Foreign Direct Investment – the Good, the Bad and the Ugly

Courting foreign investors in a dollar-starved economy is a rite of passage for every successive government. As we speak, pledges are being sought from Middle Eastern investors and efforts are underway to divest a batch of state-owned enterprises. And why not, one may ask. After all, some of the largest economies in the world such as US, China, Hong Kong, Germany or Netherlands are as much investor economies as investee economies. 

Indeed, where FDI results in the transfer of capital, technology and expertise to address a country’s unique pain points or generates employment and improves the balance of payment, it is a worthy pursuit. Yet, in Pakistan’s context, such benefits are vanishingly uncommon. Seven decades of ad hoc policies ushering investments, and fifty billion in FDI dollars later, there is nary a sector that is regionally competitive without subsidies or trade protections. Past experiences from across industries, whether consumer goods, communications or utilities suggest that when left on their own, manufacturing enterprises gravitate towards trading and the service industry lets the quality degrade to avoid reinvesting in people, processes, and infrastructure. Meanwhile, the overall economic activity continues to be defined by a conspicuous absence of food security, energy security, human development, and climate action – a state of deprivation made worse only by the hard currency demands of these businesses. 

Just as government policies on investments are often motivated by political expediency rather than long-term capacity building, unsurprisingly, the capital we tend to attract is similarly opportunistic. Annual foreign direct investments in excess of a billion dollars a year began entering the country in the early 2000s. A third of this capital propped up the power infrastructure, which has historically offered a wide range of incentives to investors including guaranteed sales, dollar IRRs  in the 20% ballpark and favourable taxation. It would have been wonderful to report win-win outcomes for both the public and the investors, except that the consumers are now burdened by capacity payments owed to imported fossil-fuel based IPPs that are dispatched at half their available capacity. I can reach across the table and say that the governments did what had to be done to bring significant electricity generation capacity online within a relatively ambitious timeframe, but the caveat remains: there is still no energy security for Pakistan without access to and control over generation inputs. 

One doesn’t have to look hard to find other examples where short-termism of the policymakers has placed us squarely in the eye of the balance of payment storm for sectors that are not quite as strategic as energy. Take the automobile industry for instance, featuring on the priority list of the Board of Investment, where capital was solicited under the Automotive Development Policy 2016-21. To assess the efficacy of such FDI through the balance of payment lens, we can look at a typical assembler’s transactions with their stakeholders, that is, capital providers, contractors, customers and input suppliers during the business lifecycle. 

Let’s begin with cashflows during the investment and pre-commissioning period. For most capital-intensive projects, it is a fair assumption that the engineering, procurement and construction contract would be awarded to experienced international firms who are often subsidiaries or affiliates of the offshore investor. The contracts would be remunerated in dollars and be 50%-70% of the total capital cost of the undertaking. We also expect that these projects would be leveraged such that the debt component would pay for 50%-80% of the assets of the company. A back of the envelope calculation indicates that for every $100 in invested equity, there is an outflow of $100 to $350 for imported equipment and technical services, from the get-go. Note that I haven’t even considered joint venture arrangements where the foreign equity component is actually a fraction of the total investment, nevertheless entitling them to sell components, spares or fully built vehicles to the Pakistan operations under long-term contracts.  

The next cash outflow on the agenda is the return on capital owed to foreign investors, which like the initial investment, is independent of the nature of the business. Since Pakistan is a frontier market with a high degree of political risk, macroeconomic imbalances, precarious security situation and questionable infrastructure, the return levels that incentivize foreign investors tend to be in the double digits with typical payback periods averaging at five years or lower while profit repatriation would happen throughout the life of the business. So again, hard currency outflows far exceed the original investment inflows when considered over longer time horizons. 

The litmus test for long-term desirability of these enterprises is in how they impact the trade gap during their operations phase. There are four possibilities that determine whether the business is a net consumer or producer of dollars: 

A: The inputs are paid for in rupees and sales are also generated in rupees

B: The inputs are paid for in rupees and sales are generated in dollars

C: The inputs are paid for in dollars and sales are generated in dollars

D: The inputs are paid for in dollars and sales are generated in rupees

It is easy to see that B is the most favourable scenario. A & C are quite acceptable, while D spells trouble. Any CBU and CKD kit reliant automobile assembler would fall squarely in category D, even before we consider secondary effects such as putting more gasoline-chugging, carbon-emitting, private vehicles on our crumbling roads. 

A review of data from the State Bank of Pakistan provides support for this thesis. The cumulative Net FDI in all sectors of the economy during the seven years from 2016-2022 has been $15.2 billion, while profit repatriation was $11 billion. Foreign inflows in the power sector were estimated at $5 billion while $7.6 billion worth of equipment was imported, some of it for renewable energy and indigenous coal-based plants. Data for auto industry’s initial capex is not identified separately by the SBP but their operating inputs, being CKD kits, stood at $9.4 billion for the same period. 

My analysis would not be so grim, had Pakistan been an attractive market, with far more greenbacks flowing in with each passing year, than leaving the ecosystem. Or if we were building our own turbines or industrial robots or self-winding watches. Or tens of thousands were being employed at a decent living wage and upskilled. Or if the businesses were so competitive, that they would export their output globally and pay meaningful taxes too. 

This gap between what could have been and isn’t, makes it clear that the “Come one, come all!” approach to FDI needs a rethink. The policymakers must discriminate and direct incoming funding to sectors that align with the country’s long-term goals for economic prosperity, preferably in areas where we have or could acquire a competitive advantage. Investors must also be held to standards of conduct, to not indulge in exploitative business practices on product or service pricing, or wages and working conditions, or contribute to environmental degradation. Should they acquire significant market power, one must remember Russia as a cautionary example where at least a thousand foreign firms curtailed operations recently, leaving significant gaps in provision of goods and services. 

Let’s qualify investors based on their value proposition: Ask not what this country can do for them, ask what they can do for this country.