The myth of foreign investment

there are no shortcuts to development

In 2015, Pakistan signed a major investment deal with China worth about 15% of GDP, known as the China-Pakistan Economic Corridor (CPEC). Touted as a "game changer," it promised to reshape Pakistan’s economy. But nearly a decade later, has it lived up to the hype?

The numbers tell a different story. Comparing Pakistan’s investment rate before and after CPEC shows no improvement—in fact, it has declined. Why did total investment decline despite tens of billions in CPEC investment? The reason lies in the economics of foreign investment.

Every foreign investment creates a financial liability for the country since the investment is expected to be paid back with profit. This liability can only be paid back in a foreign currency, which a country can only manage by generating an equivalent export surplus. Thus if foreign investment is largely used to fund domestic consumption, as was the case with CPEC, it would generate negative pressure on the country’s balance of payment situation - increasing risk, raising cost of capital, and tightening financial conditions in the process.

Beyond the currency mismatch issue, foreign investment still has to generate sufficient domestic productivity gains. Since every foreign investment is a liability, prudent policy requires that domestic gains from foreign investment must significantly outweigh the liability. For example, prudent policy (as is the custom in countries like Vietnam, China, India etc.) requires that large-scale foreign investment occur through domestic joint ventures to guarantee that skills and technology from the investment passes through to domestic firms.

Even more important is the selection of industries in which to prioritize foreign investment - there’s not much technical content in the production of roads, bridges or legacy power plants. Instead foreign investment should be prioritized in sectors closer to the frontier of global technology, such as chip manufacturing, renewable energy supply chains, space technology etc. Careful consideration should go in embedding such investment through local firms and universities - so knowledge sticks and grows. Again there are many examples to learn from in the region.

On the financing side, the goal should be to minimize the foreign liability, while maximizing domestic gains through strategies outlined above. This can be done by financing a major portion of total investment via domestic debt, and then splitting the equity piece between domestic joint venture companies and the foreign investor. An equally important issue is the valuation of equity - this must be done on market principals - the lower the valuation by the foreigners, the higher will be the implied liability that the country owes going forward.

A terrible way to finance is to borrow both debt and equity entirely from abroad. Even worse would be to do so under sovereign guarantees on both debt and equity! In fact, there is no such thing as “equity” if it comes with a guaranteed rate of return in dollars! But this is how most of foreign investment was financed by Pakistan - another reason i keep saying, the nervous system is broken.

We are now in a position to understand why the 2015 foreign investment deal of around 15% of GDP made zero impact on Pakistan’s total domestic investment. The deal was structured to primarily finance the non-tradable sector. It focused on sectors without much productivity or technology content. It had no significant joint venture content - the entire supply chain, often including labor, was to be imported from China. The entire financing - debt plus equity - was largely foreign based, and denominated in dollars. There was little market discipline, like competitive bidding to avoid over-invoicing for example. With all these negatives, the addition of foreign liability that came with CPEC crowded out domestic investment. The net result is depicted in Pakistan’s total investment numbers before and after.

Pakistan is repeating the same old mistakes in the next round of “game changing” foreign investment in the form of SIFC. Once again, foreign investment is being seen as a silver bullet - without regard to understanding the fundamental issues with the domestic economy. History is likely to repeat itself.

None of this is to say that Pakistan should not target foreign investment - it should. Countries like China and others have a lot to offer. But it must be done as part of a broader macro-financial framework. For example, Pakistan should closely follow the advice I laid out for Bangladesh. Only within such a structure can foreign investment be fruitful.

(This post comes after a bit of delay - I want to write more frequently, but my priority remains research and teaching, which slows down the posts.)