Page 9 Oeconomics of Knowledge, Volume 5, Issue 4, Fall 2013

Impact of Exchange Rate on Foreign Private In-

vestment in Pakistan

Muhammad Asif
Management Sciences Department
COMSATS Institute of Information Technology
Abbottabad, Pakistan

Bahadar Shah
Management Sciences Department
Hazara University
Mansehra, Pakistan

Abstract: This study is focused on analyzing exchange rates on foreign

private investment in Pakistan. Times series data from peri-
ods 1973 to 2012 was used for the analysis. The results of
estimation suggest that an exchange rate and gross domes-
tic product are the most important variable that affects pri-
vate foreign investment in Pakistan. Exchange rate was rec-
ommended to be more market responsive compared to the
other variables of the model.

Keywords: Foreign Private Investment; Exchange Rate; Inflation and

GDP.

JEL: A10, G10.

Page 10 Oeconomics of Knowledge, Volume 5, Issue 4, Fall 2013

Introduction
Foreign Private Investment (FPI) plays an important role in the fu-
ture as a source of capital, managerial expertise, and technology for both
developing economies and economies in transition. The direct and indi-
rect benefits from appropriate FPI are substantially greater than normally
assumed, but host countries have problems in realizing these flows. For-
eign Private Investment no doubt has positive contributions to the econo-
my.

Foreign Private Investment is a significant component of foreign pri-

vate capital flows that provide much needed finance to increase the use
of existing capacity to stimulate new investment in the developing coun-
tries. FPI has two major components: portfolio investment and direct in-
vestment. Portfolio investment is the form of equity capital that empow-
ers its owner to flow dividends. On the other hand, foreign direct invest-
ment enables the foreigner to own the physical productive assets, which
operates. Large multinational or transnational corporations essentially
carry out this flow of resources with headquarters in the developed na-
tions.

The need for foreign capital to supplement domestic resources was

felt by the developing economies, in view of growing mismatch between
their capital requirements and saving capacity. Furthermore, many devel-
oping countries view foreign capital as a key element in their develop-
ment strategy against the other forms of foreign financing as it aids in
upgrading technology in hi-technology concentrated industries. Foreign
capital generates employment in the host country when a multinational
enterprise directly employs a number of host country citizens.

Awan et al (2010) examined the overall impact of FDI inflows in Pa-

kistan’s economy. They used annual time series data for the period 1971-
2008. Results indicate that Gross Fixed Capital Formation (GFCF), Degree
of Trade Openness (TO) and Inflation rate (INF) are statistically signifi-
Page 11 Oeconomics of Knowledge, Volume 5, Issue 4, Fall 2013

cant with positive signs, whereas Current Account Balance (CAB) is also
found statically significant with negative sign. The study also revealed
that Debt servicing and Gross Domestic Product found statistically insig-
nificant and it seems that these variables have no significant impact on
FDI inflows into Pakistan.

Zaman et al (2006) examined the economic determinants of FDI in

Pakistan for the period running from 1971-2003. They used FDI as a de-
pendent variable and unit labor cost (ULBC), inflation (INF), market size
(MS), service sector (SS) and trade balance (TB) as explanatory variables
in their model. They found that TB, ULBC, INF, and MS have significant
impact on FDI, on the other hand service sector did not reveal significant
role in promoting FDI in Pakistan.

Sharif et al (2009) examined the causal relationship between foreign

direct investment and economic growth. The results revealed that in the
case of Malaysia there was no strong evidence of a bi-directional causali-
ty and long-run relationship between FDI and economic growth. They
suggested that FDI has indirect effect on economic growth in Malaysia.

According to Obadan (2004), foreign private capital flows do not

constitute economic aid, as they do not provide resources to developing
countries on concessionary terms even though they may yield substantial
benefits. Foreign direct investment generally involves the transfer of re-
sources, including capital, technology, and management and marketing
expertise. Such resources usually extend the production capabilities of
the recipient country (Odozi, 1995). Foreign portfolio investment con-
sists of the acquisition of assets by a foreign national or company in a
domestic stock/market. It refers to the holding of transferable securities,
equity shares, debentures, bonds, promissory notes and money market
instruments issued in a domestic market by the nationals of some other
countries. The money market instruments include treasury bills, commer-
cial papers, bankers’ acceptances and negotiable certificates of deposits
(Obadan, 2004).
Page 12 Oeconomics of Knowledge, Volume 5, Issue 4, Fall 2013

According to Ekpo (1997) and Iyoha (1998), the factors influencing

foreign direct investment include inflation, exchange rate, government
expenditures For a developing country that is highly dependent on trade,
the exchange rate, which is the price of foreign exchange, plays a signifi-
cant role in the ability of the economy to attain its optimal productive ca-
pacity. A stable foreign exchange rate regime will lead to macroeconomic
stability and encourage investment and growth. An overvalued exchange
rate tends to encourage capital flight. Stability of the exchange rate re-
gime will therefore, reduce capital flight and encourage capital inflows in
the form of foreign private investment (Iyoha, 1998).

Theoretical literature is not clear about the direction of the effect of

real exchange rate on the rate of investment. On one hand, a real depre-
ciation raises the cost of imported capital goods, and on the other hand,
a real depreciation, by raising the profitability of activity in the trade able
goods sector, would be expected to stimulate private investment in this
sector but depress the investment in the non trade able goods sector
(Akpokodje, 1998). A high rate of inflation is an indication that govern-
ment lacks the ability to manage the economy (Fisher, 1993). Hence,
high rates of inflation are expected to lead to a contraction of private in-
vestment .

