Foreign direct investment and stock market development in Pakistan

• DOI: https://doi.org/10.1108/JITLP-02-2013-0002
• Published date: 06 September 2013
• Pages: 226-242
• Date: 06 September 2013
• Author: Ihtisham Abdul Malik,Shehla Amjad
• Subject Matter: Economics

Foreign direct investment and

stock market development

in Pakistan

Ihtisham Abdul Malik and Shehla Amjad

Department of Management Sciences,

COMSATS Institute of Information Technology, Abbottabad, Pakistan

Abstract

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 variables for aggregate

stock market development in long run. Granger causality test is also applied to check the causal

relation between the variables. Correlation analysis and regression analysis has been used for

examining the relationship of sector wise development, FDI and economic growth in Pakistan.

Findings – The results support the positive role of FDI in boosting the aggregate stock market

development in long run. Bi-directional causality between FDI and economic growth has been found

along with the uni-directional causality between aggregate stock market development and economic

growth. For sector wise development the relationship of FDI is positive in the sectors where FDI

concentration is high in recent years whereas and negative in other sectors.

Originality/value – Co-integration coefficients showed a positive and statistically strong

relationship between FDI and aggregate market capitalization thus reflecting the complementary

role of FDI in the stock market development of Pakistan.

Keywords Co-integration,FDI, GDP, Granger causality

Paper type Research paper

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 incre ase

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 Pakista n 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

The current issue and full text archive of this journal is available at

www.emeraldinsight.com/1477-0024.htm

Journal of International Trade Law

and Policy

Vol. 12 No. 3, 2013

pp. 226-242

qEmerald Group Publishing Limited

1477-0024

DOI 10.1108/JITLP-02-2013-0002

JITLP

12,3

226

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 (Soumare

´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 develo pment

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 eco nomic growth.

Using ADF technique, regression analysis and graphical comparison, Nazir et al. (201 0)

provided empirical evidence that increase in market capitalization boosts the economi c

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

FDI and stock

market

development

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