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FDI impact on
Macroeconomic factors Pakistan’s
determining FDI impact on growth
Pakistan’s growth
Khalid Zaman, Iqtidar Ali Shah and Muhammad Mushtaq Khan 79
Department of Management Sciences,
Received 3 March 2011
COMSATS Institute of Information Technology, Abbottabad, Pakistan, and Revised 29 November 2011
Mehboob Ahmad Accepted 29 November 2011
Bahria University, Islamabad, Pakistan
Abstract
Purpose – The purpose of this paper is to identify major macroeconomic factors that enhance foreign
direct investment (FDI) for Pakistan through the co-integration and error correction model over a
28-year time period, i.e. between 1980 and 2008.
Design/methodology/approach – The study employed the Johansen co-integration technique to
estimate the long-run relationship between the variables, while an error correction model was used to
determine the short-run dynamics of the system.
Findings – Finding suggests that FDI has had a significant positive impact on Pakistan’s economic
growth in the long run. For example, trade liberalization and their interactive terms have a positive
effect in the short run, while a negative effect is observed in the long run upon economic growth of
Pakistan. The results indicate that due to a low quality of human capital in Pakistan; the direct effect of
FDI on economic growth becomes negative.
Research limitations/implications – The study was limited to a few variables, including human
capital, trade openness, government size, population and consumer price index, in order to manage
robust data analysis.
Practical implications – The authors find that for FDI to be a significant contributor to economic
growth in Pakistan, government must focus upon improving physical infrastructure, and quality of
human resources.
Originality/value – The study confirms that Pakistan did not enjoy substantial growth benefits from
FDI because human capital, trade openness, government size and interactive terms of FDI and per
capita income have a negative impact on economic growth. These findings have important policy
implications.
Keywords Pakistan, Macroeconomics, Economic growth, International investments,
Foreign direct investment, Trade liberalization, Human capital, Government size, Co-integration
Paper type Research paper

Introduction
The role of foreign direct investment (FDI) in the economic growth process has been
an important subject since globalization picked up speed in the early 1980s. Over
the last two decades, many developing countries have persistently devoted a great
deal of energy and attention to encouraging FDI inflows, with the expectation that
these would enhance growth in their domestic economies. The theoretical premise in
favor of FDI inflows remains quite straightforward; that FDI is a composite bundle
of capital stocks, technical know-how and technology, which supplements local capital South Asian Journal of Global
stock, expands market access, provides positive technological spillovers for local Business Research
Vol. 1 No. 1, 2012
industries and helps accumulate and improve human capital, thereby promoting pp. 79-95
domestic economic development (see Blomstrom et al., 1994; OECD, 1999, 2000; Zhang, r Emerald Group Publishing Limited
2045-4457
1999). DOI 10.1108/20454451211207598
SAJGBR Pakistan is a capital-scarce country and has been relying on foreign capital inflows in
1,1 terms of technology and finance (Siddiqui and Kemal, 2002). However, traditionally it has
not been a large recipient of FDI. In the 1980s, the average annual inflows of FDI were
approximately $42 and constituted only 1.4 percent of its GDP. By comparison, many
east Asian economies were able to attract $2 to $4 billion of FDI per annum.
For example, in China, its contribution to domestic capital formation was 2.2 percent,
80 14.4 percent in Taiwan, 15.2 percent in Malaysia, 14.4 percent in Indonesia and
25.5 percent in Singapore (GoP, 2008). There are several reasons for this sub-par
performance. Unfortunately, during the last two decades, Pakistan’s economy has
suffered due to political disputes, a rapidly growing population, high inflation rate,
internal conflicts and confrontation with the neighboring India. Poor saving rates, low
exports and inadequate investment in socio-economic infrastructure also accounts for
lower than expected growth rates. Poor governance structures, high levels of corruption
and lack of transparency have also contributed to an unfavorable environment for
private sector investment. Flight of capital due to political instability and other socio-
economic factors and lower levels of GDP also decreased the overall productivity of the
economy. Finally, there is a narrow tax base on one hand and massive leakages to avoid
tax in the tax collection system on other hand (World Bank, 2006).
The multifaceted problems of the Pakistani economy reached a critical point in the
late 1990s. However, the problem of slower growth in the real economy persists to date.
Trade deficit during 2010-2011 surpassed US$5 billion to the current account deficit of
around US$3 billion. The national saving rate also shows an alarming decrease as a
percentage of GDP. It stood at 17.6 percent during 2003-2004, but dropped to 13.7 percent
of GDP in 2005-2006. Unfortunately, the burden of public sector mismanagement and
weak governance has been passed to different sectors in Pakistan. Some reports suggest
that growth-targeting measures could not realize the set objectives due to significant
uneven socio-political environment (The News, 2009). Although Pakistan has made
considerable improvements in various growth variables during different time periods,
the consistency of the growth has not been uniform. It has always missed the mark,
implying that opportunities surely emerged, which unfortunately went unrealized.
The primary purpose of this study is to analyze Short-term and long-term
relationships of some explanatory variables (such as FDI, human capital, trade
openness, government size, population, consumer price index) that determine the
impact of FDI on the economic growth of Pakistan during 1980-2008. We aim to
identify factors that have enhanced and/or inhibited the FDI impact on the economic
growth of Pakistan. We selected the period between 1980 and 2008 because several
economic liberalization and international integration policies were implemented during
this period, resulting in opening up borders for international trade, removing bans on
foreign investment in various sectors, initiating the privatization process and lessening
controls on the financial sector during this period.
The rest of the paper is organized as follows. First economic growth trends in
Pakistan are discussed, followed by a discussion of theoretical framework of the
present study. Next methodology is presented. Analysis and interpretation of results is
carried out, before concluding the study.

