Caspian Journal of Applied Sciences Research, 2(3), pp.

117-127, 2013
Available online at http://www.cjasr.com
ISSN: 2251-9114, 2012 CJASR

Full Length Research Paper

Foreign Direct Investment (FDI) in Pakistan: Measuring Impact of Cost of War

Against Terrorism, Political Instability and Electricity Generation
Afza Talat 1, Anwar Zeshan 2
1
COMSATS Institute of Information Technology, Lahore
2
COMSATS Institute of Information Technology, Sahiwal
(PAKISTAN)
*Corresponding Author: Anwar Zeshan, zeshan@ciitsahiwal.edu.pk

Received 21 December 2012; Accepted 24 February 2013

Foreign Direct Investment (FDI) was proven to be a significant source of investment for developing countries
which helps to bridge saving-investment gap, creation of employment opportunities, transfer of technology, and
ultimately increasing economic growth of the host countries. This study empirically investigated the
determinants of FDI for Pakistan for the period 1980 to 2010 by using annual secondary time series data. The
study for the first time tested the impact of cost of war against terrorism, political instability, electricity
generation, (along with the control variables of market size, inflation rate, exchange rate stability, trade openness
and incentives provided to investors) on FDI inflows in Pakistan by using both ARMA model and ordinary least
square regression technique. As expected, the estimated results confirmed that the war against terrorism and
political instability had negative impact whereas electricity generation had a positive impact on FDI flows in
Pakistan. Among the control variables market size, exchange rate stability, trade openness and incentives
provided to investors had positively influenced the FDI whereas the inflation rate shown a negative relationship
with foreign direct investment flows.

Key words: Foreign direct investment, Pakistan, cost of war against terrorism, political instability, electricity
generation.

1. INTRODUCTION by different countries to attract and benefit from

During the last couple of decades, much has been
written and discussed about the role and
decisiveness of foreign direct investment in the
context of its contribution to the growth of
developing economies. FDI not only provides
developing countries with the much needed capital
for investment, it also enhances job creation,
managerial skills as well as transfer of technology.
All of these ultimately contribute to the economic
growth and development (Wafure and Nurudeen,
2010). Developing countries are motivated enough
to contest in attracting the foreign investment in
order to foster and regulate the industrial sector in
their respective countries. Policies are being
framed, amended, and regulated in order to make it
convenient for foreign investors to make
investment in these countries. Fortunately or
unfortunately, few nations benefited in attracting
foreign investment and few started suffering. This
situation leads to pondering on the issue of
investigating the reasons behind, while evaluating
the nature of the strategies and policies formulated
this phenomenon. Developing countries face the
dilemma of saving-investment gap and thus foreign
direct investment may be helpful in fostering
economic growth by bridging this gap, transferring
innovative and advanced technology and escalating
productivity, creation of employment and also
increasing competition. FDI has proven to be a
breath providing factor to third world countries to
strengthen their national markets. Therefore, most
of the developing countries are very keen to attract
more inflows of FDI.
FDI is very crucial for the economic growth of
Pakistan as well since its economy faces the
dilemma of saving-investment gap. Pakistan does
not have sufficient internally generated sources to
maintain the tempo of economic activities,
therefore, FDI is very important to complement the
domestic investment in order to achieve economic
objectives. FDI is crucial for Pakistan in order to
finance development projects, strengthening
industrial sectors, increasing employment
opportunities, attaining improved technology,
enhancing domestic managerial skills, enhancing

