Given its fragile balance of payments position and urgent need to boost industrial production, Pakistan needs to significantly increase its mobilisation of foreign resources. However, long-term official assistance will become increasingly scarce, while promoting large portfolio investments is not a proper policy option due to Pakistan's underdeveloped and narrow capital market. Significant increases in commercial borrowings are also not desirable. It is, therefore, crucial to accord high priority to foreign direct investment (FDI).

The inflow of FDI into Pakistan is small and concentrated only in a few areas, mostly in the power sector. In 1997, Pakistan accounted for 0.2 percent of world FDI, less than one percent of developing country and Asian country FDI, and 18 percent of South Asian countries. In spite of liberalising its formerly inward-looking FDI regime, tempering or removal of obstacles to foreign investors, and according various incentives, Pakistan’s performance in attracting FDI has been lacklustre. Why could the state not succeed in attracting sufficiently large FDI, despite liberalising its payments and exchange regime as well as inward FDI regime?

A relatively large inflow of FDI into the power sector since 1995 has created some adverse effects, most important of which was the large increase in imports of capital goods for the construction of power plants, and the ongoing conflict between the government and foreign independent power producers (IPPs) on the power rate the government needs to pay to the IPPs under the purchase contract.

Another negative effect of FDI concentration on the power sector was that as the remittances by IPPs began to increase, it severely constrained the balance of payments given that foreign exchange earnings through exports of goods and services remain low. From this undesirable pattern of FDI in Pakistan, very important lessons could be drawn for developing economies: they should be careful in allowing a large amount of FDI to non-foreign exchange earning sectors during a short period of time; and FDI should be promoted in the foreign exchange earning sector at the initial stage and to the domestic-oriented sector at subsequent stages, or, at least, to both sectors simultaneously.

Pakistan was basically an agricultural economy on its independence in 1947. Its industrial capacity was negligible for processing locally produced agricultural raw material. This made it imperative for succeeding governments to improve the country’s manufacturing capacity. In order to achieve this objective, however, changing types of industrial policies have been implemented in different times with a changing focus on either the public or the private sector.

During the 1960s, government policies were aimed at encouraging the private sector; whereas during the 1970s, the public sector was given the dominant role. In the 1980s and 1990s, the private sector was again assigned a leading role. Especially during the decade of the 1990s, Pakistan adopted liberal, market-oriented policies and declared the private sector the engine of economic growth. Moreover, Pakistan has offered an attractive package of incentives to foreign investors.

The basic rules of foreign investment as stated above were laid down in the Foreign Private Investment (Promotion and Protection) Act 1976. Originally, each foreign investment was subject to separate authorisation, but this requirement was eliminated in May 1991. In general, no special registration was required for FDI, and the same rules and regulations were applied to FDI as to domestic investors. The requirement for government approval of foreign investment was removed with the exception of a few industries such as arms and ammunition, security printing, currency and mint, high explosives, radioactive substances, and alcoholic beverages (in fact, these industries were also closed to domestic private investors).

In all industrial sectors other than those indicated above, not only foreign equity participation of up to 100 percent was allowed, but also foreign investors could purchase equity in existing industrial companies on repatriable basis. In non-industrial sectors, foreign investment was excluded from agricultural land, forestry, irrigation, and real estate, including land, housing, and commercial activities.

All investors, whether domestic or foreign, were required to obtain a No Objection Certificate (NOC) from the relevant provincial government for the location of their projects. Thus, the physical location of the investment was effectively controlled by the provincial governments, which was considered a major bottleneck in speedy industrialisation. Incompetence, favouritism and corruption started to rear their ugly heads and have now become godzillas. At present, an NOC is only required for foreign investment in areas that are in the negative list of the relevant provincial government. There are only a small number of areas that are on the negative list of the provincial governments.

In the past, investors (domestic and foreign) were not free to negotiate the terms and conditions of payment of royalty and technical fees suited to the requirements of foreign collaborators. One of the most important measures taken recently by the government affecting FDI has been the liberalisation of the foreign exchange regime. Residents and non-resident Pakistanis, as well as foreigners, are now allowed to bring in, possess and take out foreign currency, and to open accounts and hold certificates on foreign currency. Foreigners using foreign exchange have now access to the capital market. For example, no permission is required to issue shares of Pakistani companies to foreign investors, unless they belong to industries included in the Specified List.

To further liberalise the foreign exchange regime, the Pakistani rupee has been made convertible effective from July 1, 1994. The ceiling earlier imposed on contracting foreign loans has been abolished. The permission of the federal government or the SBP would not be required regarding interest rate or payment period of foreign loans not guaranteed by the Government of Pakistan. Also, the foreign currency account holders are allowed to obtain rupee loans collateralised against the foreign currency account balance.

More so, the government has enacted an extensive set of investment incentives, including credit facilities, fiscal incentives and visa policy. Foreign-controlled manufacturing companies exporting 50 percent or more of their production can now borrow working capital without any limit. Other foreign-controlled manufacturing companies, including those not exporting and selling in the domestic market, can borrow rupee loans equal to their equity without prior permission of the SBP. Its permission is also not required for raising domestic credit to meet fixed investment requirement.

There is a strong perception among foreign investors that the pro-business policies and inducement used to attract prospective new investors are somehow weak given realities when they actually begin to set up and operate their business in Pakistan. Extremism has only worsened an already worsening situation.

n    The writer is a retired secretary of the Government of Pakistan.