Literature review
The FDI-growth nexus is clearly identified by the neoclassical growth models.
The neoclassical growth model considers technological progress and labor force as
exogenous, therefore arguing that FDI increases the level of income only and has no
long-run growth effect on the economy if it does not augment technology (Miankhel FDI impact on
et al., 2009). It also proposes that a long-run growth can only be increased through Pakistan’s
technological and population growth (Solow, 1956). Easterly et al. (1994) also argue that
technology transfer depends on the diffusion process and that can take place through growth
four modes: transfer of new technologies and ideas; high-technology imports; foreign
technology adoption; and quality of human capital. Using endogenous growth theory,
Makki and Somwaru (2004) point out that FDI can be growth advancing if it results 81
in increasing returns in production through spillover and technological transfers via
diffusion processes.
Modernization and dependency theories have also been used to explain the impact
of FDI on host countries’ economies. Modernization theories are based on the
neoclassical and endogenous growth theories, which suggest that FDI could promote
economic growth in developing countries. The modernization perspective is founded
upon the principle that economic growth requires capital investment. New growth
theories posit that transfer of technology through FDI in developing countries
is especially important because most developing countries lack the necessary
infrastructure in terms of an educated population, liberalized markets, economic
and social stability that are needed for innovation to promote growth (Bengoa and
Sanchez-Robles, 2002). Kumar and Pradhan (2002) note that, apart from technology
and capital, FDI usually flows as a bundle of resources, including organizational and
managerial skills, marketing know-how and market access through the marketing
networks of multinational enterprises (MNEs). As a result, FDI plays a twofold
function by contributing to capital accumulation and by increasing total factor
productivity (Nath, 2005). In contrast, dependency theorists argue that dependence on
foreign investment is expected to have a negative effect on growth and the distribution
of income. Bornschier and Chase-Dunn (1985) claimed that foreign investment creates
an industrial structure in which monopoly is predominant, leading to what they
describe as “underutilization of productive forces.” The assumption being that an
economy controlled by foreigners would not develop organically, but would rather
grow in a disarticulated manner (Amin, 1974). This is because the multiplier effect by
which demand in one sector of a country creates demand in another is weak, thereby
leading to a stagnant growth in the developing countries.
The role of FDI on economic development and growth remains contentious in the
literature. Some studies have shown its positive impact on economic development,
while others have highlighted its negative effects as well. Bhagwati (1978) analyzed the
impact of FDI with special reference to international trade. He found that countries
actively pursuing export-led growth strategy were able to reap enormous benefits from
FDI. Gonzalez (1988) found that FDI enhances the social uplift of the people.
Blomstrom et al. (1992) conclude that the growth of income per capita in developing
countries has a positive relationship with the average of the FDI inflows to GDP ratio.
On the other hand, Borensztein et al. (1998) find that FDI alone has a negative impact
on the economic growth. They show that the combined effect of FDI and human capital
accumulation on growth is positive.
It can be argued that a well-developed domestic financial market is the pre-condition
for attracting FDI. The speed of technological innovation and patterns of economic
growth of a country are highly dependent on the evolution of its financial sector, which
acts as a mechanism to channel financial resources between surplus and deficit units,
as well as helping to transfer technology embodied in FDI inflows (Choong et al., 2004).
Financial systems not only pool the savings of individuals but also have a profound
SAJGBR affect on economic development. Levine (1997) argues that in addition to a direct effect
1,1 of savings on capital accumulation, savings mobilization can improve resource
allocation and boost technological innovation. Hermes and Lensink (1999) and Bailliu
(2000) studied the significance of FDI inflows and financial development as a channel
for promoting economic growth. They concluded that capital inflows have positive
spillover efficiency and a significant impact on economic growth, if the domestic
82 financial sector has achieved a certain minimum level of development. De Mello (1999)
found FDI to have a significant impact on economic growth in a group of industrialized
and developing countries. The study showed that growth-enhancing effects of FDI
depend on the association between FDI and domestic investment. Zhang (2001) found
that FDI is likely to be an engine of host country’s economic growth, because FDI
inflow may enhance capital formation, manufactured exports and even lead to
employment generation. Hermes and Lensink (2003) have pointed out that the
development of the financial system of the host country is an important pre-condition
for FDI to exhibit a positive impact on economic growth. UNCTAD (2006) also
emphasizes that FDI has the potential to generate employment, raise productivity,
transfer foreign skills and technology, enhance exports and contribute to the long-term
economic development of the world’s developing countries. In the case of Pakistan,
various studies (Shabbir and Mahmood, 1992; Ahmed and Hamdani, 2003; Yasmin
et al., 2003; Shah and Ahmed, 2003; Naveed and Shabbir, 2006) also establish a positive
link between FDI and economic growth.
Petri and Plummer (1998) argue that it is not clear whether FDI causes exports or
exports cause FDI. Others (e.g. Gray, 1998) question the role of market-seeking
(substitute) FDI or efficiency-seeking (complement) FDI. Kojima (1973) analyzes
whether FDI is trade oriented or anti-trade oriented. Vernon (1966) explores whether
FDI is at the early product life-cycle stage (substitute) or at the mature stage
(complement). Hsiao and Hsiao (2006) assert that exports increase FDI by reducing
investor’s transaction costs. They also show that FDI may reduce exports by serving
foreign markets through the establishment of production facilities there.
Human capital has been defined as the reserve of economically productive human
capabilities. According to Sen (1993), the stock of human capital represents the
summation of being and doing – the ability to “be” and “do.” Human capital thus
comprises an individual’s capabilities and functions. It is generally believed that there is
a strong relationship between FDI inflow and human capital development of the host
country. It is a well-known fact that the MNCs mostly belong to the capital-intensive
countries (Subbarao, 2008). They establish subsidiaries and joint ventures in various
countries, which provide capital-intensive technologies for a productive output. These
technologies introduce new activities to the host country, replacing slow evolutionary
local processes (UNCTAD, 2005). Technology is also transferred by upgrading existing
activities in some cases, keeping local processes but upgrading technology used and by
supplying capital research and development, technological skills, managerial practices
and access to markets. UNCTAD (1994) reports that the MNCs “demand for highly
trained graduates manifests itself in the form of financial support, particularly to
business schools and science facilities, the provision of assistance and advice through
membership of advisory boards, curriculum review committees, councils and senates.”
Since FDI and economic growth are of primary importance to Pakistan’s
socio-economic development, there is a need to analyze the FDI-growth nexus. In the
following sections, we will test the relationship between FDI and other socio-economic
growth variables, such as human development, trade openness, government size,
population, consumer price index and GDP in Pakistan. These variables are selected FDI impact on
because of their vital importance to an emerging economy like Pakistan. For example, Pakistan’s
human development addresses long-term development related to improving education/
health of people and indicates social prosperity (WHO, 2006). Trade openness impacts growth
FDI directly by improving the investment climate. CPI is a vital economic indicator and
provides information about price changes to business, labor and citizens. It is also used
as an indicator of effectiveness of government policies (BLS, 1997). Government size 83
and population are also of particular importance to Pakistan because in recent years,
both have been growing fast. In fact, a large government size has been criticized and
attributed to inefficiencies (Garrett and Rhine, 2006) and a rapidly growing population
has raised alarming economic situations such as high unemployment and difficulties in
providing basic education and health (Musambachime, 1990).

