International Journal of Applied Economic Studies Vol.

5, Issue 5, October 2017

Available online at http://sijournals.com/IJAE/
ISSN: 2345-5721

An analysis of exchange rate volatility and FDI inflow in Pakistan; using ARDL bound
testing technique (1981-2015)
Usman ullah Khan (corresponding author)
E-mail: usmanwazir91@gmail.com
M.phil Scholar Department of Economics Hazara University Mansehra, Pakistan
Farhad Sultan
E-mail: farhad4210@yahoo.com
M.phil Student Department of Economics Hazara University Mansehra, Pakistan
Zia Ur Rehman
Department of Economics Gomal University Dera Ismail Khan
Abstract
Using ARDL bound testing framework, the impact of exchange rate volatility and foreign direct investment was
investigated in Pakistan for the period of 1981 to 2015. The purpose of research is to examine the impact of exchange
rate, exchange rate volatility, GDP, trade openness and current account balance on FDI. ARDL technique is used to find
the short run and long run relationship of these variables with FDI. The result shows that exchange rate volatility and
current account balance have negative impact on FDI in short as well as in long run. While the result of all the other
variables are according to our expectation and prior studies. The empirical results obtained in this paper recommend the
economy’s politicians in Pakistan to implement exchange rate policies that promote stability of exchange rate, which
can help reduce exchange rate volatility in order to attract more FDI.
Keywords: Exchange rate volatility, FDI, ARDL, Current account balance.
1. Introduction
Foreign direct investment is the net inflows of foreign investment in a country. On the importance of inward FDI in
host countries empirical studies implies that the inflow of foreign capital increases the funds supply for investment thus
enhancing capital formation in the host country. Developing countries of the world face various problems, scarce
financial resources are one of the main problem. With the passage of time investment requires to raise along with other
things, these needs are fulfilled through capital inflow from developed countries to the less development countries either
in the form of aid or foreign direct investment (Ellahi and Ahmad, 2011). FDI is an important source of capital inflow
that carried out the technological spread out and managerial know-how in the least development countries through
introducing better production methods. So it is necessary to keep up smooth inflow of inward investment into these
countries, and control any factors that cause disruption of this FDI stability (Agnes and Thierry, 2005).
Exchange rate volatility is a type of risk faced to international traders and investors engaged in FDI. Therefore, we
conclude that exchange rate volatility is an important factor that restrict the trade volume and decrease the investment.
When this volatility appears in developed countries causes instability in the world (Chege, 2009). It is a large
recognised fact that exchange rate uncertainty in LDCs is the important factor that brings economic instability in the
whole world (Chege, 2009). Exchange rate volatility affects FDI by the way that the depreciation of the currency of host
country against the home country currency increases the relative wealth of foreigners which results in boom of
attractiveness of FDI inflow as firms are able to acquire assets cheaply available in the host country. Therefore a
depreciation of host country currency should raise the FDI inflow in the host country, on the other hand an appreciation
of the host country currency must declined the FDI (Froot and Stein, 1991). Recent studies have attempted to explored
channels through which exchange rate affects FDIs. As domestic currency appreciates enable the FDI attractive to
domestic firms by two reasons. The first is as domestic currency appreciates exports more expensive in foreign market
and established production units in the foreign country become more attractive to domestic firms. Second, the initial
cost of production in the foreign market will be cheaper as a result of domestic currency appreciates. In the past studies
of Cushman (1988) and Barrel and Pain (1998) investigated that the appreciation of domestic currency decreasing the
FDI inflow, but the study of Goldberg and Klein (1997) found that depreciation increasing the FDI inflow. Hence
appreciation of domestic currency flight out the capital of the countries on both accounts. Domestic currency
appreciation means development of the economic fundamentals of a country and as a result better expected investment
returns. Current account balance is an important factor of the quality of macroeconomic management, so the expected
relationship between FDI and current account balance is positive.
Although the issue of impact of exchange rate volatility on FDI inflow has been increasingly attention among the
researchers concerning the case of Pakistan, contribution to the short run and long run relationship between exchange
rate volatility and FDI in Pakistan rather limited as compared to its importance. Up to date, a little empirical studies
(e.g. Ellahi, 2012; Ullah, 2012; Yousaf, 2013) have been conducted to investigate the impact of exchange rate volatility
on FDI inflow in Pakistan. For example, the study of Ullah et al, (2012) address causality between exchange rate
volatility and FDI in Pakistan, but their study show limitations in terms of analysis of short run and long run

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An analysis of exchange rate volatility and FDI inflow in Pakistan; using ARDL bound testing
technique (1981-2015), Usman ullah Khan, Farhad Sultan, Zia Ur Rehman

relationship between exchange rate volatility and FDI. However, the study of Yousaf, (2013) showed limitation in terms
of short run and long run relationship between FDI and current account balance together with exchange rate volatility.
So, this study fill the gap by investigating the short run and long run relationship between exchange rate volatility and
FDI, by especially including an important variable current account balance which is an important factor determines the
strength of its currency. Deterioration of current account balance leads to depreciation of the host country’s currency,
causing inflation and variations in exchange rate in economy. If this is the case then an increase in current account
deficit will lead to reduction of FDI inflows.
The remaining paper proceeds as follows: Section 2 deals with a relevant literature on the subject. Section 3 describes
data and methodology. Section 4 estimates empirical results. Section 5 presents conclusion and policy recommendation.

