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Foreign Aid to Pakistan: Impact on GDP

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2009 EABR & TLC Conferences Proceedings Prague, Czech Republic

Foreign Aid to Pakistan:

Impact on GDP
Asma Salman, Harbin Institute of Technology, People‟s Republic of China
Hui Xiao Feng, Harbin Institute of Technology, People‟s Republic of China

Abstract

Foreign direct investment flows have increased dramatically in recent decades. As developing
countries, remove restrictions and implement policies to attract FDI inflows, trade and investment
have become increasingly intertwined. The analysis of the impact of foreign aid on economic
development, suggests that poor countries have to relay on the foreign aid as a resource to fill the
deficit. There are many forms of foreign resources like Foreign Direct Investment, Grants &
Loans, Foreign Portfolio Investment, Export Credit, Official Aid, Technical Assistance, Emergency
Relief, Project and non project aid. This paper reviews recent developments in FDI flows and its
impact, and the importance of the policy context in which those flows occur. It analyses the trend
and impact of foreign aid on the economic development of Pakistan during a three decade period,
using different statistical techniques. From the analysis it is clear that the foreign capital flow has
a positive impact on the GDP, thus a direct impact on the economic development of Pakistan.

1. Introduction

The role of foreign direct investment (FDI) has been widely recognized as a growth-enhancing factor in
developing countries. There are a variety of channels through which FDI can promote economic growth, in the host
country. The most important being is technology transfer and spillovers. Literature on economic growth has
established the importance of technological progress in economic development. FDI often leads to technology
transfer to affiliates of multinational firms in the host countries. Spillover can occur through the interaction of
multinational firms with domestic suppliers, customers and worker mobility. Therefore, FDI can have impact on
income [GAO (2004)]. Most of the developing countries rely primarily on FDI as a source of external finance
because FDI stimulates economic growth more than other sources of capital inflows. Particularly, FDI is supposed to
be less volatile to offer financial resources, transfer of modern technology, market access and managerial know-how.

Financial resources are largely used to expand productive capacity by increasing fixed investment in the host
countries, while transfer of technology and managerial know-how improves productive capacity. Furthermore, FDI
brings various networks such as sales and procurement networks to the host countries, which can be used to expand
their business opportunities. FDI also increases competitive pressures to the local firms that result in an
improvement in technical and allocative efficiency in the host country.

It can be argued that economic growth depends on technological progress and FDI can play a crucial role
because it facilitates technology diffusion. Zhang (2001) has noted that FDI is likely to be an engine of host
country‟s economic growth, because (i) inward FDI may enhance capital formation and employment generation, (ii)
FDI may promote manufacturing exports, (iii) FDI may bring resources into host country such as, management
know-how, access of skilled labour to international production networks, and established brand names, and (iv) FDI
may result in technology transfers and spillover effects. In the light of important contributions that FDI delivers to
both home and host countries, it is useful to analyse its impacts on growth of the domestic economy. Figure-1 has
identified the following linkages between FDI and development.

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2009 EABR & TLC Conferences Proceedings Prague, Czech Republic
Fig.1 Linkages between FDI and Development; further details at Pradhan (2003)

Foreign Direct Investment

Firm specific intangibles like

Filling saving Relaxing foreign marketing, technology etc.
investment gap exchange Externalities
constraints

Development

Export
Productivity Labour Spillovers
Spillovers Competitive Demonstra- Linkage
Effect -tion effect Effect Turnover
Effect