117
 Talat et al.
Foreign Direct Investment (FDI) in Pakistan: Measuring Impact of Cost of War Against Terrorism, Political
Instability and Electricity Generation
productivity and output, improving balance of
payments, improving foreign exchange reserves,
improving physical infrastructure and human
resources and ultimately achieving higher rate of
economic growth.
Economy of Pakistan has been under severe
economic pressure because of War against
Terrorism, which is expanding for the last four
years in Afghanistan. Since 2006, that War has
spread like contamination in Pakistani areas and it
has cost us more than 35,000 people, 3,500
security staff, infrastructural destruction, millions
of citizens internal migration, deterioration of
investment environment, huge decline of
productivity, rising unemployment and especially
decline of economic activity (Economic Survey,
2010-2011). Pakistans economy has not
experienced such a destructive economic and
social turmoil ever before. Pakistan is continuously
paying serious price both in security and economic
terms and a larger proportion of its resources is
being utilized for this war since the year 2000.
Pakistans economy is bearing massive direct and
indirect costs, which have risen from $ 2.669
billion during 2001-2002 to $ 13.6 billion during
2009-2010, and are expected to reach at $ 17.8
billion during 2010-2011 (Economic Survey, 2010-
2011). During the last 10 years, direct and indirect
costs of war against terrorism for Pakistan are $
67.926 billion (Economic Survey, 2010-2011).
Investments to GDP ratio of Pakistan has dropped
from 22.5 % during 2006-2007 to 13.4 % during
2010-2011 and it also has severe affects on
economys job creating capacity (Economic
Survey, 2010-2011). Current security conditions
are the crucial determinant of present and future
FDI flows. Based on facts and figures, it is
expected that cost of war against terrorism is
significantly influencing FDI inflows in Pakistan.
Poon (2000) argued that MNCs select a location
that is politically stable for investment. Thus,
stability of political environment in a country is a
major factor for MNCs while selecting their
investment destination. Since its independence in
1947, Pakistan is facing the problem of political
instability which hinders inflows of FDI in
Pakistan. Akhtar (2000) has mentioned that
political instability has been a common
phenomenon in Pakistan and affecting almost all
sectors of the economy and also deteriorating
investors confidence on Pakistans investment
environment. Domestic as well as foreign investors
are hesitant to make investments in Pakistan due to
its unstable political environment. Investors are
uncertain about their future return on investment
118
due to the volatile political conditions and
therefore, are unwilling to undertake investment
projects in Pakistan. Hence, it can be hypothesized
that political instability in Pakistan is also
adversely affecting FDI inflows.
Another major current challenge being faced by
Pakistan is the electricity shortfall resulting in load
shedding. Load shedding of electricity in Pakistan
has risen manifold and is severely affecting all
sectors of the economy including FDI inflows.
Although the Government assured that the load
shedding will end by the end of 2009, whereas it
has been doubled in comparison to 2009.
Government has been unsuccessful in fulfilling
their promises and therefore, investors are hesitant
to make investment within Pakistan. It is one of the
major issues in Pakistan and also expected to affect
FDI inflows significantly as the domestic and
foreign investors are shutting down their industrial
units since it is impossible to sustain without the
provision of electricity.
A remarkable growth for world FDI has been
witnessed during the last 20 to 25 years. Aggregate
FDI stock amounted to merely 6.6 % of world
GDP in 1980, whereas, it has risen to nearly 23 %
in 2003 (UNCTAD, 2004). World FDI inflows
during 2010 accomplished a projected amount of
$1,244 billion (UNCTAD, 2010) representing a
smaller rise from 2009 position of $1,185 billion.
The FDI growth within developing economies
grew from $ 2.4 billion annually in year 1962 to
about $ 17 billion in year 1980. Flows of
developing nations grew by 40% ($ 233 billion)
during 2004. Consequently, their portion of
aggregate FDI stock was recorded at 36% which
is the highest percentage since year of 1997.
Contrary to the developed region and transition
economies where FDI flows declined during the
year of 2010, FDI flows mounted by 12 % (i.e. $
574 billion) in developing countries during 2010.
Pakistan has received relatively greater FDI
flows during the last two decades, because of its
market oriented investment strategies and
investment enabling environment. Because of the
restrained investment strategies, FDI flows were
meager upto 1991; though, it gradually went up
during post liberalization era (Khan, 2000). FDI
improved from $ 23 million during 1970 to $64
million during 1980 (UNCTAD, 2010). The
second spur took place during late 1980s, when
government eliminated restrictions for flows of
capital, ownerships and transfer of remittances.
The time period after 1988 is associated with
privatization and liberalization processes which
helped in accelerating FDI inflows from $ 110
 Caspian Journal of Applied Sciences Research, 2(3), pp. 117-127, 2013
million during 1987 to $ 711 million during 1997
(Husain, 1999). These flows declined by $ 183
million during 2000. There is a major rise in
capital inflows since 2004 where FDI amounts
reached to $ 5.4 billion during 2008, representing
443 % increase in comparison to 2004; but, just
0.26 % greater than 2007. FDI flows had a
decreasing trend tendency after 2007.
Consequently, during 2009 FDI amounted to $
3.21 billion, presenting a 51.1% decrease as
compared to 35.3% decrease in previous year.
Overall, Pakistan has a lot of potential for
attracting FDI. Even though growth in FDI trend
for several sectors reveals policies success;
however, FDI flows significantly slowed down
because of the worsening security conditions,
institutions weaknesses, corruption, political
instability, weaker regulatory structures, and
unstable global political relationships. The present
study therefore, aims at exploring the relationship
of cost of war against terrorism, political
instability, electricity generation, market size,
inflation rate, exchange rate stability, trade
openness and incentives provided to investors with
inflows of FDI in Pakistan for the period of 1980
to 2010 through Ordinary Least Squares (OLS)
regression technique.
The rest of the study has been organized as
follows: section two presents literature review,
section three explains materials and methods
whereas results have been explained in section four
