FOREIGN DIRECT INVESTMENT

Inflows to Pakistan are still below US$ 1.0 billion mark, which is less than one percent of total FDI towards developing countries

By SHABBIR H. KAZMI
Jan 17 - 30, 2005

None of the developing countries can afford to achieve economic development without the foreign direct investment, which not only provides the much needed capital but also helps in bringing new technologies. The overseas investors have played a vital role in the economic development of Pakistan also, mostly in establishing capital intensive ventures as well as industries based on state-of-the-art technologies.

However, expecting inflow of FDI in the absence of willing local entrepreneurs can only be termed 'hoping against the hope'. Pakistan has witnessed inflow of FDI even during the worst time only because the overseas investors were able to find credible local partners. Now Pakistan has entered the phase of development, which requires FDI along with transfer of technology as well as buy back agreements, for achieving higher exports. It is the time to let the world know what Pakistan offers attractive opportunities and also to talk about the success stories.

While the critics may hint towards a number of factors affecting the working environment in Pakistan, it is also a fact that no foreign investor has ever left the country because of hostile conditions. According to a CEO of a transnational company, "The ground realities in Pakistan may not be as good as we wish to see. But, it is also true that the overall conditions are not as bad as prevailing in most of the developing countries. However, a factor which does not allow us to implement long-term plans is absence of long-term government policies. I am willing to work in the most hostile environment but certainly need consistent and coherent policies. The situation over the last five years has certainly improved but a lot more needs to be done."

Worldwide foreign direct investment (FDI) inflows declined sharply by 17.5 percent from US$ 678.8 billion to US$ 559.6 billion in 2003, continuing the downward visible since 2000. As against this, FDI to developing countries witnessed a rise in the same period. It rose by approximately 9 percent in 2003. FDI flow into Pakistan has been increasing in recent years pushing up its share in the global FDI as well as FDI flows to developing countries. However, this rise is very slow, and in absolute terms, FDI inflows to Pakistan are still below US$ 1.0 billion mark, which is less than 1.0 percent of total FDI towards developing countries. As a result, Pakistan's FDI stock to GDP ratio during 2003 was at 10.7 percent. This highlights the need to further improve the investment climate in the country.

Following the global trend, services sector attracted the highest share in FDI in Pakistan followed by oil, gas, mining and quarrying. The share of trade, transport, storage & communication in total FDI rose from 19.2 percent in 2003 to 28.0 percent in 2004, followed by financial business with a share of 25.5 percent. The increased FDI in communication sector stemmed from entry of new cellular phone companies in the country, while the rise in FDI inflows in financial business was mainly due to the privatization of a large public sector bank, Habib Bank Limited (HBL).

Another sector, which attracted significant FDI during 2004, was oil, gas mining and quarrying. Moreover, an important development is the increased FDI inflows in value-added activity of petroleum refining and petro-chemicals, which registered a rise in its share in total FDI from 0.4 percent in 2003 to 7.6 percent in 2004. In contrast, FDI in chemicals decreased by 82.2 percent during 2004, mainly due to transfer of chemical plant of a multinational company to a local group. As a result, the share of chemical in total investment decreased from 10.8 percent in 2003 to 1.6 percent in 2004.

An analysis of FDI inflows into Pakistan by country of origin during 2004 shows that one-fourth of the total flows were from USA followed by Switzerland and UAE with shares of 21.6 percent and 14.2 percent respectively. FDI from USA was principally into oil and gas explorations, mining and quarrying, while the jump in FDI inflows from Switzerland was related to privatization of HBL. The FDI from UAE investment was concentrated mainly in petroleum, refinery, petro-chemicals, trade, transport, storage and communication. Contrary to the overall growth in 2004, FDI from UK and Saudi Arabia decreased by 70.4 percent and 83.4 percent respectively. The decrease in FDI from UK is due to heavy disinvestments in the power sector.

REGULATORY HURDLES

That cannot be any doubt that a conducive business environment is an obvious pre-requisite for any country's ability to attract investment, and indeed to its relative competitiveness in the global markets. However, the term 'conducive environment' is a catch phrase that incorporates a number of different elements, including amongst others tax policy, profitability, market size, security, governance, macroeconomic and political stability, consistent policy scenario, accounting standards, etc. Thus, efforts to assess the relative standing of countries in specific elements provide valuable insights for policy makers. If the regulators wish to know the perception about Pakistan, they must look at a report prepared by the World Bank "Doing Business in 2004: Understanding Regulations" that attempts to compare the regulatory environment prevailing in various countries.

