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«THE DETERMINANTS OF FOREIGN INVESTMENT IN PAKISTAN: A GRAVITY MODEL ANALYSIS Syed Waqar Azeem1, Haroon Hussain2, Rana Yasir Hussain3 1) Independent ...»

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LogForum 2012, 8 (2), 81-97

Scientific Journal of Logistics

http://www.logforum.net e-ISSN 1734-459X

p-ISSN 1895-2038



Syed Waqar Azeem1, Haroon Hussain2, Rana Yasir Hussain3


Independent Researcher, 2)Department of Commerce, University of Sargodha, Pakistan, 3) University of Education, Lahore ABSTRACT. Background: During the last two decades Pakistan was one of the most attractive countries that received Foreign Direct Investment (FDI) among developing economies, and especially in first half of the last decade the growth was so rapid and sustainable in different industries as well as in agriculture. In Pakistani economy the role of Foreign Direct Investment is very important. Policies are clear about the foreign investment even then adjustments are made according to the time, objective, needs and economic circumstances in the country.

Methods: The present study aims to investigate the determinants of foreign investment in Pakistan by using Gravity model.

By using panel data of FDI which is used as dependent variable and Gross domestic product, Gross domestic product per capita, Gross domestic product growth rate, Inflation rate, Trade, Total government expenditure, Population growth and Distance used as independent variable from 1999 to 2009 for empirical consequences, the study encompasses the examination of Foreign Direct Investment inflows from different countries and their geographical distance from Pakistan.

Results: Two type of test is used (1) fixed and (2) random effect to check the relationship among foreign direct investment and independent variables. In our both models distance shows a negative impact on the decision to make an investment by investing partner while GDP and GDP growth have a positive and significant impact. Gravity in this regards does not effect that much for foreign direct investment attraction because results are negatively significant in this case that shows higher distance is a hurdle for the inflow of foreign investment but rest of the variables are significantly positive and related to the inflow of foreign investment except population growth which is negatively correlated.

Conclusion: This research concludes that there is a strong evidence of existence of gravity between Pakistan and its investing partners. It is also conclude that those countries have less distance from Pakistan, having more investment in Pakistan, therefore, attracting these countries for investment in Pakistan would cause a greater chance of economic growth in Pakistan.

Key words: gravity model, foreign investments, Pakistan.


World is transformed into global village and the developing countries and developing countries also try to be part of this transformation. To overcome the scarcity of technology and capital therefore they always try to attract foreign investment inflow in their economy. Both the investor and the investee are having mutual benefit of foreign investment. The local market provides the facility of withdrawing the skill resources within the host country. This provides the employment opportunities to the local ones and this act of foreign direct investment (FDI) helped its contribution in the economic growth as compared to the local investment in the country. It is also said that external financing is one of the major sources of the foreign direct investment that contributes along with the savings of the host country. As foreign direct investment accompanies the technical know how, so this also help the host country to be more innovative in research and development (R&D) sector which also leads towards self dependency, higher GDP and at the end contribute in the expansion of exports, more employment and higher tax revenue for government [Mirza 2004]. In 1990s the global foreign direct investment grows significantly which shows rise of about 54000 transnational corporations. These corporation as Copyright: Wyższa Szkoła Logistyki, Poznań, Polska Citation: Sev Azeem S.W., Hussain H., 2012, The determinants of foreign investment in Pakistan: A Gravity Model Analysis.

LogForum 8 (2), 81-97 URL: http://www.logforum.net/vol8/issue2/no1 Accepted: 06.03.2012, on-line: 5.04.2012.

Azeem S.W., Hussain H., 2012, The determinants of foreign investment in Pakistan: A Gravity Model Analysis.

LogForum LogForum 8 (2), 81-97.

URL: http://www.logforum.net/vol8/issue2/no1 recorded were responsible of global inflows to developing countries of almost average of 13% of total inflows from 1990-1997 [Carson C. S. 2003]. Over inflow of 70% and outflow of 94% is accounted by the developed countries of the world [International Monetary Fund 2003]. In the last couple of decades the trend of Regional Trading Agreements (RTAs) and Bilateral Trade Agreements (BTAs) have grown remarkably. A large number of World Trade Organization (WTO) Countries are the members of Regional Trading Agreements. World Trade Organization notified total 312 Regional Trading Agreements out of 170 are in position in 2005, whereas remaining are in operation [Rahman, Shadat & Das 2006].

Pakistan started to facilitate foreign investor and for this market based economic reorganizational policies are introduced in early 1980 and in late 1980s. At the same time government has also taken the start towards the liberalization of trade and investment attraction, like offering the generous fiscal and trade incentives to the upcoming investors like provision of credit facility, tax and tariff concessions as well as relaxing the control over foreign exchange [Khan & Kim 1999]. In start political stability, peaceful law and order situation, level of technical labor force and mineral resources and liberal policies of the government became main forces to attract foreign investors in Pakistan [Aqeel & Nishat 2005]. But later political instability rumors and inconsistent policies, electricity shortage and then law and order situation affect the inflow of foreign investment in Pakistan. These are the main contributors of very low foreign investment in last couple of years. The economic policies of Pakistan shows heavy reliance on foreign investment, this decade brought significant amount of 22881 million dollars of FDI in Pakistan. The specific objectives of this research include;

evaluation of the foreign investment in Pakistan, to evaluate the determinants of foreign investment inflows into Pakistan using Gravity Model and to the improvement of investment climate in Pakistan for the attraction of FDI, policy recommendation are provided to the makers of policy.

