Pakistan Journal of Social Research

ISSN 2710-3129 (P) 2710-3137 (O)

Vol. 5, No. 2, June 2023, pp. 1-7.
https://doi.org/10.52567/pjsr.v5i02.1162
www.pjsr.com.pk

IMPACT OF FOREIGN DIRECT INVESTMENT ON ECONOMIC GROWTH: A

TIME SERIES ANALYSIS OF PAKISTAN

Aqsa Awan*
Graduate Student, Department of Economics, University of Sargodha, Pakistan
[email protected]

Muhammad Waqas
Assistant Professor, Department of Economics, University of Sargodha, Pakistan
[email protected]

ABSTRACT
The study aims to determine the relationship between foreign direct investment and economic growth
in the case of Pakistan by using the annual data from 1973-2021. The three independent variables are
foreign direct investment, inflation, and trade while gross domestic product (GDP) is the dependent
variable. The unit root test results explore that all variables are integrated at first difference. The
Johansen cointegration technique examines both short- and long-term relationships. The study found
log run as well as short run relationship among variables. All variables are integrated at first difference,
based on the outcomes of the first unit root test. The Johansen cointegration method is used to
investigate both the short-term and long-term connections. The findings suggest that while inflation
negatively correlates with GDP, trade and foreign direct investment have a favorable (positive) effect
on economic expansion. The policy recommendation is that only some foreign investment sectors benefit
Pakistan's economy due to the different characteristics of developing and developed countries. The
Government may give incentives to foreign investors, give cheap raw materials, and make better
economic policies that are fruitful for foreign investors. The Government may reduce the taxes directly
and indirectly and give subsidies.
Keywords: Economic Growth, Inflation, Trade, FDI

INTRODUCTION
Foreign direct investment is a significant component that affects economic growth. A country's
economy benefits when a sizable contribution from outside sources enters the country. This approach
has helped developing countries' economies as a whole by generating money. Over the past ten years,
foreign investment in developing nations has expanded in order to boost the country's development and
economic progress (Muhammad, 2007). Increased productivity, more job possibilities, and
technological advancements are typically mentioned as benefits of FDI. The main advantages of foreign
direct investment in emerging countries are better management and raw material availability. Access to
marketing is also provided to foreign investors. The stock of human capital in the host economy also
increases. In providing a thorough definition of foreign direct investment (FDI) in 1996, the
Organization for Economic Co-operation and Development (OECD) stated that it was the goal of a
resident firm (a direct investor) to acquire a long-term stake in an economy that is different from the
investor's own. This serves as yet another contributing aspect, demonstrating the important role that
FDI plays in the development of the economy (Shahbaz & Rehman, 2010).
Foreign direct investment (FDI), despite the developing countries' small or even falling share
in the global distribution of FDI, has grown through time to become the main source of external resource
flows to these countries and a crucial portion of capital formation in these countries. Foreign direct
investment (FDI) is widely acknowledged to aid in the expansion of developing countries (Khan, 2007).
Since 1950, there have been two separate generations of models based on the economic growth
hypothesis. Up until the late 1960s, the literature was dominated by exogenous causes for long-term

*
Corresponding Author

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growth, or the neoclassical model, which influenced the first generation of growth models (exogenous-
growth models). Then, the focus shifted to inflation and unemployment as factors impacting growth.
The Romer hypothesis enabled the second generation of growth models, often known as new
growth models or endogenous-growth models. Combining research on the transmission of technology
with endogenous growth models has lately brought attention to how important foreign direct investment
is to the economy (Bashir, 1999).
The major objective of the study is to investigate the relationship between FDI and economic
growth in Pakistan from 1973 to 2019. The objectives are to examine the relationship between inflation
and economic growth as well as the relationship between trade and economic growth in the case of
Pakistan.

