Improving foreign investment climate

‘After a steep drop in 2020 and a strong rebound in 2021, global foreign direct investment (FDI) declined by 12 per cent in 2022, to $1.3 trillion. The slowdown was driven by the global polycrisis: the war in Ukraine, high food and energy prices, and debt pressures.

International project finance and cross-border mergers and acquisitions (M&As) were especially affected by tighter financing conditions, rising interest rates and uncertainty in capital markets.’ – An excerpt from the recently released ‘World Investment Report 2023’ by United Nations Conference on Trade and Development (UNCTAD)

As per this Report, FDI inflows in Pakistan averaged around a meager $2 billion during 2017-2022. This reflects a poor investment environment in the country. Moreover, there have been big dips in FDI inflows in both 2018 and 2022. Hence, in 2017 FDI inflows stood at $2.5 billion, which dropped by $759 million to $1.7 billion in 2018.

This may have to do with greater political instability during that time, not to mention the artificially appreciated rupee against the US dollar also disincentivizing investment decisions due to unnaturally (and hence unjustifiable) signals of higher domestic asset prices, and lower profitability.

Moreover, last year FDI inflows, as per the same Report, decreased by $808 million, when compared to 2021, to stand at $1.3 billion in 2022. This may likely have happened due to dwindling financial stability situation of the country, not to mention rising political instability, and in addition to overall global supply shock, high cost of capital, and ongoing war in Ukraine.

FDI inflows have been traditionally low, while foreign portfolio investment (FPI) has also been highly volatile, both because of underlying weak domestic economic fundamentals – although FPI is any way quite risky because of its hot money nature globally, and like in China and India, for instance, needed less policy attention, especially in terms of raising policy rate also to use this tool as a pull factor, and much stricter capital controls regime – and fast changing fortunes of political stability at the back of seriously weak political institutional quality in the country, with important factors like quality education, income inequality and poverty, and economic empowerment at low levels.

It is, therefore, important to approach foreign investment from a broad scope, then just the neoliberal mantra that Pakistan has continued to follow mostly both in or outside of the International Monetary Fund (IMF) programme.

An analysis below indicates the variables at play, and also the cross-cutting nature of economic objectives having quite a singularity kind of basis – attaining one objective like enhancing exports, or improving large-scale manufacturing, or reducing the supply-side bottlenecks, or lessening imported inflation, or decreasing twin deficits, are not only correlated in terms of the capacity of inter-pay with each other, but also policy choices affect all of them, including foreign investment, in similar ways.

Economic exchange depends on production of goods, and services. The value of that production, in turn, depends upon its quality; determined both in terms of extent of innovativeness, and expenditure efficiencies. Price of the product – whether goods or service – therefore depends on value, in addition to profit margins, and also underlying transaction costs involved in the production process.

Here, transaction costs arise as a response to expenditures made to inspect and gather information regarding the production process, and in making sure that all the economic agents involved in the production process abide by all the contractual obligations.

Economic institutional quality, or the quality of economic ministries at the federal level – or departments in the case of totally devolved constitutional subjects to the provinces – therefore, plays a pivotal role in setting out the laws, rules, and procedures that make up the economic environment under which organizations – for instance, state-owned enterprises (SOEs) in the public sector, firms in the private domain – both of which have hierarchical structures involved for production – and public-private partnerships –operate, in the setting of markets which, in turn, may also take place under more facilitative circumstances of special economic zones (SEZs).

Economic institutions provide the overarching governance and incentive structures which, in turn, determine the allocative and production expenditure efficiencies within an economy and, in turn, also help reduce the involved transaction costs; where under elite capture through unjustified initial distribution of property rights – like for instance, during the colonial times – lesser information asymmetries that they face due to the size and significant network effect that elites posses, and also due to disproportionately rising influence of elites on public policy, as a result of their increasing money contribution to election campaign funding of political parties.

The importance of a certain economic philosophy, whether neoliberal or social democratic for instance, comes to the fore here, both in terms of the extent of role of government in providing governance and incentive structures, and also in understanding the difference of overall pursuing economic institutional reform under a particular economic philosophy, and the nature and extent of structural adjustments in terms of governance and incentive structures, which a particular system will deliver.

For instance, China did not allow price shock therapy by opening up price decisions to purely market prerogative, but adopted ‘strategic price controls’ under an overall production strategy in its formative years, economy-wise, during the 1980s and 90s, a stage where Pakistan finds itself currently.