Methodology
General practice in the literature routinely takes the relationship between FDI, exports
and GDP together, as given – in an ad hoc manner, arguing that when testing the effects
of “openness” on growth, both exports (or trade) and FDI should be considered for the
true sense of “openness.” Omitting one will commit the omission of variable error and
render the causality relations ambiguous (Ahmad et al., 2004; Cuadros et al., 2004).
However, the present study shows that the theoretical underpinning of the econometric
model can be derived from the national income model. For simplicity, we assume
equilibrium in the money sector and the government sector. Then, the equilibrium
condition of the Keynesian model of aggregate demand and aggregate supply is:

Y ¼ CðY Þ þ I ðY ; rÞ þ F þ X  M ðY ; eÞ ð1Þ

where Y, C, I, F, X, M, r and e are the real GDP, real consumption, real domestic
investment, real FDI inflows, real exports, real imports, interest rate and exchange
rate of foreign currency in term of the domestic currency, respectively. XM(Y, e) is
the current account surplus in domestic currency of the host country. Since the
present study aims to evaluate the real and financial aspects of the economy,
i.e. financial liberalization, trade liberalization and government size is related with the
financial aspects of economic growth; however, real sector is based upon the human
development, population and inflation which is included as a proxy in the model for
overall development policies pursued by Pakistan. Re-writing in more general implicit
function form, we have:

H ðY ; F; O; H ; S; P; I Þ ¼ 0 ð2Þ

where Y, F, O, H, S, P and I are the output growth, FDI inflows, trade openness, human
capital, size of the government, population and inflation. Thus, we examine the
long-run relationship between the variables.
Equation (3) is used to assess changes in GDP as a result of explanatory variables
which determine the impact of FDI on GDP:

