Foreign investments come to Pakistan in two forms: direct investments (FDI) and portfolio investments (FPI). Direct investments are so called because the foreign investor is actively involved in the management of the domestic concern.
These are what the preceding graph shows. Portfolio investments, on the other hand, are passive: the foreign investor holds a business’s securities without involving itself in the management.
Since direct investors are more deeply involved in the domestic economy, most academics reason that direct investments should be less volatile than portfolio investments. Surprisingly, if one examines the data from the last decade, the reverse is true in Pakistan. It appears that direct investment has plummeted faster than portfolio investment. Why should this be? And why should we care?
To answer the second question first, FDI is associated with better run businesses. Most multinational corporations (MNCs) in Pakistan are foreign direct investments. Our home-grown multinationals, such as Descon and Engro, are equally outstanding businesses. However, they are vastly outnumbered by foreign MNCs, and so the latter have larger spillover effects on the economy.
These spillover effects are the main reason that governments prefer direct investments to portfolio investments. Four positive externalities of FDI are knowledge transfer, competition, privatisation, and deregulation. First, with a direct investment, the foreign investor brings expertise that its employees can later adapt to any local ventures that they join.
Second, foreign businesses provide healthy competition to local concerns, which should lead to lower prices for consumers.
Third, foreign investors are sometimes the only bidders with adequate resources to acquire privatised government enterprises such as PTCL.
Finally, foreign investors are supported by their home governments, which allow them to push against rent-seeking regulations in ways that no domestic business can.
A second reason that governments prefer FDI is that it is supposed to last longer than FPI. This brings us to our first question: why is FDI so volatile in Pakistan? Portfolio investors can easily sell their securities and move on; however, direct investors have substantial assets on the ground, and have to bear onerous costs to relocate elsewhere.
There are at least four reasons why FDI might nevertheless be more volatile than FPI. First, FPI levels have always been low in Pakistan, so no great variation has been possible, whereas FDI levels mushroomed in the mid-nineties. Second, Pakistan makes several concessions to lure direct investments, some of which enable quick divestment.
Third, some FDI concerns are especially vulnerable to shortages of electricity and other resources. Finally, country-level risks such as insecurity and political instability can also add to the direct investor’s uncertainty.
Since a foreign direct investor is a long-term investor, it is particularly interested in the long-term prospects of the host country. FDI that is lured by transient incentives is likely to leave when those incentives expire. However, improvements in long-term indicators lead to long-term FDI, but temporary incentives yield temporary investments.
We are currently seeing glimpses of a revival in FDI.
MNCs that have thrived in Pakistan have contributed substantially to employment, consumer satisfaction, and corporate social responsibility. So the question is how do we get FDI to stay? Since direct investments are long-term propositions, there is no shortcut to retaining them.
source: compiled by state bank of pakistan’s data
There are two routes to offering such long-term protections: one is to give the foreign investor privileges and protections beyond those offered to local investors; another is to improve the protections offered to all investors, whether local or foreign.
The first solution, typified by bilateral investment treaties, entails compromises of national sovereignty. The second solution, which requires improvements in general legal protections, whether for foreign or domestic investors, is more sustainable. This is the route taken by countries that lead the FDI rankings: our erstwhile top investor, the United States, and our present top investor, China.
The writer is a professor of law and adjunct professor of business at Lums
Published in The Express Tribune, November 16th, 2015.