and section five presents the discussions.
2. LITERATURE REVIEW
A number of perspectives and theories have been
established to explain the pattern and level of FDI
since the late 1950s. Both empirical and theoretical
research on the motivation for FDI and the
formation of multinational enterprises (MNEs) has
emphasized and pointed out different variable
effecting FDI flows. Given that there are numbers
of theoretical models which explain FDI flows, a
number of variables have been tested in empirical
studies to ascertain their impact on FDI.
For instance, Tcha (1999) explored the
determining factors of Australian FDI flows
utilizing a combination of country-specific and
aggregate quarterly pooled data (six developed
economies including the US, the UK, Japan, New
Zealand, Germany and Canada). In quarterly FDI
model, labor disputes and real exchange rate were
the only two determining variables. Whereas, in
country-specific model of FDI, volatility of
exchange rate, home countrys current account
119
balance and dummy variable for the Canadian
investment were significantly negative. Yang et al.
(2000) analyzed the quarterly FDI inflows to
ascertain the important determinants of Australian
FDI. The change in the host countrys interest rate,
changes in wage rates and industrial disputes
enhanced FDI flows, whereas lagged inflation and
openness decreased these flows.
Fuat and Ekrem (2002) investigated the
determinants of FDI inflows in Turkey for the
period of 1980-1998 by using Johansen co-
integration technique. The study found that the
host countrys market size, infrastructure,
attractiveness of domestic economy and openness
of economy were positively related to inflows of
FDI. The results had further shown that instability
of exchange rate negatively affect FDI, whereas
the variable representing instability of economy
had negative but insignificant relationship with
FDI inflows. Fedderke and Romm (2004) probed
FDI determinants within South Africa by utilizing
cointegration along with error correction
techniques. Their findings demonstrated that
political risk, property rights, market size, labor
cost, openness and corporate tax rates were
important variables in attracting FDI. Elijah (2006)
examined the locational factors of FDI inflows in
Kenya by applying Johansen co-integration, OLS
and ECM techniques. The study found that
openness of economy and human capital had
positive effect on inflows of FDI in the shorter
time period. But real exchange rate and inflation
had negative relationship with FDI inflows in the
long-run and short-run respectively. Moolman et.
al (2006) focused on the supply side determinants
of FDI in South Africa for the period 1970-2003.
The findings pointed that openness, size of market,
nominal exchange rates and infrastructure were the
variables which policy makers in South Africa
should concentrate on while striving to attract FDI.
Sinha (2007) in his thesis focused on what the
emerging economies (India) could learn from
leader economies (China) for inviting FDI flows.
He compared FDI inflows in India and China and
found that India had developed because of its
human capital, market size, political stability and
market growth rate. Whereas, in case of China,
congenial business climate variables consisting of
creating strategic infrastructure, making structural
changes, undertaking strategic policy initiatives for
providing economic freedom, creating flexible
labor laws and opening up of its economy were
recognized as significant factors for attracting FDI.
Mottaleb (2007) identified influential variables of
FDI in 60 developing nations through OLS
 Talat et al.
Foreign Direct Investment (FDI) in Pakistan: Measuring Impact of Cost of War Against Terrorism, Political
Instability and Electricity Generation
methodology for period of 2003-2005. He
confirmed that more GDP, larger growth rate of
GDP, friendly business environment and
infrastructure effectively attracted FDI. Demirhan
and Mascan (2008) explored determining variables
of FDI inflows within 38 developing nations
through regression analysis covering period of
2000-2004. Results revealed that per capita GDP
growth rate, telephone lines per 1,000 persons and
openness had significant and
positive relationship, while taxation rates and
inflation had significant but negative association
with FDI inflows.
Masuku and Dlamini (2009) investigated
locational variables of FDI in Switzerland by
utilizing Cointegration along with ECM techniques
over period of 1980-2001. The authors concluded
that internal and external economic stability,
infrastructure and economys openness had
positive correlation whereas home market size and
domestic market attractiveness had negative
correlation with FDI stock. Yol and Teng (2009)
explored short run and long run domestic variables
affecting FDI in Malaysia through cointegration
econometric analysis covering period of 1975-
2006. The results depicted that GDP, exchange rate
and infrastructure positively whereas exports
negatively affected FDI in long run. In short run,
GDP, infrastructure and exports negatively
whereas exchange rate and openness positively
influenced FDI. Sen and Mohsin (2010) examined
the determinants and problems which decelerated
FDI stock in Bangladesh for period from 1986 to
2008. They discovered that inferior infrastructure,
urban violent activities, political disturbances,
inconsistency of economic policies and
bureaucracy were the crucial deterrents of FDI.
Shahrudin et al (2010) analyzed FDI determinants
in Malaysia for period of 1970-2008 by using
ARDL framework. The study established that GDP
growth rate and money supply had positive and
significant correlation with FDI inflows.
Wafure (2010) observed the determining factors
of Nigerian FDI for period of 1977-2006 through
employing Error Correction Model (ECM)
technique. The results of the study stated that the
host countrys market size, deregulation of
economy and political instability had a positive
and significant effect on FDI, whereas the
exchange rate had negative and significant
relationship with FDI. Rihab and Lotfi (2011)
investigated important variables to determine the
level of FDI for 71 developing countries by
utilizing dynamic panel data technique for period
of 2001-2006. They found that GDP, human
120
resources, economys openness and governance
system quality had significant positive association
whereas individualism, hierarchal distance and
corruption control had negative association with
FDI inflows.
Researchers had also investigated various
factors which determine the level of FDI inflows in
Pakistan. For example, Akhtar (2000) analyzed
locational determinants of FDI. The author argued
that market size, exchange rate and relative interest
rate had positive and significant relationship with
