Foreign direct investment and stock market development in Pakistan

Author:Ihtisham Abdul Malik
Position::Department of Management Sciences, COMSATS Institute of Information Technology, Abbottabad, Pakistan
SUMMARY

Purpose – This paper aims to investigate the impact of FDI on the stock market development in Pakistan, both aggregate as well as sector wise, the reason being that no such work has been carried out in this context. Design/methodology/approach – The study is based on secondary data for the period 1985-2011. Johansen co-integration approach is used for determining relationship among... (see full summary)

 
INDEX
FREE EXCERPT
Introduction

A major source of investment inflow for a developing country is foreign direct investment (FDI) that provides a passage for technology, managerial skills and human capital for host country ( Chen, 1992 ). Raza et al. (2010) showed a positive impact of FDI along with exchange rate (ER) and domestic savings in developing stock markets of Pakistan. FDI provides capital, market access, technological up gradation and management. Sectors with competitors allow for more comparative advantage to be highly profitable and FDI creates economies of scale, linkage effects and increase production level ( Sultana and Pardhasaradhi, 2012 ). Stable macro-economic environment is expected to boost stock market development and attract more foreign investment. Currency risk being the most important factor for foreign investors, ER is usually used as measure of macro-economic stability. If the ER of host economy being an indicator of growth is depreciating, investor's profit will decrease. In Pakistan this has been the major cause of decreased FDI and market capitalization over the past three years. Pakistan's rupee has been depreciating since 2007 against US$ (the most traded foreign currency in Pakistan) and at present ER is PKR 97.1 to a US$ which was PKR 60 to US$ in 2007 ( Business Recorder, 2012 ). The study aims to determine the relationship between FDIs, economic growth and stock market development (aggregate and sector wise). It studies the level to which FDI affects the stock market development in Pakistan.

Literature review

FDI is a cross-border investment in which a resident in one economy acquires a lasting interest in an enterprise in another economy. Usually, atleast 10 percent ownership in a foreign enterprise is necessary for being called a foreign direct investor otherwise it is portfolio investor ( OECD, 2008 ). FDI and ER have a significant and direct impact on stock market performance in South Asian countries (Aurangzeb, 2012). FDI can be linked positively with economic growth in home countries but developed countries do not show this trend. Panel data study from emerging economies showed positive relationship between FDI and stock market development but for sectors the relationship was found to be uncertain ( Soumaré and Tchana, 2011 ). The relationship between FDI and fixed capital is found to be positive ( Krkoska, 2001 ; Chousa et al., 2008 ; Adam and Tweneboah, 2009 ). In Pakistan it was found to be significant and positive ( Shahbaz et al., 2008 ). Theoretical work shows positive relationship between stock market development and economic growth (Gay, 2008; Levine and Zervos, 1996 ; Singh, 1997 ; Demirguc-Kunt and Levine, 1996 ; Brecher and Diaz-Alejandro, 1977 ).

Korgaonkar (2012) argued that the development of the financial system of the host country is vital and a prerequisite for FDI to have a positive impact on economic growth. Using ADF technique, regression analysis and graphical comparison, Nazir et al. (2010) provided empirical evidence that increase in market capitalization boosts the economic growth of Pakistan. The relationship between capital market and growth of economy using time series has been examined and a positive linkage is found between the stock market development and economic growth but this positivity is tied to high liquidity and activity of the market ( Boubakari and Jin, 2010 ).

FDI in Pakistan has less growth impact as compared to other developing economies ( Azam and Khattak, 2009 ). ER volatility is a major driver and risk for foreign investors in a developing economy ( Billmeier and Massa, 2007 ). FDI plays a vital role in stock market performance and the investments from abroad are positively related to the stock prices but this positivity can be seen in the home country financial market ( Baker et al., 2004 ). Caporale et al. (2004) found a long run relationship between economic growth and stock market development suggesting that it can foster economic growth in the long run. Financial markets (stock markets) are prerequisites for a positive impact of FDI on growth on the basis of data collected from 67 predominantly developing countries ( Hermes and Lensink, 2003 ).

Market capitalization (stock market development) and long run economic growth is found to be positively and robustly associated. Economic development is a prerequisite for financial development of any country with stock market development being positively related to economic growth ( Levine and Zervos, 1996 ; Levine, 1996, 1997 ).

Another relationship discussed in this study is the impact of FDI on economic growth. Handsome numbers of studies have been conducted in this context. Domarchi Veliz and Nkengapa (2007) using panel data analysis found that FDI positively affects the growth as host country is provided with updated techniques. Borensztein et al. (1998) also revealed that FDI acts as a vehicle for technology transfer thus more contribution to the growth is made than by the domestic investment. Nunnenkamp and Spatz (1996) also supported the positive relationship between FDI and economic growth that FDI should be brought to the developing countries to boost the economic development.

Alfaro et al. (2004) examined several linkages among FDI, financial markets and growth. FDI is a vital player stimulating the economic growth. Study by Hermes and Lensink (2003) supported the growth affect of FDI in a cross-country analysis with most of the countries from Asia and Latin America.

FDI in contrary to previous literature does have a positive relative relationship but not as robust as the previous literature due to inefficient governance, bureaucracy and instability in political processes (Athulorala, 2003). Yartey (2008) linked FDI with the rules and regulations, institutional reforms and efficiency in the market strengthening the stock market base leading to increased capital inflows.

Methodology

The study is based on secondary data for all the sectors listed at KSE. The market capitalization of KSE is taken for the period of 26 years (1985-2011) and for sectors, time span is limited to ten years (2001-2011) due to non-availability of data. The variables for the study include aggregate stock market development, sector wise development, FDI and economic growth. Aggregate market and sector wise development are taken as dependant variables where as FDI and economic growth are the independent variables.

Stock market development is referred to as increase in the market capitalization of the stock market. Market capitalization as a share of GDP is used as an indicator for stock market development ( Nazir et al., 2010 ; Boubakari and Jin, 2010 ; Adam and Tweneboah, 2009 ; Buckley et al., 2004 ). Net FDI inflows are used as proxy for FDI ( Adam and Tweneboah, 2009 ; Claessens et al., 2001 ; Kalim and Shahbaz, 2009 ). The study examines FDI as a major factor affecting the stock market development, currency risk being most important to foreign investors, the direct quote ER (PKR to US$) is used as measure of macro-economic stability ( Kolapo, 2011 ; Adhikary, 2009 ; Subair and Salihu, 2010 ). The following hypotheses are formulated for empirical testing:

H1. There exists a positive relationship between FDI and KSE market capitalization as a share of GDP.

H2. There exists a negative relationship between ER and KSE market capitalization as a share of GDP.

H3. There exists a negative relationship between FDI and ER.

Linear regression model is used to identify the relationship between the stock market development, FDI and economic growth. The regression equation is: Equation 1 where:

MC/GDP =market capitalization as share of GDP.

α =constant.

FDI =net foreign direct investment.

ER =exchange rate (PKR to dollar).

GDP =gross domestic product.

ɛ´ =error term (based on Adam and Tweneboah (2009) ).

The data is analyzed using different statistical and econometric techniques including correlation analysis, regression analysis, augmented Dickey-Fuller (ADF) approach, Granger causality test, Johansen...

To continue reading

REQUEST YOUR TRIAL