Human Capital and Foreign Direct Investment: Lessons for Pakistan

Foreign direct investment plays a key role in economic development of all countries. Because of its enormous importance, a large number of empirical studies has focused on finding out the factors determining foreign direct investment. Level of human capital development is one of the major factors influencing foreign inflows. However, earlier studies examining impact of human capital on foreign investment inflows has majorly used literacy rate, school enrolment and government spending on education as its proxies. This paper also examines the impact of human capital as determinant of foreign direct investment. Contrary to earlier empirical studies, it uses cognitive skills as proxy for human capital. Cognitive skills measure the quality of education instead of literacy rate or government spending on education as proxy for human capital. Results indicate that human capital has significant positive effect on foreign direct investment for sample countries. This result is robust to disaggregated data for developed and developing countries. Other factors that determine foreign direct investment inflows are inflation, capital account openness, trade account openness and real income. Based on empirical results, it is recommended that the relevant authorities must make human capital as part and parcel of strategies aimed at augmenting economic growth in the country. There is also a lesson for a developing country like Pakistan to focus more on quality of education instead of school enrolment or education spending for attracting foreign direct investment to boost economic activity (J.E.L Classification Codes: O4, O15, P22).

Determinants of Foreign Direct Investment Fdi and Policy Analysis. an Econometric Analysis. a Case Study of Pakistan

The rapid growth of literature on foreign direct investment is testimony to the increasing importance of the phenomenon as both a reality in daily life and a topic of inquiry within the academia. The debate over the advantages and disadvantages of foreign resources has occupied the attention of both scholars and policy makers. The literature on foreign direct investment (FDI) and development reveals more than its fair share of controversy, large part of this literature is unedifying and unscientific. Attitudes towards foreign direct investment have changed significantly since the early 1980s because of decreasing flows of other types of foreign capital, such as bank loans and foreign aid, and the increasing globalization of the world economy. Consequently, FDI has become increasingly the source of capital for developing and transition economies. Many countries are liberalizing their economies and implementing policy changes to participate more fully in the internationalization of production. The objective of this study is to understand the magnitude, direction, and rate of change, characteristics, impact and determinants of Foreign Direct Investment (FDI) in Pakistan’s economy and to quantify the key FDI determinants in dynamic econometric model from 1971-2003. We have tried to find out the relationship among the set of variables in context with macroeconomic variables and policy instruments. Our study also measured the causality direction among the set of key variables. Furthermore, we have measured the impact of policy changes in various structural periods i.e., 1979 Afghan war, 1988 structural adjustment program (SAP), and 1998 nuclear tests. This enabled us to know whether the liberalization policies significantly attract the large level of FDI inflows. We have reviewed the investment policies over the period 1971-2003 and their potential implications and trends on FDI. We have hypothesized that the degree of attraction of cost-related, investment environment, development strategy factors with ownership and internalization factors and other factors i.e. political risk, business conditions, historical trend of investment, impact of various investment policies on FDI, the relationship of domestic and foreign direct investment, as well as macro economic variables more likely to affect the FDI both qualitative as well as quantitative terms. The aim of this study is to understand, whether and at what extent the FDI reacts to some development characteristics of the country. Following hypothesis been tested i.e., (1) The high degree of attraction of cost related factors, the better investment environment factors, development strategy factors with ownership and internalization factors, more it will attract FDI. (2) The more stable socio political, economic conditions, the more likely that investment will take place. (3) The instable political scenario results in low investment. (4) The higher international transactions, increases in the inflows of FDI. (5) The more viable the development strategy and policies the more of FDI. (6) The more open the economy, more likely, the better chances of investment will take place. (07) The more liberal the economy is, the higher will be the inflows of FDI. (8) The higher the output growth, the more likely the investment will take place. (9) The availability of skilled work force both technical and managerial will induce FDI. (10) The high and good level of quality of infrastructure paves ways to the desired FDI inflows. This study has used the Co integration, VAR, and VEC methodologies, the Co- integration, VAR (Vector Auto Regressive), and VEC (Vector Error Correction) methodologies. VAR model developed by Sims (1980, 1982, and 1986), Doan Litterman and Sims (1984) and Litterman (1984) used these techniques. The ‘model’ framework of VAR and VECs methodologies models is well documented and there is little need to say much about them. The Causality has been determined on the basis of one-way causality or either direction techniques suggested by Engle and Granger (1987). To employ the VAR in orthodox format, or in the form of VEC, this is Johansen (1995) VAR incorporating (potential) error correction terms, consequent upon the potential Co integration vectors. These techniques accompanied with the impulse response functions and the Variance decomposition functions. The dummy Variables of structural periods the economic liberalization period (1988) used to testify the structural changes and the significant effect of these periods on key variables. The necessary model checking and identification procedure have been applied for the suitability of the model, optimal lag lengths based on criterion used by the FPE (Final Prediction Error), AIC (Akakai’s information Criterion) and SC (Schwartz Criterion). For policy analysis, a model has been nested based on 3SLS to capture the relationship between FDI and its determinants. A system of equations based on the relationship used to adjust the monetary policy variables, trade related policy and fiscal policy variables. Our results suggest the cost-related, macroeconomic factors and cumulative country risk index variables are the major determinants emerged in short-run analysis. The results also suggest long run relationship among FDI, Openness and macroeconomic factors consistently. Openness emerges as dominant factor in long run dynamics. Evidence suggests that determinant variables that exhibit short run dynamics may also exhibit long run dynamics vice versa. The country requires to maintain macroeconomic stability and continuity in openness policies of reform process of the last 20 years, along with maintaining cost advantage by controlling the level of prices, wage rate, cost of doing business and investment friendly environment. This implies continuity of sustained stable macro economic policies, improvement in country’s risk profile followed by cost related