FDI stock. Shah and Ahmad (2003) examined the
determinants of FDI for the period of 1961-2000
by applying Johansen co-integration which was
followed by Error Correction Model (ECM). The
author found that cost of capital had negative
relationship, while infrastructure, tariffs, market
size and political stability had positive relationship
with FDI inflows. Aqeel and Nishat (2004)
empirically identified the variables of FDI growth
in Pakistan for the period of 1961 to 2003. They
used co-integration along with error correction
techniques for identifying factors which influence
level of FDI. The results had shown that corporate
tax rate, import tariffs, exchange rate, devaluation
of rupee and liberalization measures had positive
and significant relationship with FDI inflows. Dar
et al. (2004) analyzed the explanatory variables
which determine the patterns of FDI flows in
Pakistan for the period of 1970-2002 through
applying ARDL econometric technique. The
variables which were considered in the analysis
consist of economic growth rate, economys
openness, stability of exchange rate, interest rate,
unemployment and political risk index. The
authors found that all the variables were significant
with expected signs to explain FDI inflows in
Pakistan. Azam and Luqman (2006) investigated
effects of a variety of economic factors on FDI
inflows into Pakistan, Indonesia and India for the
period of 1971 to 2005. The authors found that that
market size, infrastructure, trade openness,
domestic investment, return on investment had
significant and positive relationship while external
debt, indirect taxes had significant and negative
relationship with FDI inflows. Azam and Kahttak
(2009) evaluated the influence of political
instability and human capital on FDI stock in
Pakistan for the period ranging from 1971 to 2005
by utilizing least square method. This paper found
a positive and significant relationship between
human capital and FDI stock, while the
relationship between political instability and FDI
was positive but statistically insignificant.
 Caspian Journal of Applied Sciences Research, 2(3), pp. 117-127, 2013
Awan et al. (2010) evaluated the FDI
determinants for period of 1971-2008 by applying
co-integration and ECM econometric techniques.
The authors concluded that Gross Fixed Capital
Formation, inflation and level of trade openness
had statistically significant and positive impact on
FDI, whereas, current account balance had
statistically significant and negative impact on FDI
inflows in Pakistan. Awan et al. (2011) studied the
most important economic determining factors of
FDI flows within Pakistans commodity producing
sector for the period of 1996-2008. This paper
applied Error Correction Model (ECM) and Co-
integration techniques to estimate the explanatory
factors of FDI inflows. The study found that GDP,
GDP real growth rate in commodity producing
sector, foreign exchange reserves, gross fixed
capital formation, per capita income and trade
openness had positive signs with FDI inflows
within Pakistans commodity producing sector.
Hakro and Gumro (2011) observed the
determinants of FDI in Pakistan for the period of
1970-2007. Four broad groups of variables had
been tested to determine their relationship with
FDI which consisted of cost related variables
(wage rate, foreign exchange rate and interest rate);
factors improving investment environment
(liberalization and economys openness); macro-
economic variables (output growth, human capital,
market size, and infrastructure quality);
development strategy, political stability, and
cumulative risk rating together with structural
shocks related to 1988, Nuclear tests in 1999 and
event of Sept. 11, 2001. The results suggested that
the macro-economic factors, cost related factors
and cumulative risk index factors as the key
determinants in short-term analysis. The finding
also suggested that there was a long run
relationship among FDI, macro economic variables
and openness.
Currently, Pakistan is facing severe problems of
cost of war against terrorism, political instability
and electricity generation and these factors are
expected to affect level of foreign direct
investment as foreign investors are losing
confidence on Pakistans economic and political
environment. After reviewing existing literature on
determinants of FDI, it can be observed that there
is a dearth of literature which investigated these
variables as determinants of foreign direct
investment in general and for Pakistan in
particular. Therefore, this study for the first time,
intends to determine the relationship of cost of war
against terrorism, political instability, electricity
generation, market size, inflation rate, exchange
121
rate stability, trade openness and incentives
provided to investors with inflows of FDI in
Pakistan for the period of 1980 to 2010 through
Ordinary Least Squares (OLS) regression
technique.
3. MATERIALS AND METHODS
The data for the period 1980 to 2010 has been
collected from reports of State Bank of Pakistan
(SBP), Board of Investment (BOI) Pakistan,
Economic Surveys of Pakistan, Federal Board of
Revenue (FBR) Pakistan and Federal Bureau of
Statistics (FBS) Pakistan, World Bank
Development Indicators, IMF, USDA/ERS
International Macroeconomic Database and United
Nations Statistical Division Database. First of all,
descriptive statistics have been calculated for
dependent and Independent variables. Correlation
matrix has been calculated to analyze the
prevalence of correlation among the variables. The
time series nature of the data has made it essential
to check the stationarity of the data, therefore,
stationarity of the data has been measured through
Augmented Dickey-Fuller (ADF) Unit Root Test.
The Least Squares regression model has been used
for measuring the relationship of FDI inflows with
cost of war against terrorism, political instability,
electricity generation, market size, inflation rate,
exchange rate stability, trade openness and
incentives provided to investors.
The following regression model has been stimated:
LnFDI = 0 + 1LnTerror + 2Pol + 3LnElec+
4RGDP + 5Trade + 6Exch + 7Inf + 8Incen +
Ut
Where:
LnFDI = Inflows of foreign direct investment in
million rupees
LnTerror = Cost of war against terrorism in
million rupees
Pol = Value of 0 for civilian rule and value
of 1 for military rule
LnElec = Electricity production in KWH
RGDP = Real growth rate of gross domestic
product in percentage
Trade = Trade openness calculated as ratio of
exports to Imports
Exch = Annual growth rate in exchange rate
of Rupee / $
Inf = Annual rate of inflation in percentage
Incen = 1 for the period of 1989 to 2010, 0
otherwise
4. RESULTS
 Talat et al.
Foreign Direct Investment (FDI) in Pakistan: Measuring Impact of Cost of War Against Terrorism, Political
Instability and Electricity Generation

