FDI: a double-edged sword

KARACHI:

In a report issued last week the State Bank of Pakistan (SBP) reported that a record amount of $918 million on account of profits and dividends was remitted abroad by foreign investors in May. This amount, close to a billion dollars, represents the return foreigners expect on their investments in Pakistan.

Earlier, in a meeting chaired by Prime Minister Shehbaz Sharif, he is quoted as saying, “The Pakistani government would leave no stone unturned to cater to foreign investors and provide facilities to foreigners coming to the country for investments.”

He went on to state, “Huge investment is expected from various countries in a range of sectors, including renewable energy, oil refining, mining, food security, banking and financial services, logistics, water supply, and waste management.”

So, on the one hand, we see that a billion dollars leave the country as payments to foreign investors. And, on the other, we see the prime minister roll out the red carpet for foreign investment.

Something does not connect here

Clearly, the prime minister’s statements suggest that he believes that Foreign Direct Investment (FDI) is an unfettered “good” and that all of Pakistan’s economy should be fair game for foreign investors.

Unfortunately, it seems that PM Sharif does not have a full understanding of the nuances involved in FDI. And to proceed with the policies he has enunciated may well damage Pakistan’s economy rather than benefit it – case in point: the $1 billion outflow recorded last month.

It is indeed true that FDI holds potential for transforming economies, yet its impact on countries like Pakistan is multifaceted. This article explores the ramifications of FDI on Pakistan, with a focus on issues such as profit repatriation, Balance of Payments (BoP), and the cost of capital. While FDI offers avenues for growth, its implications underscore the need for careful navigation to ensure sustainable development.

Foreign investors’ expectation to repatriate profits to their home countries poses a significant challenge for countries like Pakistan. When FDI is directed towards projects reliant on the local market, profit repatriation can strain foreign exchange reserves. This scenario creates a conundrum, as profits generated locally are siphoned out of the economy, impacting the availability of foreign currency reserves crucial for stabilising the currency and meeting international obligations.

The impact of FDI on Pakistan’s BoP varies depending on the nature of investment. Projects oriented towards exports can yield positive outcomes by bolstering foreign exchange earnings. In such cases, profit repatriation aligns with the inflow of foreign earnings, contributing to a favourable BoP position. However, investments geared towards the local market may exacerbate BoP deficits as repatriated profits outstrip foreign exchange earnings, leading to imbalances in trade and payments.

Cost of equity vs cost of debt

From a cost point of view, as any first year MBA student will tell you, the cost of equity is always higher than the cost of debt. This has to do with several factors including the fact that interest is recorded as an expense on financial statements and so reduces the company’s tax burden. Dividends, on the other hand, are subject to the full corporate tax rate. Other factors such as investors’ risk perception result in their expecting a higher return on equity than on debt.

So, for Pakistan, FDI comes at a cost that is almost always higher than the cost of borrowing money. To put it bluntly, if foreign money is needed, it is almost always cheaper, other factors being equal, to borrow it rather than to bring it in as FDI. This consideration underscores the need for robust investment frameworks along with incentives to invest in export oriented sectors to justify the higher cost of equity

Hence, FDI emerges as a double-edged sword for Pakistan, presenting both opportunities and challenges. While FDI inflows inject capital, technology, and expertise, the associated profit repatriation and cost considerations necessitate cautious management:

Strategic investment promotion

Prioritising FDI in export-oriented sectors to align profit repatriation with foreign exchange earnings, thereby bolstering BOP stability. And, offering targeted incentives and concessions to attract FDI in critical sectors while safeguarding national interests and promoting sustainable development.

Regulatory oversight, monitoring

Implementing robust regulatory frameworks to monitor profit repatriation and ensure transparency and accountability. And, instituting safeguards to mitigate the adverse impact of profit repatriation on foreign exchange reserves, including caps on dividend payments or reinvestment requirements.

Optimal capital structure

Striking a balance between equity and debt financing to optimise the cost of capital for FDI projects, thereby enhancing investor confidence and project viability. And, leveraging innovative financing mechanisms, such as public-private partnerships and venture capital, to diversify funding sources and mitigate reliance on equity financing.

Long-term sustainability

Embracing a holistic approach to FDI that prioritises long-term sustainability over short-term gains, fostering inclusive growth, and equitable development. And, investing in human capital, infrastructure, and institutional capacity to maximise the spill over effects of FDI and enhance its contribution to national development goals.

FDI presents a formidable opportunity for Pakistan’s economic transformation, and yet its realisation hinges on prudent policymaking and strategic management. By navigating the complexities of profit repatriation, balance of payments dynamics, and cost of capital considerations, Pakistan can harness the potential of FDI while mitigating its inherent risks. Ultimately, FDI, a double-edged sword, must be wielded judiciously, unlocking avenues for growth while safeguarding national interests and promoting sustainable development.

The prime minister’s statement, quoted at the start of this article, betrays his lack of appreciation for the dangers of this double-edged sword. Not all FDI is good.

THE WRITER IS CHAIRMAN OF MUSTAQBIL PAKISTAN. HE HOLDS AN MBA FROM HARVARD BUSINESS SCHOOL