GDP ¼ fðFDI ; TOP; HCAP; SIZE; POP; CPI ; FDI PCI ; FDI TOP; FDI HCAPÞ
þe
ð3Þ
SAJGBR where GDP, gross domestic product (Pakistan Rs. in million); FDI, foreign direct
1,1 investment (Pakistan Rs. in million); TOP, trade openness Pakistan (trade to GDP
ratio); HCAP, primary school enrolment in millions are taken as a proxy for human
capital; SIZE, government size (government consumption to GDP ratio); POP, population
of Pakistan (in millions); CPI, consumer price index (in percentage); FDI  PCI,
interactive term, i.e. foreign direct investment  per capita income; FDI  TOP,
84 interactive term, i.e. foreign direct investment  trade openness; FDI  HCAP,
interactive term, i.e. foreign direct investment  human capital; e, error correction term.
The data were taken from the various issues of GoP (2008, 2009, 2010, 2011) and
International Financial Statistics (IFS) (2009). The time-series data often shows the
property of non-stationarity in levels and the resulted estimates usually provide
spurious results (Granger, 1981). Thus, the first step in any time-series empirical
analysis is to test for the presence of unit roots to remove the problem of inaccurate
estimates. The other important step taken was to check the order of integration of each
variable in a data series in the model to establish whether the data under hand suffer
unit root and how many times it needed to be differenced to gain stationarity. This
approach is similar to the Yousaf et al.’s (2008) study of economic evaluation of FDI in
Pakistan, in which they use the Johansen cointegration test for establishing the short-
and long-run relationship between the variables.

Results
Augmented Dickey Fuller (ADF) test and cointegration tests have been used to check
the stationarity of the data and to estimate a long-run relationship between the
variables, respectively. Once the variables are found to be cointegrated, meaning that
long-run equilibrium holds between them, they may still be in disequilibrium in the
short run. Therefore, we employed an error correction model (ECM) to determine the
short-run dynamic of the system.

ADF and cointegration tests

A cointegration test consisted of two steps: first, the individual series were tested for a
common order of integration. If the series are integrated and are of the same order, it
implies cointegration. Dickey and Fuller (1979) devised a procedure to formally test for
non-stationarity. The ADF test was used to test the stationarity of the series. The ADF
test is a standard unit root test: it analyzes the order of integration of the data series
(Dickey and Fuller, 1981). These statistics are calculated with a constant and a constant
plus time trend and these tests have a null hypothesis of non-stationarity against an
alternative of stationarity.
In order to apply cointegration, we used Johanson’s cointegration test to the series of
same order to determine the long-run relationship between the variables. If series
are cointegrated of order 1, trace test ( Johansen’s approach) indicates a unique
cointegrating vector of order 1 and hence indicates the long-run relationship. In the
multivariate case, if the I(1) variables are linked by more than one cointegrating vector,
the Engle and Granger (1987) procedure is not applicable. The test for cointegration
used here is the likelihood ratio put forward by Johansen and Juselius (1990), indicating
that the maximum likelihood method is more appropriate in a multivariate system.
Therefore, this study has used this method to identify the number of cointegrated
vectors in the model. The Johansen and Juselius method was developed in part by the
literature available in the field and reduced rank regression and the cointegrating
vector “r” is defined by Johansen as the maximum eigenvalue and trace test or static,
there is “r” or more cointegrating vectors. Johansen (1988) and Johansen and Juselius FDI impact on
(1990) proposed that the multivariate cointegration methodology could be defined as: Pakistan’s
ðGDPÞt ¼ ðFDI ; TOP; HCAP; SIZE; POP; CPI Þ growth
which is a vector of elements. Considering the following autoregressive representation:
85
X
K
GDPt ¼ p þ pi ðGDPÞt1 þ mt
T¼1

Johansen’s method involves the estimation of the above equation by the maximum
likelihood technique and testing the hypothesis Ho; (p ¼ Cx) of “r” cointegrating
relationships, where r is the rank or the matrix pð0ffrffPÞ; Cis the matrix of weights
with which the variable enter cointegrating relationships and x is the matrix of
cointegrating vectors. The null hypothesis of non-cointegration P among variables is
rejected when the estimated likelihood test statistic fi f¼ n pt¼rþ1 lnð1^li g exceeds
its critical value. Given estimates of the eigenvalue ð^li Þ, the eigenvector (xi) and the
weights (Ci), we can find out whether or not the variables in the vector (GDPt) are
cointegrated in one or more long-run relationships among (FDI, TOP, HCAP, SIZE,
POP and CPI).