First of all, the time series nature of the data had
made it essential to analyze the stationarity of the
variables. Therefore, before estimating the
regression model, the Augmented Dickey Fuller
(ADF) unit root test had been performed to check
the stationarity of the dependent and independent
variables. The results of the ADF unit root test had
been presented in table 3:
The results of table 3 shown that variables of
Foreign Direct Investment (FDI), electricity
generation, real growth rate of GDP, exchange rate
and inflation rate were stationary at level, whereas
variables for cost of war against terrorism and
trade openness were stationary at first difference.
After testing stationarity of the variables, the
ARMA model had been employed to determine the
relationship of cost of war against terrorism,
political instability, electricity generation, real
growth rate of GDP, trade openness, exchange rate
stability, inflation rate and incentives provided to
investors with FDI inflows in Pakistan. Least
Squares method had been used for estimation of
ARMA parameters. The results of ARMA model
had shown that the moving average term for
dependent variable i.e. LnFDI(-1) had insignificant
coefficient, indicating that FDI lag value was not
affecting FDI inflows in case of Pakistan.
Therefore, ARMA method was not appropriate in
this case, and consequently, Ordinary Least
Squares (OLS) regression model had been
employed to estimate the relationship of FDI
inflows with independent variables. The values of
adjusted R-square, log likelihood, F-statistic and
Durbin-Watson statistics had also shown that the
results of OLS regression model were better than
results of ARMA model. Therefore, OLS
estimation results had been presented in the table
4.
Estimated results of regression equation
demonstrated that the value of Adjusted R-square
was 0.95 which indicated that the independent
variables in the regression equation had explained
about 95 percent variations occurring in inflows of
foreign direct investment for Pakistan. The value
of Durbin Watson statistic for this regression
model was 2.37 which indicated that the
mathematical form of the regression equation was
accurate and also absence of autocorrelation
among the variables used in the regression
equation. The value of AIC for this regression
model was 0.78, which indicated that the model
had substantial support for relative goodness of fit
and highly capable of being utilized for making
inferences.