REVIEW OF LITERATURE
Shkodra et al. (2022) study found that FDI and economic development positively impact North selected
countries. The study used time series data from 2005 to 2020. The dependent variable is economic
growth and independent variables are foreign direct investment, wages and salaries, subsidies, social
transfers, and capital expenditures. The data has been taken from several sources like central banks,
statistical agencies, and World Bank indicators (WDI). The study found that some nations have the
opposite relationship with economic expansion. In some nations, economic expansion and FDI flow are
significantly and positively related. In Kosovo or Bosnia and Herzegovina, investments have no positive
impact on economic growth.
Quadro et al. (2012) examined the relationship between Pakistan's GDP, FDI, and inflation
(CPI). The study used time series data collected from the World Bank's data source covering the years
1981 through 2010. GDP was used as the dependent variable, while FDI and inflation were used as the
independent variables. Results of the study show significant and negative relationships between GDP
and FDI and a significant and negative relationship between GDP and inflation.
Javaid (2016) tried to determine the relationship between Pakistan FDI and economic growth
and employed the ARDL approach. The study used the time series data collected from World
Development covering the year 1966 through 2014. GDP was used as a dependent variable while FDI,
inflation, population, gross capital formation, and trade were used as independent variables. Results of
the study demonstrate that FDI has positive and significant effects on GDP in the long and short run,
and negative effects on inflation and favorable effects on population. Trade and gross capital formation
play no significant role towards Pakistan's economic growth.
Mahmood et al. (2012) analyzed the effects of foreign direct investment on Pakistan's economic
expansion experimentally. The Study used time series data gathered from Pakistan state bank and world
bank from 1971 through 2009. The study used the independent element (FDI) and the dependent
element (change in per capita GNP) as (CHK). Exports of commodities and services as a percentage of
GDP, used as independent variables. The Government of Pakistan calculated the labor force growth
rate (LBGR) (1996, 2006). Study used the bound testing procedure for cointegration within the context
of the autoregressive distributed lag model (ARDL). Study's findings show the positive effect that FDI
has on economic growth. Foreign direct investment yields higher productivity than domestic
investment. Exports have a small but positive impact.
Ahmed et al. (2005) examined the foreign direct investment and economic growth on pakistan
sector wise multivariate cointegration analysis. Study data work on panel data and selected variables
Gross Domestic Product (GDP), Institutions, domestic investment, infrastructure, human capital, and
foreign direct investment (INST). Information was gathered from several sources like the United
Nations Development Program reports of the World Governance Indicators, the Pakistan Bureau of
Statistics, the Pakistan State Bank, and the Economic Survey of Pakistan (2012–2013). The fully
modified ordinary least square (FMOLS) test, the panel unit root test apply for checking the variables
stationarity, the panel cointegration test, and vector error correction model used in this study (VECM).
The panel cointegration test's findings indicate that FDI, domestic investment, infrastructure, human
capital, and institutions are all long-term partners. Furthermore, the expansion of the economy in
Pakistan is negatively correlated with domestic investment, and human capital. The features of foreign
projects must be the primary focus of the policies rather than FDI. The ability to admire FDI results
should lie with the lender and human capital. Increase domestic markets' secondary and tertiary
permeability to increase growth and prevent spillover effects to other industries.

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 Impact of Foreign Direct Investment on Economic Growth: A Time Series Analysis of Pakistan