DOING BUSINESS IN 2004: UNDERSTANDING REGULATIONS

Some insights of the report about Pakistan and key countries from ASEAN and South Asia are:

* Starting a business in Pakistan requires only 22 days (the lowest in the sample), with India at the bottom with 65 days. However, businessmen have to go through the highest number of procedures in China and Pakistan and the least in Bangladesh. The cost of starting a new business requires less than US$ 200 in Pakistan, Sri Lanka, China and Thailand, while it is US$ 272, US$ 309 and US$ 960 in Bangladesh, India, and Malaysia respectively. This area offers Pakistan an opportunity for quick improvement. The availability of a true one-window operation would help significantly cut down the number of procedures and costs for start-ups.

* Similarly, Pakistan ranks second for the availability of full time and part time worker (as measured through a flexibility of hiring index), with Thailand providing businesses the most flexibility. In terms of legislation related to well-being of the workers India is at the top followed by Bangladesh and Pakistan. However, it is more difficult to fire a worker in China, Sri Lanka and Pakistan than in Malaysia or India. The overall employment law index suggests that Pakistan's labor market is subject to rigid regulations, ranked at second worst after Thailand in the sample, while the Malaysian economy offers the least protection to labor. There does not appear to be any easy solution to this problem, as the introduction of legislation to increase labor market flexibility is likely to prove controversial. Nonetheless, international experience does indicate that very rigid labor laws increase inefficiency and reduce productivity in an economy.

* Businesses have to face about 30 legal procedures to enforce contract procedures in Pakistan, the highest amongst the selected countries. It also requires substantially more time and cost for a settlement in Pakistan. Enforcement of contract is the quickest in China, with relatively lower cost. However, procedural complexity index in aggregate suggests that the more complicated procedures exist in South Asian countries like Sri Lanka, India and Pakistan. Efforts towards judicial reforms, etc. are in progress in Pakistan.

* Credit market failures are a major cause of low investment in a country even when profitable business opportunities are available. The report assesses whether the rules of public registry are formed in way to support credit transactions, through a public registry index. China ranks highest in the sample with the index value of 159 indicating an extremely conducive environment for credit transactions. India, Sri Lanka and Thailand register zeros. All sample countries other than Bangladesh had functional private credit information bureaus. Pakistan has the lowest score in the index for creditor's rights. This area is expected to see significant improvement as the financial sector reforms take root. The efforts to extend the coverage of the existing credit information bureau to cover all loans by financial institutions as well as the increase in financial intermediation should significantly improve Pakistan's standing.

* Insolvency laws are very important in ensuring that the most efficient firms remain in business and weaker entities have orderly exit processes. In almost all selected countries insolvency takes less than three years, except India where it takes more than 11 years, while no legal process exists in Bangladesh. Interestingly, the insolvency index shows that the insolvency system functional in Pakistan is the best amongst the sample countries. A related indicator is court power index, which measures the involvement of the courts in insolvency process. A score of 33 suggest relatively lesser court involvement in insolvency process in Pakistan, India, Malaysia and Thailand. This is another area where Pakistan's ranking can see significant gains in the short-term, with the enactment of appropriate bankruptcy laws and procedures for the orderly termination of claims.

The analysis paints a mixed picture for all selected countries even China, which was the top recipient of FDI in 2003, has various rigid regulations in place such as a high minimum capital requirement for a new business (approximately US$ 3.6 million, in comparison most countries have no restriction at all). Pakistan lies approximately in the middle of the sample, with significant advantages in some regulatory areas being eroded by visible weaknesses in others. However, this is not an excuse for complacency. Despite significant improvements in the domestic economy and increased political stability, the investment environment in the country continues to be negatively effected by other factors, many of which are either exogenous or not addressable in the short-term. Thus, it is even more important for the country to improve on factors that are addressable relatively quickly.