Table 3: ADF Stationarity Unit Root Test for Variables

T-ADF
Variables Critical Values Decision
Statistics

1% level = -4.356068
-4.843915
LnFDI 5% level = -3.595026 Stationary at level
(0.0033)
10% level = -3.233456

1% level = -3.679322
-5.444722 Stationary at 1st
LnTerror 5% level = -2.967767
(0.0001) difference
10% level = -2.622989
1% level = -3.670170
-4.488018
LnElec 5% level =-2.963972 Stationary at level
(0.0013)
10% level = -2.621007
1% level = -3.670170
-4.032378
RGDP 5% level =-2.963972 Stationary at level
(0.0041)
10% level = -2.621007
1% level = -3.679322
-5.423869 Stationary at 1st
Trade 5% level = -2.967767
(0.0001) difference
10% level = -2.622989
1% level = -3.670170
-4.113373
Exch 5% level = -2.963972 Stationary at level
(0.0033)
10% level = -2.621007
1% level = -3.711457
-3.753901
Inf 5% level = -2.981038 Stationary at level
(0.0091)
10% level = -2.629906

122
 Caspian Journal of Applied Sciences Research, 2(3), pp. 117-127, 2013

Table 4: OLS Regression Estimates

Dependent Variable: LNFDI
Method: Least Squares
Included observations: 31 after adjustments

Variable Coefficient Std. Error t-Statistic Prob.