2. Literature Review
Ellahi (2011) using time series data during the time period of 1980 to 2010, to investigate the impact of exchange rate
volatility and other variables on FDI in Pakistan. Applying modern and robust technique of ARDL and VECM test to
find the direction of causality between the mentioned variables. Result of this study shows that exchange rate volatility
has negative effect on FDI inflow in short run while in long run has positive impact on FDI. Capital account balance has
positive and significant impact on FDI inflow. Exchange rate, Trade openness and GDP have negative impact on FDI
but these effects are significant for exchange rate and GDP but insignificant for Trade Openness.
Upadhyaya et al, (2011) worked on the impact of exchange rate volatility on the FDI inflow in South Asian countries. A
panel data for Bangladesh, India, Pakistan and Sri Lanka is used for a period of 1986 to 2009, using unit root test,
Johansson cointegration test and ECM for time series data properties. The result shows that GDP is positive on FDI for
all the above mention countries, but is significant in Pakistan, Bangladesh and Sri Lanka and insignificant for India.
Trade openness and exchange rate is insignificant in all countries, current account balance is significantly negative
impact on FDI in Bangladesh and Sri Lanka but is significant in India and insignificant for Pakistan. Real exchange rate
volatility is significant negative in India but significant with positive sign in Pakistan, significant with negative sign in
Sri Lanka and insignificant with positive sign in Bangladesh, and thus an inconclusive impact of Real exchange rate
volatility on FDI inflow in South Asia. Another research is done by (Azhar et al, 2015) on SAARC countries includes
Pakistan, India and Sri Lanka, used time series data from 1981 to 2013. GMM technique is used and the result shows
that exchange rate volatility has negative relationship with FDI, while the other variables which include real exchange
rate, GDP per capita and Trade openness have positive relationship with foreign direct investment.
Ullah et al, (2012) determine the impact of exchange rate and exchange rate volatility on foreign direct investment in
Pakistan, by covering the data from 1980 to 2010. In this study FDI take as dependent variable and exchange rate,
exchange rate volatility, trade openness and inflation as independent variables. Applying different time series
econometrics techniques such as unit root test, volatility analysis, cointegration technique and causality analysis for the
purpose of analysis. Finding of this study indicates that exchange rate volatility has negative impact on FDI. Rupees
depreciation has positive impact on FDI, similarly inflation has positive impact on FDI but it is insignificant. This study
concludes the policy recommendation is to decrease exchange rate volatility and maintain the exchange rate in well-
suited form.
Khan et al, (2012) investigated the effective of exchange rate in Pakistan, by applying unit 1980 to 2009. Their result
shows that there exist long run relationship between exchange rate and FDI, trade openness, GDP, while found no long
run relationship between exchange rate and inflation. There is runs bidirectional causality between exchange rate and
FDI, but no causality runs between exchange rate and GDP.
Danmola (2013) examine the impact of exchange rate volatility on macro economic variables in Nigeria, by applying
Ordinary Least Square (OLS) and Granger Causality test. In this study used annual data from 1980 to 2010. This study
finds that exchange rate volatility has positive impact on FDI, GDP and Trade Openness, but negative impact on
inflation in the country. This study also finds that causality moves from exchange rate volatility to FDI (i.e.
unidirectional). Similarly, Sharifi-Renani and Mirfatah (2012) carried out research on impact of exchange rate volatility
on FDI in Iran, used quarterly data from the period 1980Q 2 to 2006Q3. Applying Johansen and Juselius’s cointegration
approach and found that GDP, openness and exchange rate have positive relation with FDI, but exchange rate volatility
and world crude oil prices have negative relation with FDI in Iran. Yousaf et al, (2013) have made an attempt to
examine the relationship between exchange rate, exchange rate volatility and FDI in Pakistan, over the period of 1980-
2011, using different time series econometrics techniques like as GARCH, Histogram test, Phillips-Perron test, ADF
test have been used for analysis. They argued that exchange rate volatility and inflation have negative impact on FDI,
while exchange rate has positive impact on FDI. Wang (2013) investigated the relationship between exchange rate
volatility and FDI in BRICS (Brazil, Russia, India and China) economies for the period 1994 to 2012. He found
negative long run between exchange rate volatility and FDI for Russia and India, and short run relationship was found
for Russia, India and China. But no relationship was found for Brazil. Azma et al, (2015) carried out research on effect
of exchange rate volatility on FDI in SAARC countries which include India, Pakistan and Sri Lanka for the period 1981
to 2013. GMM technique and unit root test were used. They take FDI as dependent variable and Trade Openness,
volatility of exchange rate, exchange rate, GDP per capita. They conclude that exchange rate volatility has negative

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International Journal of Applied Economic Studies Vol. 5, Issue 5, October 2017

relationship with FDI for these countries, and the other variables i.e. Trade Openness, exchange rate, GDP per capita
have positive impact on FDI.