Pakistan has experienced GDP growth in the 6-8% range in 2004-07, spurred by gains in the industrial and
service sectors. Poverty levels have decreased by 10% since 2001, and Islamabad has steadily raised development
spending in recent years, including a 52% real increase in the budget allocation for development in financial year
2007. Since independence Pakistan has had to depend on foreign assistance in its development efforts and to balance
its international debt payments. In 1960 the World Bank organized the Aid-to-Pakistan Consortium to facilitate
coordination among the major providers of international assistance. The consortium held 92% of Pakistan's
outstanding disbursed debt at the end of June 1991. The consortium's members include the United States, Canada,
Japan, Britain, Germany, France, and international organizations such as the World Bank and the Asian
Development Bank (ADB). The World Bank accounted for 26% of the outstanding debt, and the ADB, which was
the largest lender in the early 1990s, accounted for 15%. Most non-consortium funding comes from Saudi Arabia
and other oil-producing Middle Eastern countries. Most aid is in the form of loans, although the proportion of grants
increased from around 12% in the late 1970s to around 25% in the 1980s, mainly because of food aid and other
funds directed toward Afghan refugees. With the decline in this aid after 1988, the proportion of grants decreased to
16% in 1992. The United States has been a major provider of aid since independence and was the largest donor in
the 1980s. The unsustainable economic growth has been blamed mainly on the high inflation rate, a mounting fiscal
deficit, increasing foreign debt and debt servicing, weak foreign demand for Pakistani products, low level of
physical and human capital, unfavorable weather, political instability, and, among other factors, a deteriorating law
and order situation in the country. Pakistan is a rapidly developing country and a major emerging market with an
economic growth rate of 7 % per annum for four consecutive years up to 2007. Despite being a very poor country in
1947, Pakistan's economic growth rate was better than the global average during the subsequent four decades, but
imprudent policies led to a slowdown in the late 1990s. The 2005 estimate of foreign debt was close to US$40
billion. Pakistan's gross domestic product, as measured by purchasing power parity (PPP), is estimated to be US$
475.4 billion while its per capita income (PCI) stands at $2,942. The poverty rate in Pakistan is estimated to be
between 23% and 28%. Pakistan's GDP growth rates have seen a steady increase over the last 5 years. However,
inflationary pressures and a low savings rate, among other economic factors, could make it difficult to sustain a high
growth rate.

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2009 EABR & TLC Conferences Proceedings Prague, Czech Republic
1.2 Overview of the Financial and Trade Policies in Pakistan

financial development is necessary for economic growth at the macro-level [Andersen and Tarp (2003);
Khan and Senhadji (2000); Levine (2002)]. A more advanced intermediation enables firms to raise and manage large
amount of funds more effectively, resulting in a rapid economic development. Particularly, the development of
financial sector is important for developing countries because bank-based system has greater impact on growth at
the early stage than does a market-oriented system [Fase and Abma (2003); Tadesse (2002); Iimi (2004)]. The graph
gives us a clear idea about the portfolio investments in china and Pakistan, our interest however is Pakistan. Data is
available from 1995.

Graph 1: Portfolio Investment

Portfolio investment, equity (DRS, current US$) Since 1995

China Pakistan

25000000000
Portfolio investment, equity

20000000000
(DRS, current US$)

15000000000

10000000000

5000000000

0
1994 1996 1998 2000 2002 2004 2006
-5000000000
Year

Source: World Bank

2. Literature Review

Pakistan has been relying on the foreign aid to support its development programs since independence. And
the aid still has a larger proportion in the foreign capital inflows to Pakistan. The role of foreign economic assistance
in economic development and growth remains continuous in economic literature. Some studies proved its positive
impact on the economic development, while some studies highlighted its negative effects. Chenery and Strout [3]
concluded, on the basis of empirical evidence from LDCs, that foreign capital has a positive effect on the economic
growth. Burnside and Dollar [2] in their study found that aid has a positive impact on economic growth in
developing countries with a good fiscal policy, while it has negative effect on economic growth in the presence of
poor policy. Leff analyzed its negative impact on growth. They argued that foreign aid could adversely affect the
economic growth by substituting the domestic saving. Mwafaq Dandan Al-Khaldi [7] concluded that the foreign aid
has positive effect in the economic development. Robert and Nicholas found that the relationship among foreign aid,
government policy and economic growth is tenuous and depends heavily on the particular set of countries included
in their study. In case of Pakistan, the foreign aid is a major form of the foreign capital inflow and has a significant
role for the country‟s economic development. In Pakistan, several economists have tried to find out the role of
foreign aid in economic development of Pakistan. As, Shabbir & Mahmood (1992) and Khan & Rahim [9] (1993)
concluded that the aid has accelerated the rate of growth of GDP. Aslam [1] (1987) examined that the public FCI did
not affect the domestic investment significantly, while the private FCI covered the domestic saving-investment gap.
Khan (1993) concluded that foreign aid has played an extremely important role in influencing the pace of
development, especially investments and imports have to a large extent depended upon the amount of foreign aid.
However, this dependence on foreign aid, on the other hand, has led to the emergence of rising debt burden.