LNTERROR -0.009942 0.020866 -0.476471 0.6384

POL -0.586467 0.301843 -1.942954 0.0649 ***
LNELEC 2.524508 0.315306 8.006535 0.0000 *
RGDP 0.097663 0.035629 2.741119 0.0119 **
TRADE 0.126975 0.026525 4.786925 0.0001 *
EXCH 0.023206 0.011460 2.024926 0.0552 ***
INF 0.016170 0.026123 0.619001 0.5423
INCEN 1.037961 0.384701 2.698095 0.0131**
C -25.24071 3.419254 -7.381934 0.0000*

R-squared 0.966203 Mean dependent var 5.965065

Adjusted R-squared 0.953913 S.D. dependent var 1.478668
S.E. of regression 0.317437 Akaike info criterion 0.780626
Sum squared resid 2.216859 Durbin-Watson stat 2.366091
Log likelihood -3.099705
F-statistic 78.61873
Prob(F-statistic) 0.000000

* Significant at 1 Percent.
** Significant at 5 Percent.
*** Significant at 10 Percent.

The estimated results had shown that the cost of
war against terrorism had a negative sign as
expected which was consistent with results of
Agrawal (2011) who investigated the impact of
terrorism on FDI inflows and reported that
transnational terrorism events negatively affect
total FDI inflows in developed countries. In case of
Pakistan, this variable had insignificant
relationship with inflows of FDI which might be
due to the fewer observation for cost of war against
terrorism for 10 year i.e. from year 2001 to year
2010. However, it confirmed the expectation that it
is one of the major hindrances in attracting
overseas investors and foreign direct investment in
Pakistan as the foreign investors were facing
security threats and they are also uncertain about
return on their investment.
The results also revealed that political
instability had a negative and significant affect on
inflows of FDI as anticipated. This result was
similar to the results of Azam and Khattak (2009).
The investors made investment in only those
countries where they believed that their capital
investment and return on that investment would be
safe and sound. But unfortunately, Pakistan
constantly faced the dilemma of instable political
environment, therefore, foreign investors were
hesitating to make investment in Pakistan because
of political instability.
The electricity generation was positively and
significantly affecting the inflows of FDI in
Pakistan as expected. The high coefficient for
electricity generation indicated the magnitude and
effect of electricity generation for attracting FDI
inflows. Pakistan was continuously unable to
generate sufficient quantity of electricity to fulfill
the existing demand for electricity. The shortfall in
the supply of electricity resulted in electricity load
shedding and causing all sorts of troubles for
businesses as well as residents of Pakistan. The
business and industrial units were not able to
survive and a large number of businesses were
shutting down their production units resulting in
outflows of capital investment from Pakistan.
The market size had significant and positive
role in attracting inflows of FDI into Pakistan. This
result is consistent with findings of Azam and
Lukman (2006), Awan et.al. (2010) and Azam et.
al., (2011). The estimated results further revealed
that trade openness of the Pakistans economy also
had a positive and significant relationship with
inflows of FDI in Pakistan. This finding

123
 Talat et al.
Foreign Direct Investment (FDI) in Pakistan: Measuring Impact of Cost of War Against Terrorism, Political
Instability and Electricity Generation

corresponds with findings of Dar et.al. (2004),
Azam and Lukman (2006) and Awan et.al. (2010).
Moreover, the estimated results also disclosed that
exchange rate stability had a positive and
significant effect on FDI. This result is in align
with the findings of Aqeel and Nishat (2004) and
Dar et.al. (2004) that appreciation of exchange rate
encourages FDI within host economy.
Another finding of regression results was that
the fiscal incentives provided by the Pakistani
government were positively associated with
inflows of FDI, was significantly attracting FDI.
This finding corresponds with results of Aqeel and
Nishat (2004) and Wafure and Nurudeen (2010).
Finally, the variable of inflation rate had positive
association with inflows of FDI which was
contrary to its expected sign but this relationship
was statistically insignificant. This finding is
consistent with the findings of Azam and Lukman
(2006).
The regression diagnostics have been estimated
to verify and support the regression results. First of
all, normality of the data has been tested through
One-Sample Kolmogorov-Smirnov Test. The
results have been shown in table 5:
The results of One Sample Kolmogorov-
Smirnov Test indicates that the data has normal
distribution because the P-Value is 0.949 which is
greater than 0.05, therefore, the hypothesis
regarding normality of data has been accepted. As
mentioned above, the value of Durbin-Watson
Statistics is 2.366092 which depicts that that the
observations are independent of each other as the
values is within acceptable range of 1.5-2.5.
Secondly, to check collinearity of predictors,
Variance Inflation Factor (VIF) Values have been
estimated and the results have been shown in table
6:

Table 5: One-Sample Kolmogorov-Smirnov Test

Unstandardized Residual
N 31
Normal Parametersa Mean .0000000
Std. Deviation .27183687
Most Extreme Differences Absolute .094
Positive .092
Negative -.094
Kolmogorov-Smirnov Z .521
Asymp. Sig. (2-tailed) .949
a. Test distribution is Normal.