Under this economic policy, allocative priorities – for instance, which sectors to be given priority, given their underlying importance for the domestic production, exports, and foreign investment – and in bringing expenditure efficiencies, in an effort to both diversify economic production horizon of both goods and services, and also to keep cost of production, including transaction costs, low.

Hence, China used this strategy, which flowed from its not adopting neoliberal policy, but by meandering between capitalism and social, or social democracy, similar to the path adopted by Scandinavian countries, also called the ‘middle-way’ between capitalism and socialism, where both the countries primarily ran SOEs, and also managed private sector to insulate citizens from over-profiteering and short-termism; with benefits in terms of greater economic diversification, and resilience, and in terms of diminishing creation and perpetuation of elite capture.

Economic institutions – or ministries, or departments in the case of having complete autonomy over a certain constitutional subject like health or education, among others – need to provide good level of governance structures, and incentive structures to improve the working of underlying organizations, SOEs and private sector firms.

Governance structures primarily include far better technocratic basis of government servants, where it is being argued that the current duality in the shape of civil service should be replaced with one unified government service, with normal and fast streams – on the style of UK’s civil service, for instance –within it.

Certain sectors of the economy such as agriculture, textile, minerals, etc. need to be selected, given a good performance depth of these sectors, on one hand, and another set of sectors selected under this thought process like IT, artificial intelligence, among others, to diversify the economy in an overall effort to make it more resilient, especially in a world with polycrisis.

For this, markets specifically underlying these sectors need to be regulated with greater government intervention in strategic price setting, while an overall price commission may also be set up to improve upon pricing mechanisms to control over-profiteering, especially by middle-men, and to reduce transaction costs. Also, SEZs created and improved upon.

On the incentive structure side, fixing the markets in terms of reducing information asymmetries, fixing the price of effort (or wages/incomes) and keeping level of profits to reasonable domains across the real, and financial sectors, along with targeted subsidies, better quality of government service, and more one-window facilities will in turn provide a much-needed impetus to not just foreign investment but also domestic investment.

Moreover, stricter monitoring and greater role of government regulation of markets, SEZs, and SOEs will not only bring greater allocative and productive efficiency, and alignment with long-term objectives of the economy, but will also bring greater economic resilience and better quality of democracy.

Through more progressive taxation, reasonable level of banking spread, and lesser monetary- and fiscal austerity will also serve as important incentive structures, which among other things will create greater certainty with regard to policy, improved supply change, more spread-out aggregate demand across the country, and low cost of capital – all important foreign investment pull factors, not to mention their positive impact in terms of creating more inclusive economy.

Also, tax breaks on investment with regard to green, clean energy and economy, and low-cost capital, even more subsidized for such projects, are other important incentives for foreign and domestic investment. Lesser information asymmetries, and overall reduced transaction costs through better governance structures will further incentivize greater investor participation.

The above tries to throw light on economic policies that highlight the need for moving away from market fundamentalism, wrongly premised on virtually unbounded economic agents’ rationality, and overall Neoliberalism, and towards a more social democratic, entrepreneurial state, economic policy framework, which also has much-needed broadness of improving upon cost of doing business, or private sector facilitation.

For instance, under an entrepreneurial state, government is not only seen as a market facilitator, reacting only to fix market failures, and not doing much to deal with over-profiteering and short-termism, under the neoliberal mantra – also having centrality in Bretton Woods institutions – that market knows best, and which sees privatization as a panacea, and not learn from the serious misgivings of privatization over the years, in an overall environment of weak regulation and low-capacity governments due to years of reliance on outsourcing major functions.

Instead, an entrepreneurial state actively participates in economic exchange decisions, and protects the interest of its citizens from private sector’s over-profiteering mindset. Also, given the precarious level of economic situation, the government should approach investment enhancing reforms, as part of the overall reform strategy, to adopt a ‘mission-oriented’ approach. Routine will not do.

It is imperative that the government should also pay attention to renowned economist Mariana Mazzucato’s thought emphasis, whereby she championed the need for an entrepreneurial state in terms of emphasizing this over the years, and also the need for adopting a mission-oriented strategy, just like it was taken during President Kennedy’s tenure, to successfully plan for landing on the moon within a decade.

It is in this spirit that the government may have to formulate an ‘economic war council’ and to create organizational structures like ‘Pakistan Development Bank’, and even a specialized ‘Ministry of Economy’ to create this mission-oriented spirit, to both get involved in the economy properly, and to take along the private sector and the foreign investors appropriately.

It may be indicated that the writer has written in detail on the suggested organizational structures, among other topics above, in his previous contributions to this newspaper.

Copyright Business Recorder, 2023