In short, we can conclude on the review of the above literature foreign capital has stimulated the economic
growth on one hand and has substituted the domestic savings on the other hand. And it caused a severe debt serving

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2009 EABR & TLC Conferences Proceedings Prague, Czech Republic
problems in Pakistan. It is open to question how far the LDCs could achieve self-sustaining economic growth with
foreign aid. Could foreign aid reduce poverty, inequality and unemployment? It helps traditionalism to be upgraded
and they think it helps modernization and adaptation. But critics say, concessional resources from aid donors delay
self-reliance of the recipient countries, thwart domestic saving, prop up authoritarian and repressive regimes, and
distort domestic development. They also think foreign fosters dependence syndrome, which proves difficult to
break. Such criticism led to evaluation of the impact of foreign aid. It raised questions whether or not aid works. The
Development Advisory Committee (DAC) of the Organization for Economic Cooperation & Development (OECD)
states that aid has helped build key development-promoting institutions like agricultural universities as well as
technical and enterprise management training institutes in many countries. A number of econometric studies
estimated that about 23% of foreign-capital inflows offset the declines in domestic savings.

3. Trends of foreign aid in Pakistan

The trends and the patterns have shown that the FDI, portfolio investment and borrowing through private
sources have also increased sharply. But Pakistan is still unable to attract such FCIs. Pakistan lacks physical,
financial & human capital as well as political & macroeconomic stability. So, it has to rely on foreign aid or foreign
debt. The role of foreign aid varies from one country to another. Like other developing countries, FCI in Pakistan is
being widely considered as an important vehicle for economic growth. Pakistan has introduced a wide range of
incentives, congenial for local and foreign investors and has increasingly tended to turn to FCI as source of capital,
technology, managerial skills and market access needed for sustained economic development.

Table 1. Pakistan: official development assistance (FA) and official aid (Current US$ Millions)

Due to low income the taxable capacity remains lower, i.e. government earning also remain low. In such
situations the underdeveloped countries have to face saving investment deficit as well as the deficit in the balance of
payment. The two- gap model suggests that developing countries have to rely on the foreign capital inflow to fill
these two gaps: The import-export gap and the saving investment gap. Foreign aid can involve a transfer of financial
resources or commodities (e.g., food or military equipment) or technical advice and training. The resources can take
the form of grants or concessional credits (e.g., export credits). Regardless the fact that all the under developed
countries need foreign capital inflows for their development, the amount and the form of the country size and the
economic circumstances of the country are the major determinants of the volume and the form of the foreign capital
inflows. For instance the least developed countries of Africa have been relying on the foreign aid, while the
developing countries of the East- Asia are largest beneficiary of the foreign direct Investment. The composition of
aid is a big factor as well.

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2009 EABR & TLC Conferences Proceedings Prague, Czech Republic
Graph 2. Capita aid to Pakistan (1970-2007)
Aid per capita (current US$) Since 1970's

Pakistan

Aid 16
per capita (current US$)
14
12
10
8
6
4
2
0
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Year

Source: World Bank

The Figures (1&2) depict an altering behavior of foreign aid over the time (1978-2007) in terms of both FA
as well as Per Capita Aid. From 1978 ~1988, there is a rising trend. There is another period of decline in aid from
1990 to 1998, while there is swift increase in the aid after 2000 in terms of both FA and Per Capita aid. But the over
all trend of foreign aid in Pakistan (during 1978-2007) is increasing. In most of LDCs, (including Pakistan) the
population growth rate was about 3%. Thus the growth rate of 6% was assumed as a target for the rapid economic
development. According to the Harrod-Domar [8] Growth Model, to achieve the target of 6% growth rate the
savings (investments) must be equal to the 18-20%. The Two-Gap Model suggests that the Poor countries have to
rely on the foreign capital inflows (FCI) to fill the two Gaps: Import-Export Gap and the Savings Investment Gap.
The most common type of foreign aid is official development assistance (FA), which is assistance given to promote
development and to combat poverty.

Table 2. Official development assistance

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2009 EABR & TLC Conferences Proceedings Prague, Czech Republic
The primary source of FA - which for some countries represents only a small portion of their assistance, is
bilateral grants from one country to another, though some of the aid is in the form of loans, and sometimes the aid is
channeled through international organizations and nongovernmental organizations (NGOs). For example, the
International Monetary Fund (IMF), the World Bank, and the United Nations Children‟s Fund (UNICEF) have
provided significant amounts of aid to countries and to NGOs involved in assistance activities. So, LDCs (including
Pakistan) have to rely on the Foreign aid, rather than portfolio investments. We can see an increase in the net private
inflows and an increase in the GNI as well, during 2004-2006. The top 10 donors of gross FA to Pakistan is shown in
the upper-right corner of the Table No. 1. It shows IDA as the major donor, providing 744 million US$ to Pakistan in
2005- 2006 while USA being the second highest. After analyzing the list it becomes clear that Pakistan is highly
dependent upon the USA, IDA, AsDF and Japan, as they are the top 4 donors to Pakistan in 2005-06.