Data source and methodology

This is a brief description of the estimation method used is this
study.

FPI  f ( Inf , ER, GDP)

---------------------------- (1)
Where FPI is the foreign private investment, Inf, is the inflation rate,
ER is the exchange rate and GDP is the gross domestic production. FPI is
the explained variable while Inf, ER, GDP are the explanatory variables.
Page 13 Oeconomics of Knowledge, Volume 5, Issue 4, Fall 2013

The model can be expressed in the estimation form as presented be-

low:

FPI =  0 + 1Inf +  2 ER +  3GDP + u

------------------------- (2)
The model can be expressed in the log form as follows:

lnFPI =  0 + 1lnInf +  2 lnER +  3lnGDP + u

------------------------- (3)
Secondary source was used as the main method for data collection.
The relevant data for this study is obtained from the State Bank of Paki-
stan (SBP) Annual Report. This study is based on the times series data,
collected from period 1973 to 2012.

The regression analysis is used to estimate the coefficients of the

variables. The priori expectation of the coefficients of the parameters is
1 2 3
that our model conforms to the basic economic theory i.e. , , the
coefficients of inflation, exchange rate and gross domestic product must
be positive. Mathematically we can express as follows:

FPI  f ( Inf , ER, GDP)

dFPI dFPI dFPI

0 0 0
dInf
, dER and dGDP
This shows that the changes in the foreign private investment with
respect to inflation, exchange rate and gross domestic product are posi-
tive.

Result presentation
An analysis of the equation (3) shows that the dependent variables,
that are Exchange Rate (R), Inflation (Inf), Gross Domestic Product
(GDP), are able to explain 95.14% of the systematic variation in Foreign
Page 14 Oeconomics of Knowledge, Volume 5, Issue 4, Fall 2013

Private Investment (FPI) during the reference period.

The F – statistics 46 is greater than F (4.12) from the F table.

The F- Statistics is 46 and significant. It further justifies that the ex-

planatory variables ER, Inf, and GDP contribute significantly to the varia-
tion in the independent variable FPI. Thus the hypothesis of a significant
linear relationship between the three repressors and the dependent vari-
able FPI is validated. The goodness of fit of the overall model is indicated
by the high value of the Adjusted Coefficient of the determination value
of 0.931, which shows the overall model as a good fit. Only about 0.7 or
7% is left unexplained, attributed to other factors represented by the er-
ror term.

Table 1

Dependent Variable: L(FPI)

Variable Coefficient Std. Error t-Statistic Prob.
C -140.7998 23.35439 -6.028835 0.0005
L(ER) 11.41708 2.963450 3.852631 0.0063
L(CPI) -4.016906 1.708083 -2.351704 0.0510
L(RGDP) 10.76364 1.757317 6.125042 0.0005

In the model, the coefficient of Inflation is inversely signed, which

failed to conform with the a priori expectation of a positive relationship
between Foreign Private Investment (FPI) and Inflation (Inf). This can be
explained that, a mild increase in inflation would have led to an increase
in investment leading to more inflow of Foreign Private Investment, but
Pakistani situation has a high inflation increase which affects the pur-
chasing power and consumption power of the consumer, thereby reduc-
ing production and hence investment. All the a priori expectation/signs of
the other variables conform to our expectation and are correctly signed.
Page 15 Oeconomics of Knowledge, Volume 5, Issue 4, Fall 2013

Table 2

R-squared 0.951411 Mean dependent var 7.291519

Adjusted R-squared 0.930588 S.D. dependent var 1.022381
S.E. of regression 0.269359 Akaike info criterion 0.489741
Sum squared resid 0.507878 Schwarz criterion 0.634430
Log likelihood 1.306424 F-statistic 45.68891
Durbin-Watson stat 2.064344 Prob(F-statistic) 0.000058

The result shows that there is a decline in the foreign private invest-
ment if the explanatory variables under consideration are kept constant.
The coefficient of exchange rate (ER) is 11.42 which show that there is a
positive relationship between the exchange rate and foreign private in-
vestment. If we increase one unit of exchange rate than our foreign pri-
vate investment will increase by 11.42 units. Similarly, real GDP and FPI
have positive relationship. The result implies that boosting up one unit of
real GDP will bring up FPI by 10.76 units. There is a negative relationship
between inflation and FPI. By increasing one unit of CPI the FPI will de-
cline by four units. The calculated Durbin-Watson statistic from our re-
sults is 2.06, which is close to bench mark of no autocorrelation that is 2.

Conclusions
Exchange Rate is identified as the most important determinant of
Foreign Private Investment in Pakistan and should therefore be given due
attention in order to maximize all the benefits accrued to the Foreign Pri-
vate Investment in Pakistan. It can be said that some reform policies of
government with regards to Foreign Private Investment have been suc-
cessful in attracting foreign investment inflows in Pakistan, however, it
could be inferred from the results of this study that foreign investment
would flow freely only if the investment policies are considered investor
friendly .
Page 16 Oeconomics of Knowledge, Volume 5, Issue 4, Fall 2013

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