Investment and trade nexus

The FDI has direct and indirect advantages for the exports of host countries like Pakistan

Muhammad Ashraf March 28, 2017
The writer is director general of Trade Dispute Resolution Organisation at the Commerce Ministry

Pakistan’s exports after remaining stagnant at $24-25 billion for four years (2010-11 to 2013-14), have been declining for the last three years. One of the major causes for the stagnation and decline in exports, along with multiple exogenous and endogenous factors, is the lack of export-oriented investment.

Though the relationship between FDI and exports is complex and dynamic, it is generally agreed that FDI stimulates exports of the host country. The Multi National Enterprises (MNEs) are directly involved in 80% of international trade and are, therefore, effective agents of export enhancement of the developing countries. In Pakistan’s neighbourhood, China and India have successfully leveraged the FDI to stimulate exports. Chinese exports increased at a compound annual growth rate (CAGR) of 15% from $73 billion in 1991 to $2.275 trillion in 2015, accompanied by the cumulative net FDI inflow of $2.818 trillion. Similarly, Indian exports since 1991 increased by 11.5% annually complemented by a cumulative FDI inflow of $364 billion. In contrast, the cumulative FDI inflow into Pakistan during this period were only $36 billion, most of it into the non-manufacturing sector.

The FDI has direct and indirect advantages for the exports of host countries like Pakistan. Firstly, the horizontal FDI — duplication of production activities in multiple countries — is adopted by MNEs as a strategy to serve the host country market if the import costs are higher than the production relocation costs, or to use the host country as export-processing platform if the production costs are lower. China is a characteristic model of an export processing platform by the MNEs as 60% of China’s exports are by the MNEs.

Secondly, vertical FDI — the relocation of different stages of production by the MNEs in different countries — is one of the main drivers of global value chains (GVCs). The trade in intermediate goods constitutes 70% of international trade as the MNEs, instead of producing the goods in a single country, locate the different steps of the production process in different countries.

Thirdly, the buyer-driven FDI — the investment by the foreign large retailers and brand marketers in production networks of especially the labour-intensive products like textiles, agro-food products and footwear — is estimated to annually generate around $2 trillion exports from the host countries.

Lastly, the FDI enhances host country’s exports through multiple spillover effects on the local exporting firms. The local firms benefit by “learning through observing” the foreign firms’ export activities, new technologies and modern management techniques; the production efficiencies increase under pressure of competition from foreign firms; the domestic firms get indirect access to the global value chains of foreign firms through contract manufacturing.

Blessed with the strategic endowments, Pakistan offers multiple advantages as an investment location. The country is strategically located at the crossroads of South Asia, East Asia, Central Asia and the Middle East. More than 40% of entire global consumer base and an import market of $2.15 trillion is available on its immediate borders. Pakistan’s own 200 million consumer base, the world’s 6th largest, and a youth bulge offers a potential demographic dividend. Located in a high growth region, Pakistan’s economy has been on an upward growth trajectory — 4.71% growth during 2015-16 and 5% expected during the current year. Goldman Sachs has identified Pakistan as one of the Next Eleven countries (along with Brics), which can become the world’s large economies in the 21st century. Bloomberg has rated Pakistan as the 14th top potential investment location in 2016 and assessed Pakistan Stock Exchange as the 5th best performing market in 2016. The general security environment has significantly improved, though the sporadic incidents of terror continue to feed into Pakistan’s perception abroad as an unsafe destination for investment and trade.

These strengths notwithstanding, Pakistan has not been able to attract significant export-oriented FDI. There are two critical determinants in investment decisions by a potential investor — (a) security of investment, and (b) profitability, which in turn depends on production costs. Though Pakistan provides a secure policy environment to foreign investors, the cost of production becomes the biggest disincentive for export-oriented FDI. During the last decade, more than two-thirds of a total of $20 billion FDI inflows, have gone into non-manufacturing sectors like oil & gas, construction, financial business, construction, power and telecom, with negligible export linkage.

Pakistan’s ranking in the Global Competitiveness Index remains amongst the bottom 20 out of 138 economies; the average annual labour productivity growth in Pakistan since 2001 has been 1.8% compared with Bangladesh’s 3.5%, India’s 5.4% and China’s 8.6%. In the Ease of Doing Business index, an indicator of investment friendliness, Pakistan, at rank 144, is below most of the competitors e.g. India 130, Vietnam 82, China 78, Thailand 46, Malaysia 23 and South Korea 5. In the Enabling Trade Index, an indicator of ease in flow of goods over borders, Pakistan ranks 122 out of 136 economies. At the policy level, there is lack of synergy between the investment, industrial and trade policies. The import substitution, forsaken in theory, remains the mainstay of investment promotion strategy in practice, as the tariff protection, rather than competitive production environment, is the most persuasive incentive offered to the foreign investors. The enhanced market access negotiated under preferential trading arrangements has not translated into production for exporting to the FTA/PTA partners’ market.

In order to attract the export-oriented FDI, Pakistan needs to rework its investment promotion strategy. The simplification of procedures and improvement of institutional efficiencies are essential for integration into global value chains so that intermediate inputs can smoothly enter the borders and quickly exit, after processing. The buyer-driven FDI and horizontal relocation of export-oriented production by the MNEs to Pakistan requires a repositioning of strategy from tariff protection incentives to enhancement of competitiveness demonstrated through improvement of ranking in global indicators. The empirical evidence demonstrates that tariff liberalisation rather than protection attracts FDI.

Published in The Express Tribune, March 29th, 2017.

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