The lower portion of Table No. 2 depicts the sector-wise allocation of the FA received by the Pakistan in
2005-06. It is clear that the major share of the bilateral FA is goes to the „humanitarian aid‟ and „program assistance‟,
since Pakistan faced a major natural disaster in the form of earthquake in 2005, whereas the share of the education,
infrastructure & services, health & population and the other social sectors remained low. We can see a significant
change in the ratio of aid to action related debt, which was most dominating in the years 2002-2003. Hence, the
above analysis depicts that Pakistan‟s economy is heavily dependent upon the IDA, USA, Japan and AsDF for the
foreign aid and the major portion of the foreign economic assistance goes back to the repayment of the loans and the
debt servicing.

4. Materials and methods

This study attempts to analyze the effectiveness of the foreign aid in economic development of Pakistan
during the period 1978-2007 using for this purpose different statistical techniques. The study is based on various
sources of data bases like a) World Development Reports, b) World Development Indicators, c) Government of
Pakistan, Ministry of Finance, and d) Publications and Central Bank of Pakistan Reports OECD. The present paper
aims to study; a) The composition of foreign aid in Pakistan since 1978; and b) The impact of foreign aid in
Pakistan.

Graph 3. GDP growth in Pakistan since 1970’s

GDP growth (annual %) Since 1970's

Pakistan

12

10
GDP growth (annual %)

0
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
-2
Year

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2009 EABR & TLC Conferences Proceedings Prague, Czech Republic
Many types of studies were under taken by different authors in order to understand the impact of foreign
capital inflows on the economic development of a country and many methods and variables were used for this
purpose. Some of these studies focused on the study of impact of aid on the domestic saving, investment and capital
formation, while, some other researchers paid much attention to study the role of aid on the debt burden, GDP
growth etc. Some other studies focused upon the impact of aid on different sectors of the economy.

It is difficult to analyze the effect of foreign aid on all the sectors and variables as described above in a
single study. There for, I narrow down my analysis to the impact of foreign FA and debt on the GDP. The impact of
FA on the GDP growth rate was examined in many studies, in order to analyze the impact of official development
assistance in Pakistan the data on the FA and the GDP given in following Table 2 is used. The regression model is
fitted to the data. The quadratic model is given as:

GDP = α + β1 FA + β2 FA2

The results of the estimated model are given as:

GDP = -5471.2245 + 85.4 FA - 0.019 FA2

Coefficient Data: Overall Significance of model

(F – Statistic) = 28.776544 *

The calculated values for the coefficients are as follows:

R squared = 0.685532 = 68%

Standard Error = 15792.44321
Correlation Coefficient (r) = 0.811254 = 81 %

The result depicts the positive effect of aid on the GDP in Pakistan (during 1978-2007) as the β1 (the
coefficient of regression) has a positive sign. But the β 2 has negative sign showing that the GDP increases as the FA
increases but at the decreasing rate. All the coefficients are significant. The value of R-Squared is 68%, that is, it
explains that the 58% variations in GDP explained with the help of the FA. And there is 81% correlation among the
FA and GDP in Pakistan. This positive correlation between GDP and FA is also depicted in Figures (1&3). The
burden of excessive dependence on the foreign aid has been caused by the: firstly, the shift in the composition of
foreign aid from grants to hard loans has, over the time, thereby reducing the amount of net aid available for
financing the imports and investments. Secondly, the terms and conditions attached to tie credits have imposed both
economic as well as political costs on the country (Khan [9], 1993). The increased debt burden in Pakistan can be
depicted by the Figure 4. It shows that the amount of external debt rises over the period of the 1978-2007 in
Pakistan. It is clear that the overall debt burden also rises as the flow of foreign capital also increased over the same
period.

