Rupee volatility, lack of investor confidence impede FDI inflows

Currency depreciation can attract foreign investors if they benefit from cheaper production costs

Aadil Nakhoda July 08, 2019

KARACHI: Pakistan faces several challenges on the economic front, such as the balance of payments crisis, a burgeoning fiscal deficit and a volatile currency exchange rate.

Exports and inflow of foreign direct investment (FDI) into Pakistan are at disconcerting levels. The approval of the International Monetary Fund (IMF) package is likely to alleviate certain concerns over the economy as it will stock up desperately needed foreign currency reserves of the State Bank of Pakistan (SBP) and reduce volatility in the currency exchange rate as observed in recent days.

A considerable depreciation of the Pakistani rupee relative to the US dollar has occurred since December 2017. Although the depreciation was a necessity due to overvaluation of the rupee accompanied by a lack of sustainable foreign currency reserves, the depreciation has so far failed to help accumulate foreign currency reserves.

Rupee likely to continue downward trend

An increase in export revenue can help soothe volatility in the currency market. The lack of dollar inflows via export sales and foreign investment suggests that poor business conditions and investor confidence in the economy are likely reasons for the dampening effect not only on manufacturing activities in the country but also on investments across different sectors.

According to statistics provided by the Board of Investment (BOI), Pakistan received $1.61 billion worth of FDI inflows between July 2018 and May 2019. This was significantly lower than the $3.09 billion received in FY18.

Average FDI inflows were more than $2.7 billion between FY16 and FY18. China has been the largest source of FDI inflow into Pakistan since FY14. More than 58% of the FDI in FY18 originated from China. The UK was the second largest source, contributing 9.9% of the total FDI.

China invested more than $1 billion in Pakistan each year between FY16 and FY18, peaking at $1.8 billion in FY18. However, only $495 million was reported from July to May FY19.

There was a significant increase in the FDI inflow from Hong Kong, reporting a change of more than $126 million from the value reported in FY18. Hong Kong, with its more developed financial market and legal system, often plays the role of an intermediary for Chinese investors.

Sector decomposition of FDI inflows into Pakistan suggests a strong link with China-Pakistan Economic Corridor (CPEC)-related investments. Since FY17, the construction sector has reported an average of more than 21% of total FDI inflows into Pakistan. The power sector attracted more than 32% of FDI in FY18. However, between July and May FY19, the disinvestment in the power sector resulted in an outflow of $261 million.

The oil and gas sector was a major recipient of FDI before FY16, with an average of more than 40% between FY10 and FY15. Similarly, the financial services sector attracted more than 50% of FDI in FY16. The advent of CPEC resulted in a shift as the importance of power and construction sectors increased as recipients.

With investments in the power sector tapering off in FY19, the share of other sectors is likely to increase. It is unfortunate to note that the textile sector has failed to attract major foreign investment, even though it contributes the most to manufacturing activities and employment in the manufacturing sector in Pakistan.

Between FY13 and FY17, the average inflow into the textile sector was approximately $270 million with an average share of 16.4% of total FDI inflows. The inflow decreased to $49.7 million in FY18 and is expected to hit $60 million in FY19. Its share has fallen to less than 5% of total FDI inflows.

Furthermore, the chemical sector has reported, on average, less than 5% of total FDI inflows since FY14.

Special economic zones

According to the World Investment Report 2019 published by Unctad, the outlook on global FDI shows a modest recovery from the levels reported in 2018. The report is optimistic about the prospects of FDI in developing Asia as it expects it to increase by more than 5%.

However, the report points to a relatively gloomy picture for Pakistan as the economy reported a 27% decline in FDI in 2018. The report lists completion of CPEC-related projects and balance of payments problems as major reasons for the declining trend. It expects the inflow of FDI into Pakistan to further decrease in 2019.

Major focus of the report is the importance of Special Economic Zones (SEZs) developed to promote and improve the investment climate within a country. Globally, there are 5,383 SEZs established by law. Majority of the SEZs are between 100.1 and 500 hectares and are functioning with multiple activities rather than as specialised sector-specific zones. Approximately 90% of the SEZs are located in developing economies. China with more than 2,500 SEZs clearly outranks other developing countries. Majority of the SEZs located in China are regulated at the provincial level and involve multiple rather than specialised activities.

On the other hand, India focuses on sector-specific SEZs built on smaller land area. Pakistan has established only seven multiple-activity SEZs whereas 39 SEZs are currently at the planning stage.

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The report identifies advantages of establishing the SEZs. For instance, the SEZs in countries with weak governance may increase the ease of implementing business reforms. The cost to establish the SEZs is typically low due to the spillover effects for businesses operating in a cluster, compared to building several independent industries across the economy.

Lastly, as the SEZs and export promotion zones are more likely to attract efficiency-seeking investments rather than market-seeking investments, the firms in the SEZs will increase competitive pressure on the firms operating in the SEZs as well as on those outside the zones. In essence, Pakistan has only attracted FDI in selected non-productive sectors. The volatility in the currency exchange rate and the lack of investor confidence have reduced FDI inflows.

However, the depreciation in the currency can attract foreign investors if they can benefit from cheaper costs of production. Therefore, it is imperative that Pakistan attracts FDI inflows into efficiency-seeking manufacturing activities to boost integration into global value chains.

The writer is the Assistant Professor of Economics and Research Fellow at CBER, IBA

Published in The Express Tribune, July 08th, 2019.

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