Talking to a delegation of investors from Germany and United Arab Emirates, which recently visited Pakistan, Prime Minister Shaukat Aziz said that the deregulation measures of the government and continuity of economic policies had made Pakistan a profitable destination for investors. The government has created enabling environment in Pakistan for investment. The strategic location of Pakistan makes it a manufacturing base for exporters and an attractive destination for investment. Pakistan offers numerous opportunities for investment and legal cover for ensuring protection of investment. The large-scale manufacturing has grown by 18 per cent during the last financial year. Other sectors of economy are contributing to the growth of automobile, electronic, textile and cement industry.

The words uttered by the Prime Minister do reflect the measures taken by the government and the overall response from the investors. However, an analyst says, "Even the hardcore critics of the present regime can afford to disagree with the Prime Minister regarding potential of Pakistan. But, it is also a fact that since independence the country has not grown at a pace it should have. Most of the countries which were far behind Pakistan, in terms of economic development, have gone far ahead. Now a number of analysts say that nineties was a lost decade. However, we have not learnt any lesson. We, as a nation, are still looking at short-term gains rather than improvising the available industrial infrastructure. In nineties bulk of the investment was made in textile and sugar industries. In the new millennium we are committing the same mistake by focusing oil & gas, telecommunication and automobile sectors only."

However, another analyst says, "As opposed to nineties now we are witnessing a broad-based investment. While local investors have been investing heavily in textiles and clothing sector, bulk of the FDI has come into oil & gas and telecommunication sector. Pakistan has not been able to solicit FDI in textiles and clothing sector, despite the fact that most of the textile companies from developed countries have been investing heavily in the developing countries. One tends to get an impression that the foreign investors could not find a credible local partner or they still have certain reservations regarding the economic viability of the sector. Unfortunately, profit & loss accounts of most of the companies belonging to textile sector do not portray a rosy picture. Therefore, foreign investors are ready to invest in any country but not in Pakistan."

The basic reason for large inflow of foreign investment in oil & gas and telecommunication sector is that these sector offer enormous growth opportunities. The rate of success in oil and gas exploration in Pakistan has been very high and the petroleum policy also offers attractive incentives. Low tele-density offers enormous growth potential. The deregulation of telecommunication sector has also become an added attraction.

Privatization strategy being followed by the government has also helped in attracting foreign investment in banking sector. Now all eyes are set at privatization of Pakistan State Oil Company, Karachi Electric Supply Corporation and Pakistan Telecommunication Company. The response to government's invitation of EoIs has been very encouraging. The participation of credible foreign investors in privatization of these companies will not only help in attaining higher bids but also receiving the proceeds in foreign exchange.

In nineties significantly large amounts were invested in Pakistan's equities market by the foreign fund managers. Despite the fact that now Pakistan is among the top best performing markets, foreign fund managers do not seem to be attracted. According to an equities analyst, "An old saying 'once bitten twice shy' is keeping foreign fund managers away from Pakistan. However, the reality is that today's market is very different from those days. At that time the number of quality scrips as well as free market was very low. As against that now the number of quality scrips and market float has increased substantially. The divestment policy being followed by the government has provided new impetus. With the forthcoming listing of more state-owned enterprises on the stock exchanges the size of free float will be enhanced further. Therefore, the foreign fund managers should not ignore Pakistan."

The two adverse factors, which were major hurdle in inflow of FDI, have been removed to a very large extent. These were Pakistan's low sovereign rating and depreciating rupee. With the re-profiling of Pakistan's external debit, debit servicing has become sustainable. The growth in foreign exchange reserves and the active intervention policy of the central bank have contributed towards stabilization of exchange rate. All these factors have also improved Pakistan's sovereign rating.

The Securities and Exchange Commission of Pakistan and the management of local stock exchanges are also playing proactive role. The role being played by the regulators has also helped in overcoming some of the contentious issues ailing the market in the past. And above all use of technology, particularly the role being played by the Central Depository Company has made trading in equities a game worth playing even for the novice.

To achieve above 10% GDP growth Pakistan needs a lot more investment. Foreign investors can contribute in this regard but not without the active participation of local investors. The ground realities are not as bad as perceived by many. The Government of Pakistan cannot solicit FDI simply by playing the tune that the country offers enormous opportunities. The world needs to be informed about the success stories, there is no dearth.