Saqib et al. (2012) investigated the role of foreign direct investment FDI towards economic
growth in the case of Pakistan. The study used annual data from 1981 through 2010, collected from the
State Bank of Pakistan and the World Development Indicators. The study considered the gross domestic
product (GDP) per capita at purchasing power parities, foreign direct investment, debt, gross domestic
investment, inflation, and trade. The augmented dickey fuller (ADF) test was used to evaluate the
stationary after looking at the coefficients of the regression equation with the conventional least squares
approach. According to study findings, foreign direct investment is hurting Pakistan's economy.
However, domestic investment boosted the economy, reducing the adverse effects of the country's debt,
trade, and inflation on GDP.
Gul et al. (2015) investigated the relationship between FDI and economic expansion in a
number of industrialized and emerging countries, including Pakistan. Time series data used for 2008
through 2013 were obtained from a secondary source, the State Bank of Pakistan. Study variables
included domestic capital, labor force, FDI, and total export growth rate. GDP was held as the dependent
variable. Study used the Regression Analysis, Correlation Coefficient, and Durbin Watson Test.
According to study findings, all variables have a significant and positive relationship between FDI,
domestic capital, and total exports.
Nilofer et al. (2018) examined the three types of investment—public, private, and foreign direct
investment (FDI)—in the expansion of the Pakistani economy, with a special emphasis on the
contribution of FDI to Pakistan's GDP growth. The study used time series data from 1970-2015 obtained
from the national bank of Pakistan. The study used the ADF test for unit root, ARDL Bounds test for
cointegration, and diagnostic tests. According to the study, while FDI and public consumption harm
Pakistan's economic growth, public and private investment have a positive impact.
Abubakar et al. (2017) examined the long-term connection between economic expansion and
foreign direct investment by using time series data for the 1980 through 2010 gathered from World
Bank indicators. The study treated economic growth as a dependent variable, while labor, FDI, physical
capital, human capital, and trade were treated as independent variables. Utilize the ARDL bound
cointegration test. In the short run ARDL bound test, significant and positive effects for fixed capital,
FDI, and human capital but the negative effects on labor and trade. It suggests that the government
develop more human skills to attract more desirable FDI.
Iqbal et al. (2014) examined the association between GNP and foreign direct investment by
using the annual data from 1982 through 2012 gathered from the Pakistani state bank, World
Development Series, FBS, and Economic Surveys of Pakistan. The study used the variables Gross
Capital Formation (K), Labor (L), Health Expenditures (H), Foreign Direct Investment (FDI), and Trade
Openness in an Export-Oriented Economy (OP*FDI). The study found a favorable correlation between
Pakistan's GDP and FDI. However, over the past few decades, Pakistan has yet to attract FDI
sufficiently.
Donny (2018) used multiple linear regression models to find out the relationship between
government spending, exports of goods and services, imports of goods and services, household
expenditure, capital business investment (including FDI), and exports of goods and services. Results
show that real GDP growth increased FDI growth by 90.4%, while other model variables increased real
GDP growth by 9.6%, according to the study's findings.
Hong et al. (2018) used the data from 1986 to 2015 and found that trade openness and global
crises have a big impact on the inflow of foreign investment and economic expansion. FDI positively
impacts openness to trade, GDP is positively correlated with FDI, and openness has a negative first lag
correlation with GDP and FDI but a positive second lag correlation. The international crisis has a strong
and detrimental effect on FDI, and a detrimental impact on trade openness as exports decline due to
declining global demand.
Laura (2003) collected the data from the World Bank's Development Indicators, the Global
Country Risk Guide. The study used GDP, foreign direct investment (FDI), state spending, inflation,
quality of institutions, trade openness, credit to the private sector, and educational level. FDI flows into
the primary, manufacturing, and service sectors of the economy have diverse effects on economic
growth, according to the study's findings. While FDI inflows into the manufacturing sector positively
impact growth, they typically harm the primary sector. The evidence derived from foreign investments
in the service industry needs to be clarified. According to this research, not all types of foreign
investment are advantageous for host economies.

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Fayyaz (2012) examined the relationship between foreign direct investment flows in
developing countries like Sub-Saharan Africa, Eastern Europe, Asia, and Latin America. The last ten
years' worth of macro panel data from 57 countries with low and lower middle incomes are used in this
study (2000 through 2009). The study used the variables GDP, global trade integration tariffs,
education, inflation, FDI, and board money supply in this study, and collected the data from World
Development Indicators dataset of the World Bank served source. The Ordinary Least - square (OLS)
method and TSLS regression were both used by the author. The impact of most variables is higher when
the OLS methodology applies, according to both regression results. This suggests that measurement
error is why OLS estimates are too small. When this instrument is used, all of the variables are
statistically significant. Second, TSLS estimates point to market size (GDP per capita) and global
integration (tariff), while FDI flows into developing nations are impacted by an unstable
macroeconomic environment (high inflation). In general, developing nations can draw FDI by
concentrating on expanding their market or enacting more lenient trade policies. Additionally, they can
draw foreign direct investment by growing their skilled labor force and developing financial institutions
with moderate and stable inflation.

DATA AND METHODOLOGY

Pakistan's annual data from 1973 to 2021 has been used in the study. This study used the gross domestic
product as a dependent variable, while trade, inflation, and foreign direct investment were used as
independent variables.
Table 1: Variable Description
Variables Description Definition Source

GDP GDP is GDP calculates the cost of the completed products and WDI
measured on services brought in by the consumer that was produced in a
the annual % nation over a specified time (say, a quarter or a year)
ratio

Foreign The GDP The term "foreign direct investment" (FDI) refers to an WDI
Direct ratio investment that entails a long-term partnership and needs to
Investment measures FDI reflect a long - term interest and regulate by a resident entity
(net inflow of in a single country (fdi flows shareholder or parent
the country). enterprise) in an enterprise residing in a financial system
other than the foreign direct investors.

Inflation The Inflation In economics, inflation (or, less frequently, price inflation) WDI
rate is refers to a general increase in an economy's price level over
measured on time.
the consumer
price index
(CPI) basis.