3. Theoretical Background
FDI inflow in a country is influenced by a number of factors. Market size of the host country is an important among
them. Regarding to the market size hypothesis suggest those countries where market size is large enough attracting
foreign direct investment and support the economies of scale needed for production. This have been given pervasive
reasoning that mostly investment has been market seeking and this will help to explain why mostly FDI goes to
developed countries as compared to developing countries because of their extensive markets. The researchers Daniels
and Quigley (1980) used GDP as a proxy for market size and find that GDP is significant and important variable
explaining FDI inflow. Current account balance of the host country is an important factor determines the strength of its
currency. Deterioration of current account balance leads to depreciation of the host country’s currency. It is widely
accepted that current account deficit causing inflation and variations in exchange rate in economy. If this is the case
then an increase in current account deficit will lead to reduction of FDI inflows (Froot and Stein, 1991).
The impact of exchange rate on foreign direct investment seems to be ambiguous. However a depreciating exchange
rate may cause reduction of FDI, it may raise exports and gains from resource-seeking FDI. When host country
currency depreciate foreign investors lose also because incur cost to avoid transaction cost and translational loses. The
researchers Grosse and Trevino (1996), and Tuman and Emmert (1999) found mixed investors reactions to currency
depreciation. As exchange rate risk created exchange rate volatility also affect the flow of FDI. As by previous studies;
exchange rate risk is associated with exchange rate volatility also affects the flow of FDI. The relationship between
international trade and FDI is not clear entirely. On one side FDI encouraged in the host country by protectionist
policies. On the other hand, ability of the firms to export successfully may justify their making more permanent
investment in that country. However, several countries have imposed import substitution policies to successfully attract
FDI, a fact that help to explain why most FDI historically has been market seeking rather than resource seeking. Due to
this scenario, one would expect a country’s high import restrictions and low levels of trade to associate with high FDI.
4. Data and Methodology
4.1 Data and Sources
The main objective of this study is to analyse the causal relationship between exchange rate volatility and FDI in
Pakistan. The variables used in the present study are FDI, Exchange rate, Exchange rate volatility, Trade openness and
Current account balance. The data collected from World Bank’s reliable source World Development Indicator for the
time period of 1981 to 2015. All the variables except current account have been used in log form which makes
interpretation more robust and meaningful. Volatility of exchange rate is measured by the following formula of standard
deviation.

S.D = √Σ Xi − X /n

4.2 Model Specification

The model employed in this study was based on the previous theoretical and empirical research work of (Ullah et al,
2012; Yousaf et al, 2013). The study of Yousaf et al, (2013) state that conducted an econometric study, long run and
short run relationship between the variables is determined to the information obtained from the theoretical arguments.
Therefore this study employed ARDL bound to test the long run and short run relationship between exchange rate
volatility and FDI inflow in Pakistan. The following regression model is developed:
FDI = 0+ 1 (ER) + 2 (GDP) + 3 (VER) + 4 (TOPEN) + 5 (CAB) + e
Where;
FDI: Foreign direct investment, net inflow (% of GDP)
ER: Exchange rate
GDP: GDP growth (annual %), use as proxy for market size
VER: Exchange rate volatility
TOPEN: Trade openness (sum of export and import divided by GDP)
CAB: Current account balance
e: error term
As the signs for coefficients 1, 2 and 4 are expected to be positive, while the signs for coefficients 3 and 5 are
negative. The values of exchange rate volatility were computed by the researchers. The computations were based on
theoretical validation of research results carried out in the past (see Cho et al, 2002; Bahmani-Oskooee and Mitra,
2008), in which they used a measure of variance (i.e. standard deviation) of the first difference of the exchange rate
variable to construct the exchange rate volatility variable. According to this theoretical basis, this paper used standard
deviation of the first difference of the exchange rate variable to compute the exchange rate volatility.

