Jul 27, 2009

Political stability and FDI

The decline in foreign investment, particularly in foreign direct investment inflows and overcoming the balance of payment, is a cause of concern

By Hussain H. Zaidi
At a time when the country is in desperate need of external capital inflows to meet the current account deficit, foreign investment has come down from $5.44 billion in FY08 to $2.68 billion in FY09 by 51 percent. Foreign direct investment (FDI) has decreased from $5.40 billion to $3.72 billion, while portfolio investment (investment in the stock market) has fallen from $40.1 million to $1.05 billion during this period showing substantial capital flight.
The decline in foreign investment, particularly in FDI inflows, which are an important source of job creation and overcoming the balance of payment (BoP) problem, is a cause of concern. However, considering the country's politico-economic environment as well as global recession, the fall in foreign investment is not surprising.
The decision to invest in a foreign country, like other business decisions, is based on cost and benefit analysis. If perceived benefits outweigh perceived costs, foreign investment will be made. As a principle, foreign investment is made in those countries where risks are low and returns are high. However, speaking in specific terms, there are many factors in the host country, which restrict or promote foreign investment. These factors can be categorized into political, economic and regulatory. Of the two types of foreign investment -- FDI and portfolio -- the latter is far more volatile, as unlike the former it does not involve a long-term commitment. That is why a drastic surge or decline in the level of foreign portfolio investment is usually seen in response to slight changes in the host country's political or economic environment. Hence, cost and benefit analysis in case of portfolio investment is based mainly on short-term considerations, while in case of FDI; it tends to be based on long-term projections. Not surprisingly, during FY09 portfolio investment fell by 2,730 percent mainly as political instability escalated and the economic situation worsened.
Let's discuss the factors that promote or inhibit foreign investment, particularly FDI, with reference to the present situation in Pakistan.
We begin with the regulatory factors. Over past one and half decade, Pakistan has opened its economy through privatisation and deregulation and presently it has a very liberal FDI regulatory regime. One, there is freedom to bring, hold and take out foreign currency from Pakistan in any form. Two, fiscal incentives provided by the government cannot be altered to the disadvantage of the investor. Three, the privatisation of an enterprise is fully protected. Four, no foreign enterprise can be taken over by the government. Five, original foreign investment as well as profits earned on it can be repatriated to the country of origin. Six, equal treatment is provided to a foreign investor and local investor in terms of import and export of goods. Seven, FDI is not subject to taxes in addition to those levied on domestic investment. Eight, foreign currency accounts are fully protected and they cannot be freezed (courtesy the Foreign Currency Accounts Ordinance 2001).
Though Pakistan's regulatory regime is as much investment friendly as that of any other country in the region, the problem lies with the political and economic environment. The political environment includes political stability, law and order situation, government policies, political image of the country, continuity of policies, and clean administration. The political factors strengthen as well as emaciate the economy. Political stability and rule of law make for transparency, predictability and continuity of economic policies, build up investors' confidence, promote efficient resource allocation and increase output. Conversely, political turmoil increases the cost of doing business, precipitates erratic policy changes, makes investors sceptical and reduces the level of output. Hence, a country characterized by political instability, bad law and order, poor governance, adhocism of policies, a negative political image, and corruption in high places does not have a good potential for foreign investment, because these factors increase the risk of doing business.
Coming to Pakistan, after a period of relative political stability for five years -- during which FDI inflows registered a drastic increase though the bulk of those were restricted to the telecommunication and financial sub-sectors -- the country drifted into political instability in March 2007 when the Chief Justice of Pakistan was suspended by the then President. Since then the country has passed through political upheavals one after the other. The revival of democracy has done little to stabilise the political system; instead the political confrontation has weakened it and, what is worse, the worst is yet to be. However, it is the bad law and order situation created mainly be the wave of suicide terrorism coupled with the resurgence of ethnic violence in Karachi, the country's business capital, that more than any other factor has increased the risk of doing business in Pakistan as well as impaired the national image.
The security measures taken by the government have increased the cost of doing business. The anti-terrorism campaign has caused allocative inefficiency as increasingly resources have been diverted to security matters at the expense of economic development. Political uncertainty breeds speculation and results in capital flight. The country's credit rating goes down, which reduces its attractiveness as an investment market.
From politics we turn to the economy. The economic factors, which promote investment, include the size and growth of the economy, price and productivity of labour and other inputs, physical and commercial infrastructure, market-oriented policies like a floating exchange rate, the level of demand and proximity to other markets.
Take the relationship between economic growth and FDI, which goes both ways. Rapid economic growth attracts FDI, and increased FDI inflows in turn contribute to economic growth. In case of Pakistan where domestic savings fall well below the desired level of investment, foreign capital has played a cardinal role in economic growth. It was in FY03 that the economic growth got momentum when the real gross domestic product (GDP) grew by 5.10 percent compared with 3.6 percent in the preceding year. The same year (FY03) FDI inflows jumped to $798 million from $485 million during the previous year. Thenceforth, healthy GDP growth was accompanied by increased FDI inflows. This relationship continued until FY08, when GDP grew by 5.8 percent and FDI was registered at $5.15 billion. In FY09, economic growth shrank to 2 percent and FDI decreased by 31 percent.
Workers are widely regarded as the principal asset of a firm and the capital source of its competitive advantage. That is why there is so much emphasis in developed countries on human resource development. In Pakistan however development of human capital has been given a short shrift, which is responsible for low worker productivity. While making investment decisions, MNCs take into account both worker productivity and wages. In Pakistan wages are low but productivity is also low.
Infrastructure, including rail, road and telecommunication network, and price and availability of utilities also attract or inhibit FDI. Cost of water and power for business consumers in Pakistan is higher than those in other neighbouring countries like India and China. Infrastructure is also not up to the mark. Poor infrastructure and high cost of utilities increase the cost of doing business and make a country a less attractive market for FDI. The electricity shortage, which assumed dangerous proportions during last couple of years, has also been responsible for the decline in FDI inflows by pushing up the cost of doing business.
Finally, global recession has also contributed to the fall in foreign investment. For last more than a year, the world's leading economies, the major source of FDI in Pakistan, are in recession resulting in capital crunch and reduced investment outflows. The United Nations Conference on Trade and Development (UNCTAD) reports that global FDI inflows decreased by 21 percent during 2008. In case of Pakistan during FY09, FDI inflows from European Union countries went down by 38 percent, from the USA by 31 percent, from Japan by 43 percent, and from Norway by 63 percent.

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