As this is one of the main concerns of government to increase foreign direct investment inflow in country. Panel estimation with the help of gravity model is done to see the inflow of foreign direct investment from different countries and see the impact of different determinants on the policies to make investment in Pakistan. This study targets GDP growth, GDP p/c, Inflation and the distance as main factor which may influence the decision of investing partner to invest and see what should be done to increase the trend of FDI inflow in Pakistan, as Pakistan was an emerging market for foreign investment, therefore an empirical solution is needed to find out the rational of liberalization and deregulation and its impact on FDI, this study tries to provide the answer to all these problems.


Foreign investment plays an important role in the development of the any country, foreign investment not only provide the capital necessary for the growth but also helps out by providing job opportunities to the people of host countries. Foreign direct invest and foreign portfolio investment are the two kinds of foreign investment, where direct investment relates investment of a country or MNEs multinational enterprises in a particular field while portfolio investment focuses to invest in different fields. From home to host country attraction of foreign investment heavily rely on some incentives and factors that could include tax exemptions, market size, demand of investment in particular investing area, expectation of return, political environment etc. According to Razin and Loungani [2001] foreign direct investment faces a threat of being reversed to home country through financial transaction and benefits are limited by leverage. They also point out that FDI excess in total country's capital reflects weakness rather strength. Habib and Zurawick [2002] study examine the impact of corruption on foreign direct investment (FDI), panel data of 89 countries including developed and developing countries is used. Two models are used OLS regression and PROBIT. The result provides support for the negative impacts of corruption and foreign direct investment (FDI). The findings leads that the foreign investors usually stay away from corruption because it is taken as a wrong and it guide towards the operational inefficiencies. FDI helps out the countries that are very much behind in innovation and technology because of FDI the investing countries shift somehow the technology for the operation purposes in host countries. The shifting of that technology gives the opportunities to the Azeem S.W., Hussain H., 2012, The determinants of foreign investment in Pakistan: A Gravity Model Analysis.

LogForum LogForum 8 (2), 81-97.

URL: http://www.logforum.net/vol8/issue2/no1 host countries to excel in the innovation and technology field. Hejazi and Pauly [2003] study keep focus on the changing pattern of foreign direct investment (FDI) and its impact on the domestic gross fixed capital formation (GFCF), they regress the data of 15 available Canadian industries over the period from 1984 to 1995. They find that the increase in inflow of foreign direct investment (FDI) contributes to domestic capital formation, on the other case increased outward flow of FDI reduces it, and this generalization is inappropriate. They find that rapid growth in outward FDI, relative to inward growth, should not be considered as a negative development, and may reflect success. Empirical identification of determinants of growth in foreign direct investment in Pakistan from 1961 to 2003 by using different variables like GDP, Wages, Tariff and Exchange rate and also indicators that reflects trade, fiscal and liberalization in financial sector that helps in the attraction of FDI in Pakistan [Aqeel and Nishat 2005]. They use co-integration and error correction techniques, results indicates that the share price index and wage rate are insignificants for the attraction of FDI while others are, besides the policy of attraction of FDI on both long and short run in Pakistan. The base of gravity model is linkage and interaction of different countries across border. This model has indirect relationship between the destination and base. Ratnayake and Townsend [1999] applied the Gravity Model to analyzing the geographical pattern of international trade. The researcher had worn the concept of the Gravity Model from Anderson [1979] and Bergstrand [1985] to convey the function of variables representing the supply and demand conditions of exporters and importers and trade resisting and promoting factors.

The findings of the researchers showed that distance and exporter and importer incomes are highly significant in all year's estimated (1987-1992). The coefficient for the exporter population is also highly significant. However, the coefficient for the importer population is major in only three out of six years. The dummy variable is positive in all years as expected, but it is considerably different from the relationship among group members. The Gravity Model can estimate the cause of international trade on international debt [Rose and Spiegel, 2004]. Rose and Spiegel estimated a wealth of potential variables. Their study showed a significantly positive effect of bilateral trade on bilateral lending patterns, debtors tended to borrow more from creditors with whom they shared more international trade ties. Africano and Magalhães [2005] study the relationship between FDI stock and geographical prototype of flow of trade in Portuguese economy. The gravity model applied to trade between Portugal and organization of economic cooperation and development countries including Brazil of two year from 1998-2000. The attraction of inflow of FDI is positively associated with the trade and closely linked between two countries. Due to increase inflow of FDI reflects its strength in the shape of increasing the export as compared import and this helps the country to maintain a good trade balance. Outflow of FDI has no significant impact on exports and imports of Portugal. They also find out that FDI helps to maintain above normal exports to other countries and EU while below normal imports from the candidates countries.


Foreign investment flows from home to host country which have several reason of flowing like low labor cost, low material, tax exemptions, market size and possibility of growth etc. one of the basic aim of every investor is to maximize the profit so that’s why keeping in view of highest return the foreign investment travels from home to host country. The investing firms and countries keep a close look on the abundance of the resources the host one have and lack of competition because of lower quality of production. Electric paradigm is theory of economics that analytically views all the researches and studies of foreign direct investment and international production. Internationalization theory is the base of Electric paradigm which includes specific factors by location of different countries from the determination of foreign investment. Internationalization theory itself base on transaction cost theory and according to that theory internationalization is when transaction cost in free market is higher than within institution [Dunning 1980]. Resource-Based Theory, Grant [1980] states that competitive advantage can be gained by the business according to their market share by keeping in view of two things where and how to compete. The competitive advantage can be defined as the advantage that a firm have in particular field over its competitors. Internal and external forces help Azeem S.W., Hussain H., 2012, The determinants of foreign investment in Pakistan: A Gravity Model Analysis.

LogForum LogForum 8 (2), 81-97.

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