ECM
If time series are I(1), then one could run regressions in their first differences. However,
by taking first differences, we lose the long-run relationship that is stored in the data.
This implies that one needs to use variables in levels as well. The advantage of
the ECM incorporates variables both in their levels and first differences. By doing
this, ECM captures the short-run disequilibrium situations as well as the long-run
equilibrium adjustments between variables. The ECM term having negative sign and
value between “0” and “1” indicates the convergence of the model toward long-run
equilibrium and shows how much percentage adjustment takes place every year.
Recent developments in endogenous growth literature suggest that long-run growth
can result from more open and liberal government policies conducive to the inflow of
foreign capital (Barro, 1991; Barro and Sala-i-Martin, 1995a, b). Allowing separately
for the influence of human capital (H), domestic investment (I) and trade components
(EX and IM). In a time-series context, given the possibility of cointegration
among the aggregate variables, the appropriate empirical formulation is of the error-
correction type:

DðGDPÞt ¼a0 þ a1 DðFDI Þt þ a2 DðHCAPÞt þ a3 DðTOPÞt

þ a4 DðSIZEÞt þ a5 DðPOPÞt þ a6 DðCPI Þt
þ a7 DðFDI HCAPÞt þ a8 DðFDI PCI Þt
þ a9 DðFDI TOPÞt þ a10 ðGDPÞt1 þ a11 ðFDI Þt1 ð4Þ
þ a12 ðHCAPÞt1 þ a13 ðTOPÞt1 þ a14 ðSIZEÞt1
þ a15 ðPOPÞt1 þ a16 ðCPI Þt1 þ a17 ðFDI HCAPÞt1
þ a18 ðFDI PCI Þt1 þ a19 ðFDI TOPÞt1 þ e
SAJGBR where D stands for first difference and t1 indicates lag value. e is the error correction
1,1 term/adjustment coefficient. The coefficients a1-a9 show short-run elasticities of the
independent variables on GDP and a10-a19 represent long-run elasticities.
In the error-correction form, we can effectively determine the separate influences of
the short run and the long run on GDP growth. The coefficient of FDI is expected to
be positive as it is generally accepted. That investment is a key variable determining
86 economic growth and thus when evaluating the impact of FDI on economic
development in a host country, a key question arises whether foreign investment
crowds in domestic investment or whether it has the opposite effects of displacing
domestic producers. This means that the sign coefficient of FDI can be positive or
negative depending on whether the increase in foreign capital stock compliments or
substitutes for domestic investment, where as the coefficient of FDI  HCAP is should
have a positive sign because a higher level of human capital is often associated with a
greater transfer of technology which is growth enhancing. Government consumption is
expected to be negative because collective consumption goods such as housing and
salaries of public employees may directly or indirectly (via output taxes and subsidies)
crowd out private consumption expenditures and thus affect output in a negative
fashion (Aschauer, 1990). To the extent that they do, they may in the long-run transmit
a positive spillover effect in to domestic investment in the form of a better educated
workforce that can efficiently seize the market opportunities offered by the transfer of
technology and managerial know-how with FDI, thus affecting output in a positive
manner to support a positive sign in coefficient FDI  HCAP above. The stock of
human capital in a host country is critical for absorbing foreign knowledge and an
important determinant of whether potential spillovers will be realized. We postulate
not only a positive relationship between FDI and the GDP growth rate but also a
positive interaction between FDI and human capital in advancing economic growth.
The application of advanced technologies embodied in FDI requires a sufficient level of
human capital in host countries. That is, the higher the level of human capital in a host
country, the higher the effect of FDI on the country’s economic growth. The coefficient
of TOP is expected to have a positive sign because a higher degree of openness is often
associated with a greater technology transfer, learning by doing, greater market
discipline and an additional outlet for the goods and services produced by domestic
firms (Feder, 1983; Ram, 1986). An increase in population means the inability of the
government to meet the needs of the populace particularly in the area of education,
resulting in the decrease in human capital development. The inflation rate (CPI )
variable is expected to have a negative effect on economic growth, as the inflow of
capital stimulates increased investment and consequently an increase in inflation in a
country.

Estimation and interpretation of results

Time-series data are often found to be non-stationary, containing a unit root. Ordinary
least squares (OLS) estimates are efficient if variables included in the model are
stationary of the same order. Therefore, first we needed to check the stationarity of
different variables, which are used in our study. For this purpose we applied the ADF
test. Table I gives the results of ADF tests. Based on the ADF tests, GDP, FDI, TOP,
HCAP, SIZE, POP and CPI appear to be non-stationary at levels but stationary at first
difference. Thus, it was concluded that these variables are integrated of order 1, i.e. I(1).
The relationship between the GDP and the variables suggested in the model was
examined using the multivariate cointegration methodology proposed by Johansen
Level First difference
FDI impact on
Variables Constant Constant and trend Constant Constant and trend Pakistan’s
growth
GDP 0.578 1.425 4.082* 4.514*
FDI 0.871 0.958 3.996* 3.418**
TOP 1.479 1.456 3.911* 3.803*
HCAP 0.810 2.017 2.979** 3.716** 87
SIZE 1.402 1.586 3.603** 7.091*
CPI 1.178 2.177 3.842* 3.761**
Notes: The value shows the parameter estimates. *Significant at 1 percent; **significant at 5 percent Table I.
level Unit root estimation

