empirical experience of the East
Asian Countries which have combined a rapid inflow of FPI with an
increase in savings rates.
In fact, the results could have been improved if the
misspecification of certain variables in the model had been avoided.
Some of such misspecifications are listed below:
--GNP which, in 'growth rate' form, is the dependent
variable in the growth equation, also appears in the 'level'
form on the right-hand side as a denominator of all explanatory
variables.
--The dependent 'growth' variable has been defined in
terms of percent change in GNP at market prices. It is clear that net
factor income from abroad and indirect tax (net) which from a part of
GNP, may cause this change to deviate from the true growth rate defined
in terms of production of goods and services in the economy, which is
captured by the GDP at factor cost. For example, for 1982-83, the growth
of GNP at market prices was 9.5 percent while that of GDP at factor cost
was 6.8 percent.
--Exports, except through its effect on savings, is more an outcome
rather than a cause of growth. Since savings are already explicitly
included in the growth equation, there is hardly any justification for
including exports. If the objective is to capture the openness of the
economy, the imports in the first instance, or imports plus exports as a
second alternative, is a more appropriate variable.
Shaukat Ali Niazi
Planning Commission, Islamabad.
(1) Laster B. Pearson et al. Patterns in Development: Report of the
Commission on International Development. 1969.
(2) Grant L. Reuber Private Foreign Investment in Development 1973.
(3) Cynthia Day Wallace, "Foreign Direct Investment. A New
Climate for Negotiations with the Third World", in Yochelson (ed.)
Keeping Pace: U.S. Policies and Global Economic Change, 1988.
(4) Grant L. Reuber (1973), op. cit
Authors' Note: We would like to acknowledge but not implicate Dr Nadeem A. Burney and Dr Ashfaque H. Khan for useful discussions with
regard to this paper. The present paper is an abridged version of the
paper presented at the conference which is available with the authors.
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(1) However, much of the DFI tends to concentrate only in a few
relatively better off countries. In the 1980s, fifteen countries
received 75 percent of the total DFI. Typically, very poor countries
like Pakistan manage to garner only a small share.
(2) While the GR equation could also be motivated using a more
formal two-sector model comprising export and non-export sectors, [as a
basis for such a specification see Feder (1983)] the S equation is the
fairly standard saving function.
(3) While this source gives FPI on a calendar year basis, we have
used a two year moving average to represent the fiscal year counterpart.
(4) While in the case of exactly identified equation the estimates
of the 2SLS and the Indirect Least Squares (ILS) are identical, the 2SLS
method also yields information on asympotatic standard errors which is
not available using ILS. [See Intriligator (1978), p. 385.]
(5) While a low [R.sup.2] may just be a symptom of the degrees of
freedom constraint, it could also be a 'measure of our
ignorance' about the determinants of rate of growth which is
affected by a myriad of factors such as climate, domestic political
conditions etc. which are typically not included in the specification.
(6) The argument is often presented in terms of the ratio of
Domestic Saving (DS) to Domestic Gross Product (GDP). However, the
variable used by us i.e. National Saving (NS)/Gross National Product
(GNP) amounts to the same thing because the Net Foreign Income, the term
which denotes difference between the DS and the NS, is present both in
the numerator as well as the denominator and is thus 'flushed'
out. In any event, even when considered without relation to any measure
of national output such as GDP or GNP, the national and the domestic
saving are very highly correlated.
(7) However, we suspect that if we had a relatively longer time
series, the positive coefficient of GR in the S equation would have been
significant. In any case, since there is a strong theoretical reason for
expecting GR to have a significant impact on S, the empirical estimate
is still an open question until the degrees of freedom issue is resolved
more satisfactorily.
Tayyeb Shabbir and Azhar Mahmood are respectively, Senior Research
Economist and Staff Economist at the Pakistan Institute of Development
Economics, Islamabad.
Table 1
2SLS Estimates of Growth and Saving Equations
(1959-60 - 1987-88; N = 29)
1 2 3 4
Dependent Variable GR GR S S
Constant 0.004 -0.01 -0.12 * -0.13 *
(0.10) (-0.27) (2.12) (2.94)
FPI 8.80 *** 7.89 -11.50 * -9.57 *
(1.48) (1.26) (-2.76) (-2.42)
GR 0.24 0.07
(0.24) (0.09)
DISB 0.15 -0.08
(0.54) (-0.52)
S 0.29 0.37
(1.19) (1.24)
XM 0.14 0.18
(0.58) (0.71)
RINT 0.003 * 0.003 *
(3.01) (3.17)
[R.sup.2] 0.12 0.13 0.65 0.69
D.W. 2.03 2.01 1.52 1.41
df 25 24 25 24
* Significant at 95 percent level for two-tailed t test
for the respective degrees of freedom (df).
** Significant at 90 percent level for two-tailed t test
or at 95 percent level for one-tailed t test for the
respective degrees of freedom (df).
*** Significant at 90 percent level for one-tailed t test
for the respective degrees of freedom.