Table 3: Foreign Aid and GDP Growth in Pakistan since 1975

Years FA (Current US$ in Millions) GDP (Current US$ in Millions)

1975 664.1 11340.0
1976 1013.9 13338.5
1977 588.8 15126.1
1978 635.4 17820.1
1979 711.1 19708.0
1980 1183.1 23689.7
1981 823.1 28100.6
1982 915.5 30726.0
1983 727.9 28691.9
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2009 EABR & TLC Conferences Proceedings Prague, Czech Republic
1984 729.4 31151.8
1985 769.6 31144.9
1986 916.5 31899.1
1987 820.2 33351.5
1988 1355.4 38472.7
1989 1446.3 40171.0
1990 1129.3 40010.4
1991 1371.1 45452.0
1992 1014.1 18635.2
1993 1005.4 51478.4
1994 1605.6 51894.8
1995 823.8 60636.1
1996 884.1 63320.2
1997 596.3 62433.3
1998 1053.0 62192.0
1999 732.9 62973.9
2000 702.8 73321.0
2001 1948.2 71496.2
2002 2138.2 71485.1
2003 1065.7 82350.0
2004 1421.0 96114.9
2005 1626.4 109502.1
2006 2147.2 126867.4
2007 .. 143597.5

5. Summary of FDI Inflows in Pakistan

The higher level of saving and investment is necessary to increase the rate of capital formation. However,
in developing countries the level of domestic savings falls below the desired level because of low per capita income.
In the case of Pakistan, domestic savings account for less than 20 percent of the GDP. This gap between domestic
savings and desired level of investment can be filled by the transfer of resources from outside. FDI is one of the
most important sources. To increase the level of foreign capital inflows, liberalisation of trade and investment
regime by relaxing controls and offering financial and trade incentives like tax concessions and tariff reductions
should be needed. Furthermore, host country should pursue active liberalisation policies to overcome trade deficit,
and encourage investment in export-led sectors. To ensure that FDI stimulates domestic economic activity, the host
country should make it mandatory for the foreign investor to use a certain amount of locally made inputs in the
production of final goods.

The domestic policies opted by the host countries have an important influence on the decisions of foreign
investment. To attract FDI, the host country should adopt concrete and investor friendly policies, strong
infrastructure are the pre-conditions to restore the confidence of foreign investors.

After following somewhat restrictive economic policies, the government of Pakistan initiated market-based
reforms in the 1990s. These reforms included gradual liberalisation of trade and investment regime by providing
various trade and fiscal incentives to foreign investors through tax concessions, credit facilities, tariff reduction and
easing foreign exchange controls [Khan (1997)]. In the early 1990s, the government undertook a number of policy
and regulatory measures14 to improve the business environment in order to attract foreign investment [Anwar
(2002)]. In order to encourage FDI, restrictions on capital inflows and outflows were gradually lifted. Foreign

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2009 EABR & TLC Conferences Proceedings Prague, Czech Republic
investors were allowed to hold 100 percent of the equity of industrial project on repatriable basis without any prior
approval. Furthermore, investment shares issued to non-residents could be exported, and remittance of dividends and
disinvestments proceeds was permissible without any prior permission of State Bank of Pakistan (SBP). In 1994,
restrictions on some capital transactions were partially relaxed, and foreign borrowing and certain outward
investments were allowed to some extent. Full convertibility of the Pak-rupee was established on current
international transactions. The establishment of an interbank foreign exchange market also marked an important step
towards decentralising the management of foreign exchange and allowing market forces to play a greater role in
exchange rate determination.

Pakistan‟s foreign investment regime mainly consists of three components. (I) Regulatory, (ii) economic,
and (iii) socio-political. Regarding privatisation and deregulation, Pakistan has opted very liberal regulatory regime.
The regulatory framework for foreign investment consists of three laws facilitating and protecting foreign investors;
(i) Foreign Private Investment (Promotion and Protection) Act 1976, (ii) Furtherance and Protection of Economic
Reforms Act 1992, and (iii) Foreign Currency Accounts (Protection) Ordinance 2001. In addition Bilateral
Agreements include: investment protection with 43 countries and avoidance of double taxation with 51 countries. To
protect the intellectual property rights (IPRs), Pakistan has also updated IPR laws to bring them in compliance with
international requirements particularly, those mandatory under the Agreement on Trade Related Intellectual Property
Rights (TRIPS) of the WTO. The salient features of the Pakistan‟s regulatory regime are: These measures include:

1. Removal of the requirement of government approval of foreign investment,

2. Permission of foreign equity participation of up to 100 percent,
3. (3) Permission to negotiate the terms and conditions of payment of royalty and technical fees suited to foreign
investors for transferring technology,
4. Liberalizing of foreign exchange regime,
5. Permission of remittances of principal and dividends from FDI and portfolio investment including an
extensive set of fiscal incentives and allowances to foreign investors,
6. Convertibility of Pak-rupee from July 1994,
7. Liberalisation of import policy, and
8. Opening up the sectors of agriculture, telecommunications, energy and insurance to FDI in 1997.
9.
Further details can be seen at Zaidi (2004)