and Juselius (1990). The following cointegrating vector was determined in the
above test.
Starting with null hypothesis of no cointegration (r ¼ 0) among the variables, the
trace statistic is 233.64 and exceeds the 95 percent critical value of the l trace statistic
(critical value is 125.61). It is possible to reject the null hypothesis (r ¼ 0) of no
cointegration vector, in favor of the general alternative rX1. As evident in Table II,
the null hypothesis of rp1, rp2 also rejected at 5 percent level of significance. While the
null hypothesis of rp3, rp4, rp5, rp6 cannot be rejected at 5 percent level of
confidence. Consequently, it is concluded that there are three cointegration relationships,
involving variables GDP, FDI, HCAP, TOP, SIZE, POP and CPI.

H0 H1 Test statistics 0.05 critical values Probability**

ltrace Ltrace
r ¼ 0* r40 233.64 125.61 0.0000
rp1* r41 143.90 95.75 0.0000
rp2* r42 85.29 69.81 0.0018
rp3 r43 45.22 47.85 0.0866
rp4 r44 24.17 29.79 0.1931
rp5 r45 11.84 15.49 0.1644
rp6 r46 0.703 3.841 0.4017
Lmax values lmax values
r ¼ 0* r40 89.74 46.23 0.0000
rp1* r41 58.60 40.07 0.0000
rp2* r42 40.07 33.87 0.0080
rp3 r43 21.04 27.58 0.2734
rp4 r44 12.32 21.13 0.5155
rp5 r45 11.14 14.26 0.1472
rp6 r46 0.703 3.841 0.4017 Table II.
Cointegrating vector GDP FDI HCAP TOP SIZE POP CPI Johansen’s test for
(standard error 1 0.1550 0.1525 4.7152 0.5314 2.7971 0.1308 multiple cointegration
in parentheses) (0.0057) (0.0317) (0.0850) (0.116) (0.1734) (0.007) vectors cointegration test
Notes: Trace test and maximum eigen value test indicate three cointegrating equations at the 0.05 among GDP, FDI, HCAP,
level; *rejection of the hypothesis at the 0.05 level; **MacKinnon et al. (1999)p-values TOP, SIZE, POP, CPI
SAJGBR On the other hand, lmax statistic reject the null hypothesis of no cointegration vector
1,1 (r ¼ 0) against the alternative (r ¼ 1) as the calculated value lmax (0, 1) ¼ 89.74 exceeds
the 95 percent critical value (46.23). Thus, on the basis of lmax statistic there are three
cointegration vectors. The presence of cointegration vector shows that there exists a
long-run relationship among the variables. In the last row of cointegrating equation,
long-run elasticities of FDI, HCAP, TOP, SIZE, POP and CPI are 0.15, 0.51, 4.71,
88 0.53, 2.79 and 0.13 percent, respectively.
Similarly, long-run relationships among variables including interactive term, i.e.
FDI  PCI, FDI  HCAP and FDI  TOP are also examined separately by using the
Johansen maximum likelihood cointegration test.
Table III shows that the trace and maximum eigenvalue tests reject the null
hypothesis of no cointegration at 5 percent level of significance. Tests shows there are
five cointegration vectors. The presence of the cointegration vector shows the pressure
of a long-run relationship among the variables. The results indicate that Pakistan did
not enjoy substantial growth benefits from FDI because HCAP, TOP, SIZE and
FDI  PCI have a negative impact on economic growth. The result further shows that
due to low quality of human capital available in Pakistan; the direct effect of FDI on
growth becomes negative. On the other hand, if human capital passes a threshold,
FDI has a positive growth effect. The cointegration equation is reported in the last
row showing that FDI, POP and CPI has a positive sign while HCAP, TOP, SIZE and
FDI  HCAP has a negative effect on GDP growth. The interaction term, i.e.
FDI  TOP reveals that FDI is good for economic growth in Pakistan with open-trade
regimes. A link between FDI and growth is therefore established.
In order to check stability of long-run relationship between GDP and independent
variables, ECM is implied.
The short-run effect of GDP growth on variables suggested in the model is not
significant except for trade openness and their respective interactive terms, i.e.
FDI  TOP and FDI  HCAP at 5 percent confidence level. The results are represented
in Table IV. The adjustment parameter (p) shows negative value, indicating the long-
run convergence. The ECM estimation reveals that 46 percent disequilibrium on GDP
is reported with other independent variables in the case of Equation (1). While ECM
estimation in the remaining three equations are approximately 20 percent ; the small
sizes of coefficient of error-correction terms indicate that the speed of adjustment is
rather slow for equations to return to their equilibrium level, once it has been shocked.
ECM is applied to determine the short-run coefficients of the independent variables.
The model specified in Table V shows long-run estimates and their elasticities
simultaneously. The results of estimation of ECM are given below.
Table V indicates that FDI, TOP and FDI  TOP elasticities are significant at
5 percent confidence interval in the long run. Thus empirical results show that there
exists a long-run relationship between FDI, TOP and their interactive term, i.e.
FDI  TOP on economic growth (GDP). As shown in column (1), FDI has a positive and
significant contributor to increase economic growth of Pakistan. Similar results have
been found in column (2), (3) and (4), respectively. It is evident from the above
implications that FDI has contributed toward economic growth in the long run. Trade
liberalization has a significant and negative relationship with GDP in the long run
which implies that trade liberalization policies are not sufficient enough to boost the
economic growth of Pakistan. In column (4), FDI along with trade openness shows that
if there is a 1 percent increase in FDI  TOP interaction, economic growth decreases up
to 1.226 percent which shows more elastic results. The result implies that globalization
 FDI impact on
Hypothesis Trace statistics Critical values
H0 H1 FDI  PCI FDI  HACP FDI  TOP 5% Pakistan’s
growth
r ¼ 0* r40 344.54 372.62 416.47 159.52
rp1* r41 223.89 244.34 265.28 125.61
rp2* r42 133.84 152.65 144.60 95.75
rp3* r43 89.560 102.45 88.400 69.819 89
rp4* r44 51.734 59.814 51.1416 47.856
rp5 r45 28.816 26.263 23.3993 29.797
rp6 r46 11.039 11.859 10.2256 15.494
rp7 r47 0.2499 0.4663 0.150630 3.841
Maximum eigenvalue test
r ¼ 0* r40 120.64 128.27 52.36 52.36
rp1* r41 90.051 91.695 46.23 46.23
rp2* r42 44.282 50.202 40.07 40.07
rp3* r43 37.825 42.638 33.87 33.87
rp4* r44 22.917 33.551 27.58 27.58
rp5 r45 17.777 14.404 21.13 21.13
rp6 r46 10.789 11.392 14.26 14.26
rp7 r47 0.2499 0.4663 3.841 3.841
Normalized cointegration vector – FDI  PCI
Cointegrating vector GDP FDI HCAP TOP SIZE POP CPI FDI  PCI
(standard error 1 0.135 0.629 3.471 2.811 0.963 0.132 0.279
in parentheses) (0.004) (0.023) (0.061) (0.086) (0.128) (0.008) (0.012)
Normalized cointegration vector – FDI  HCAP
Cointegrating vector GDP FDI HCAP TOP SIZE POP CPI FDI  HCAP
(standard error 1 5.47 0.67 3.25 2.71 1.21 0.16 0.19 Table III.
in parentheses) (0.135) (0.015) (0.045) (0.05) (0.128) (0.080) (0.0049) Johansen’s test for
Normalized cointegration vector – FDI  TOP multiple cointegration
Cointegrating vector GDP FDI HCAP TOP SIZE POP CPI FDI  TOP vectors cointegration test
(standard error 1 0.071 0.387 6.365 0.126 3.657 0.134 0.227 among GDP, FDI, HCAP,
in parentheses) (0.007) (0.008) (0.052) (0.031) (0.045) (0.002) (0.0085) TOP, SIZE, POP, CPI,
Notes: Trace test and Maximum eigen value test indicate five cointegrating equations at the 0.05 FDI  PCI, FDI  HACP
level; *rejection of the hypothesis at the 0.05 level; **MacKinnon et al. (1999)p-values and FDI  TOP