Trade Trade Trade is the difference between the import and export of a WDI
percentage of country in a certain period.
GDP

Data has been taken from the World Development Indicator. The GDP has been used as a proxy
of economic growth. The study followed Saqib et al. (2013) and Gudaro et al. (2012) to use this proxy.
Consumer prices index (CPI) has been used as a proxy for inflation. The study followed the study by
Gudaro et al. (2012) to use this proxy. The study's econometric model is as follows,
GDPt = α0+ β1FDIt+ β2INFt + β3Tt +Ɛt

RESULTS AND DISCUSSION

Unit-Root test

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 Impact of Foreign Direct Investment on Economic Growth: A Time Series Analysis of Pakistan

In order to avoid the unit root problem the study used ADF test to check the data stationarity. The
results of the ADF test depict that all the variables are stationary at first difference.

Table No. 2 Results of ADF test

Series ADF – test Result

Level 1st difference

ADF P- value ADF P- value

GDP -4.761556 0.0019 -10.21272 0.0000 I(I)

FDI -3.314093 0.0767 -4.569362 0.0034 I(I)

INFLATION -3.28696 0.0829 -7.720607 0.0000 I(I)

TRADE -2.628347 0.2702 -6.760197 0.0000 I(I)

Table No. 3 Results of Pearson Correlation Matrix

GDP FDI INF Trade

GDP 1 -0.20 -0.15 0.05

FDI -0.20 1 0.05 0.25

INF -0.15 0.05 1 0.29

Trade 0.05 0.25 0.29 1

The results of the correlation matrix depicts that GDP has negatively correlated with FDI and
inflation while positively correlated trade. FDI is positively correlated with inflation and trade while
inflation is also positively correlated with trade. The overall correlation among variables is not high
which shows no possible presence of multicollinearity in the results.
Results of Johansen Cointegration test
The results of Johansen cointegration shows the existence of a long run relationship among variables.
The results show one cointegrating vector.
Table No. 4 Results of Johansen Cointegration
Rank Test for Unrestricted Cointegration (Trace and maximum Eigen-value)

Null hypothesis Fisher Stat.* Fisher Stat.*

Number of Co-integers. (From trace Prob. (From max- Prob.

Equations test) Eigen test)

None Co-Integer. equation * 79.8410 0.0000 45.6334 0.0001

There is 1 Co-integer. 34.2076 0.0146 24.9180 0.0139

equation *

There are 2 Co-integer. 9.2895 0.0339 9.1549 0.2735

Equations

There are 3 Co-integer. 0.1345 0.7137 0.1345 0.7137

Equations

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 Awan, & Waqas

(Long Run Estimates of Johansen Cointegration model)

Explanatory variables Co-efficient

𝐹𝐷𝐼𝐶 3.41E+11*

𝐼𝑁𝐹𝑡 - 9.04E+10

𝑇𝑟𝑎𝑑𝑒 +3.95E+10
The value of ECT must contain a negative sign, indicating the variables' divergence and
convergence. The value of how much is closer to -1 indicates the long-term period's convergence speed.
The Vector Error Correction Model's output is as follows.
Short-Run VECM Results
Table 5: Result of Short Run
Error Correction Model

Variables coefficient St. Error T-Statics P-value

ECT (-1) -0.65 0.21 -3.21 0.00

D (GDP (-1)) -0.145 0.16 -0.91 0.36

D(FDI) 0.506 0.76 0.67 0.50

D(INFLATION) -0.097 0.08 -1.19 0.24

D(TRADE) 0.153 0.13 1.12 0.26

D (TRADE (-1)) 0.018 0.12 0.14 0.88

R-Squared 0.36 Durbin-Watson 1.83

Adjusted R-Square 0.26 F-statistics 3.71

The findings, as mentioned earlier, show the short-term relationships between the variables.
ECM plays a crucial role in demonstrating how disequilibrium approaches long-term equilibrium. ECM
provides a speed indication for the adjustment.

RESULTS AND DISCUSSION

This study examines the relationship between foreign direct investment and economic growth
in Pakistan, using the Johansen cointegration technique to investigate both short- and long-
term connections.The results indicate that foreign direct investment and trade have a favorable impact
on economic growth, while inflation has a negative correlation with GDP. The policy recommendation
is that all foreign investment sectors are not beneficial for Pakistan's economy due to the different
characteristics of developing and developed countries. The government may give incentives to foreign
investors, give cheap raw materials, and make better economic policies that are fruitful for foreign
investors. The government may reduce taxes directly and indirectly and give subsidies.

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 Impact of Foreign Direct Investment on Economic Growth: A Time Series Analysis of Pakistan

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