Graph 4: FDI’s Net Inflows

Foreign direct investment, net inflows (% of GDP) Since
1970's

China Pakistan USA

7
Foreign direct investment,
net inflows (% of GDP)

6
5
4
3
2
1
0
-11965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Year

Source: World Bank

Freedom to bring, hold and take out foreign currency from Pakistan in any form. Privatisation of an
enterprise is fully protected. Neither it can be renationalized, nor can the government take over any foreign

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2009 EABR & TLC Conferences Proceedings Prague, Czech Republic
enterprise. Original FDI as well as profits earned can be repatriated to the country of origin. Equal treatment is
provided to the foreign investor and local investor in terms of import and export of goods. FDI is not subject to taxes
in addition to those levied on domestic investment. Foreign currency accounts are fully protected and they cannot be
frozen. All the economic sectors16 including services sector are open to FDI, foreign equity up to 100 percent is
allowed in all sectors. However, foreign equity up to 80 percent is allowed in agriculture sector. There is no lower
limit on the size of FDI in manufacturing sector. However, in services, infrastructure and social sectors the minimum
amount of foreign equity investment is $0.3 million. No government sanction is required to set up any industry, in
terms of field of activity, location, and size, except arms and ammunitions, high explosives, radioactive substances,
security printing, currency and mint and alcoholic beverages. No double taxation on income earned by foreign
investors. Pakistan has also rationalized its tariff regime. Custom duty on import of most of the primary raw material
is not more than 5 percent, while on the imported machinery is between 0 and 10 percent. Copyright law has been
amended while laws regarding patents; industrial designs and trademarks have been re-enacted. There is no
requirement for obtaining no objection certificate (NOC) from provincial governments for locating the project
anywhere in the country except in areas that are notified as negative areas. But due to the inconsistency of
government policies, the level of FDI remained low as compared to other developing countries. Pakistan has
received comparatively higher amount of FDI over the past two decades due to its market-oriented investment
policies and enabling environment for investment. FDI inflows to Pakistan can be explained in terms of its size and
percentage of gross domestic product (GDP). Due to inconsistent policies, the flow of FDI was insignificant until
1991. However, the flow of FDI steadily increased in the post-liberalisation period. Actual inflows of FDI to
Pakistan have increased from $119.6 million in the 1975-79 to $3299.8 millions Except for some sectors of strategic
importance in the 1995-99.

6. Conclusion

The current study shows both positive as well as the negative effects of foreign aid on the economic
development. Foreign aid, on positive side, has helped in boosting the GDP Growth through structural
transformation of the economy, laid foundations of the industrial and agricultural sectors, provided technical
assistance, policy advice and modern technology, assisted in overcoming the budget deficits. As the regression
analysis of the GDP and the FA confirms the positive affect of Official Development Assistance (FA) on the GDP.
Thus, the overall impact of the aid on the economic development is positive. The policies are also important in the
effectiveness of foreign aid, as the aid has a more positive impact on growth in with good fiscal, monetary, and trade
policies. What is the impact of foreign financial assistance on developing countries' economic development? They
are facing increasing debt burden. They cannot invest in the needed sectors. On the other hand, increasing
underdevelopment due to governance problems develops dependence on assistance from the developed countries.
Problems associated with foreign aid occur partially because of failures on the part of aid recipients and also because
the donor countries value strategic considerations more than the development concerns. Donor countries impose
conditional ties that do not seem to work because the steady flow of aid is meant to provide income sources to many
interest groups in the donor countries. A dominant concern remains their income, and not necessarily the well-being
of the aid recipients. Poor countries need aid that is delivered in a predictable fashion, without too many strings
attached to minimize transaction costs and maximize the value for money. All too often, they get aid that is
unpredictable, uncoordinated and tied to purchases from the donor countries. This implies that to take the advantage
of positive interaction between FDI and growth, one should liberate the economy particularly, stimulate financial
sector development in the economy.

Our findings suggest that FDI plays an important role in contributing to economic growth. However,
domestic financial sector development is crucial for positive effects to realise that has not been shown before. We
also provide evidence that the link between FDI and growth is causal, where FDI promotes growth through financial
sector development. Furthermore, the results suggest that better domestic financial conditions not only attract
foreign companies but also allow host economy to maximise the benefits of foreign investments.

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