hurts economic growth in Pakistan because of its slow pace. The trade liberalization
model in Pakistan must be viewed in relevance to the WTO and other international
institutions in order to reap the benefits of sustainable growth. FDI has a positive and
significant relationship with economic development in the long run. Results indicate
that Pakistan has to liberalize its FDI to enhance human capital development alongside
attaining other benefits of technology transfer and foreign exchange contribution.

Conclusions
The objective of this paper was to empirically investigate the effect of FDI on economic
growth in Pakistan. Overall, the analysis shows that there is a long-term relationship
between growth and FDI, human capital, trade openness, government size, population
and consumer price index in Pakistan. Factors such as the low quality of human
capital have a negative impact on economic growth. The cumulative impact of all
factors (human capital, trade openness, government size, population growth rate
and consumer price index) enhances the impact of FDI on growth, while independent
SAJGBR Variables 1 2 3 4
1,1
Constant 68.164 37.166* 2715.50 19.618
(0.874) (5.597) (1.990) (0.657)
D(FDI)t1 0.581 0.014 238.94 0.256
(1.512) (0.529) (1.162) (0.864)
90 D(TOP)t1 22.698* 1.101* 694.85* 21.806*
(2.565) (2.541) (3.121) (4.581)
D(HCAP)t1 7.466 0.147 14.998 0.860
(1.801) (0.784) (0.518) (0.984)
D(SIZE)t1 13.089 0.181 36.678 0.507
(1.691) (0.804) (0.865) (0.382)
D(CPI)t1 0.432 – – –
(1.451)
D(FDI  PCI)t1 – 0.064 – –
(1.750)
D(FDI  HCAP)t1 – – 8.859* –
(2.524)
D(FDI  TOP)t1 – – 0.508*
(3.981)
ECM 0.46* 0.21* 0.20* 0.20*
R2 0.856 0.865 0.838 0.917
Table IV. Adjusted R 2
0.687 0.706 0.648 0.799
Short-run error correction F-statistics 5.067 5.435 6.376 9.379
model – dependent
variable: D (GDP)t Note: *Rejection of hypothesis at 5 percent significance level, hence denoting significance