Table 6: Coefficients Table

Variable Collinearity Statistics
Tolerance VIF
LnTerror .208 4.811
Pol .147 6.825
LnElec .097 9.305
RGDP .706 1.417
Trade .221 4.518
Exch .669 1.495
Inf .320 3.127
Incen .107 9.381
a. Dependent Variable: LnFDI

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 Caspian Journal of Applied Sciences Research, 2(3), pp. 117-127, 2013
The results of Variance Inflation Factor (VIF)
have shown that the predictors dont have problem
of collinearty because the VIF Values for all the
predictors are less than 10, so it indicates that all
the predictors are acceptable. Thirdly, the results of
Studentized (Residuals) test have shown that there
is no outliar value in the data because all the values
are within acceptable range of -3 to +3. Finaly,
results of Cook-D Test have shown that there is no
influential value in the data as all values are less
then acceptable value of 1.
5. DISCUSSION
This study has investigated the determinants of
FDI in Pakistan including cost of war against
terrorism, political instability, electricity
generation, real growth rate of GDP, tradeopeness,
exchange rate stability, inflation rate and
incentives provided to investors for the period
1980 to 2010 based on time series data. The results
indicate that the electricity generation, political
instability, market size, trade openness, exchange
rate stability and fiscal incentives provided to
investors have significant and positive relationship
with inflows of foreign direct investment whereas
variables for cost of war against terrorism and
inflation rate have insignificant relationship with
foreign direct investment.
The main contribution of this study is to
investigate, for the first time, the relationship of
cost of war against terrorism, political instability
and electricity generation with FDI inflows in
Pakistan since these variables have not yet been
focused in the existing literature. The estimated
results have shown that these variables are
affecting, as expected, FDI inflows in Pakistan.
Therefore, these variables need to be focused in
order to attract more FDI inflows.
Based on empirical findings, the following
recommendations have been put forward in order
to attract more inflows of FDI in Pakistan:
First of all, the regulatory authorities and policy
makers should take some concrete measure in
order to reduce the cost of war against terrorism
and improve the security conditions in the country.
In this context, some sincere governmental policies
and efforts are required to bring the country out of
this problem and increase the foreign direct
investment in Pakistan. Secondly, the government
should strengthen political institutions and adopt
democratic principles for ensuring stability of
political environment which may lead to increased
FDI inflows.
125
Thirdly, Pakistan should take some effective
measures to increase electricity generation on
urgent basis for improving economic conditions of
the country. The government should immediately
formulate policies aimed at increasing electricity
generation and implement these policies
effectively to restore investors confidence. It will
assist in improving economic and financial
conditions and also attract domestic and foreign
investors to make investment in Pakistan. Fourthly,
the market size is also a very important variable for
increasing inflows of FDI in Pakistan. Larger
market size and increasing GDP growth rate
indicates better market opportunities for foreign
investors to earn greater investment returns.
Therefore, efforts should be made to increase
market size and GDP growth rate for attracting
overseas investors.
Finally, the exchange rate of Pakistani rupee
should be strengthened in order to lure the foreign
investors and to attract more inflows of foreign
direct investment. Finally, more fiscal incentives
should be offered to the foreign investors along
with further deregulation of the economy for
attracting inflows of FDI in Pakistan.
Although this empirical investigation has
produced very interesting results however, there
are few limitations of the study. The data for cost
of war against terrorism in Pakistan has been
available only for the period of 2001-2010. Some
other appropriate proxy for cost of war against
terrorism in Pakistan can be used in the analysis
for a longer time period. The dummy variable has
been used in the regression model for measuring
the political stability in Pakistan. Some other
quantifiable proxy may be used for measuring
political stability.
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