Variables 1 2 3 4

FDIt1 0.770* 0.138* 53.471* 0.526*

(2.567) (5.019) (2.714) (2.213)
TOPt1 10.267* 3.826* 379.631* 1.348*
(2.574) (5.345) (2.576) (2.567)
HCAPt1 1.263 1.005 64.379 0.910
(0.610) (1.679) (1.759) (1.071)
SIZEt1 9.429 0.558 168.000 1.033
(1.746) (1.812) (2.576) (0.591)
CPIt1 0.093 – – –
(0.290)
(FDI  PCI)t1 – 0.042 – –
(1.322)
(FDI  HCAP)t1 – – 2.459 –
(0.917)
(FDI  TOP)t1 – – – 1.226*
(3.544)
ECM 0.468 0.21 0.208 0.20
R2 0.856 0.865 0.838 0.917
Table V. Adjusted R2 0.687 0.706 0.648 0.799
Long-run error correction F-statistics 5.067* 5.435* 6.376* 9.379*
model: dependent variable:
D(GDP)t Note: *Rejection of hypothesis at 5 percent significance level, hence denoting significance
impact is not favorable. This paper confirmed that FDI alone is not enough; some other FDI impact on
factors magnify or inhibit the impact of FDI on growth. The extent to which a country Pakistan’s
would take advantage of FDI is dependent on human capital development, trade
openness, government size, population growth rate and consumer price index. growth
Another important finding is that FDI is an important vehicle for achieving economic
growth only in the presence of absorptive capacity as created through increased
exports, increased capital goods imports, trade liberalization policies and human capital 91
development. The negative impact of human capital development on economic growth
perhaps reflects the decline in public investment in education and training or the
excessive specialization in the educational system in the Pakistan. With an inflexible
labor market, firms are unable to benefit from the recent trade and institutional reforms.
The implications of present research relate to heightening the need for labor market
reforms and making the educational system more flexible. The results also indicate that
current economic malaise, as reflected by high inflation, lowers economic growth. On the
other hand, population growth is found to stimulate economic growth in Pakistan. An
interesting finding is that economic growth in Pakistan is not influenced by economic
growth of its major trading partners partly because of the recent slowdown in these
economies. With the changing trend in the geographical and historical proximity to these
trading partners through Pakistan government’s diversification of exports and it’s focus
on other emerging markets, we expect to see a declining influence of these traditional
trading partners to Pakistan’s economic growth of the future.
This paper has some limitations. First, it does not include all dimensions of the
FDI-growth factors. This was due to the limited scope of the study. However, we tried
to include variables most relevant to Pakistan’s economic and social situation. The
study is also limited in its generalizability to other countries in South Asia or globally,
because it focusses upon an emerging economy in Asia with a unique context.
However, it offers some interesting evidence and discussion points that could be used
by researchers to conduct similar studies in other regions of the world.
For FDI to be a significant contributor to economic growth in Pakistan, the
government must focus upon improving physical infrastructure and quality of human
resources. It should also facilitate developing strong local entrepreneurship, create a
stable macroeconomic framework as well as improve conditions for productive
investments to speed up the process of economic development.

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About the authors

Khalid Zaman is an Assistant Professor of Management at COMSATS Institute of Information
Technology, Pakistan. His research interests include time-series econometrics, development
economics and macroeconomics.
Iqtidar Ali Shah is an Associate Professor of Management Sciences at COMSATS Institute
of Information Technology, Pakistan. His research interests include quality assurance in
higher education, women development, people’s participation, environment, NGOs and rural
development. He received his PhD from University of Thessaly, Greece. Iqtidar Ali Shah is the
corresponding author and can be contacted at: iqtidar@ciit.net.pk
Muhammad Mushtaq Khan is Head of the Department of Management Sciences at
COMSATS Institute of Information Technology, Pakistan. His research interests include national
health policies, evaluation of health systems, programs and strategies, and social welfare. He
received his PhD from the University of Groningen, Netherlands.
Mehboob Ahmad is a Professor of Management Sciences at Bahria University, Pakistan.
His research interests include Islamic economics, income distribution, poverty, growth, etc.
He received his PhD from BZU Multan, Pakistan.

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