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An analysis of exchange rate volatility and FDI inflow in Pakistan; using ARDL bound testing
technique (1981-2015), Usman ullah Khan, Farhad Sultan, Zia Ur Rehman

4.2.1 Unit Root test

Almost all the macroeconomic variables time series data are non-stationary at their level form and the use of non-
stationary data produces empirical results spurious (Nelson and Plosser, 1982). Therefore, to ensure the data series
stationary, Augmented Dickey Fuller (ADF) test is used by Dickey and Fuller (1981) and is non-parametric in nature
which corrects serial correlation and heteroskedasticty in error terms.
Considering the simple AR (1) process
Yt = Yt-1 + Xt + μt … … … … … … (i)
Where, Yt shows the time series variable and Xt is a vector of explanatory variables, and are the estimated
parameters of Yt and Xt respectively and μt is the error term with zero mean and constant variance (0, σβ). If = 1 so the
equation (i) becomes random walk model and the series has unit root.
Subtracting Yt-1 from both sides,
ΔYt = δYt-1 + Xt + μt … … … … … … (ii)
Where Δ shows the difference and δ = θ – 1. In practice equation (ii) is estimated to see whether δ = 0 or not. If δ = 0,
it shows that θ = 1 and the variables posses unit root. Thus Dickey Fuller statistic tests the Null hypothesis H 0 = δ = 0 (θ
= 1) through ordinary square (OLS) estimation under the critical values of test statistic. If this null hypothesis is
accepted, it shows that our variables are non-stationary and its variance is increasing function of time.
But the acceptable condition of ADF test is that the error term must not serially correlate. In case of such violation,
ADF test is remedy. It augments the contemporary Dickey fuller test with lagged values of dependent variable. Suppose
that Yt follows AR (p) process, it incorporates p lagged terms dependent variable in equation (ii).
�
ΔYt = δYt-1 + Xt + ∑�= � ΔYt-k + ut ……(iii)
4.2.2. ARDL Approach
To find the co-integration among the variables, Pesaran et al, (2001) have introduced Bound test through ARDL
approach to test the cointegration. The ARDL bound test approach, testing the long run and short run relationship
among the variables can be estimated. The general form of ARDL model of co-integration is follow;
ΔY = c + t + y Yt-1 + x Xt-1 + ∑��= y ΔYt-i + ∑��= x ΔYt-i + ut ….(iv)
In the above equation (iv) Y is dependent variable and X is vector of independent variables, Pesaran et al, (2001). To
test the existence of long run relationship, F-test is to be conducting in the following way.
Ho: 1 = 2 = 3 = 4 = 5 (No co-integration)
Against
Ho: 1 ≠ 2 ≠ 3 ≠ 4 ≠ 5 (No co-integration)
To test this hypothesis, whether cointegration exists in the model or not? Pesaran et al, (2001) supply bounds on the
critical values for the asymptotic distribution of the F-statistic provide a test for co-integration based on the assumption
that in the lower bound all of the regressors are I(0) and the upper bound all of the regressors are I(1). If the computed
F-statistic above the upper bound, the null hypothesis of no long-run relationship (i.e. co-integration) is rejected.
Conversely, if the F-statistic falls below the lower bound we conclude that there is no co-integration, so the null
hypothesis cannot be rejected. Once cointegration established, the long run model of ARDL of FDI and Exchange rate
volatility is as follow:
ΔFDIt = αo + t + α1fdit-1 + α2ert-1 + α3gdp t-1 + α4ver t-1 + α5to t-1 + α6ca t-1 + ut … (v)
Short run dynamics of FDI inflow and Exchange rate volatility is as follow:
ΔFDI = ∑��= Δ ert-1 + ∑��= Δ gdp t-1 + ∑��= Δ ver t-1 + ∑��= Δ to t-1 + ∑��= Δ ca t-1 + ECTt-1 + ut … (vi)

4.2.3. Bound test

This study using bound test to find out long run relationship as given in equation (v), using F-statistic with the help of
two bounds i.e. lower bound and upper bound. To check cointegration among variables, null hypothesis assume that no
cointegration. It is concluded that if F-statistic values comes more than the upper bound then null hypothesis is rejected,
if F-statistic values comes lower than lower bound then null hypothesis is accepted. But if F-values fall between lower
and upper bound the test is inconclusive.
5. Empirical results and discussion
5.1. Descriptive Statistics
Descriptive statistics shows the key features of the data that used in empirical analysis. The following table 1 shows the
descriptive statistics of the variables. The mean value of FDI is 0.941 whereas the standard deviation which indicates
the dispersion from mean is 0.847. The mean value of ER is 4.785 whereas the standard deviation is 0.259. Mean value
of GDP is 4.706 whereas the standard deviation is 1.973. Mean value of VER is 1.083 whereas the standard deviation is
0.653. The mean value of TO is -2.018 whereas the standard deviation is 2.382. Lastly, mean value of CA is -2.018
whereas the standard deviation is 2.382. All of the variables skewness values are within the range of a normal
distribution1.

1 For a normal distributed variable, the skewness coefficients are, respectively, 0 and 3 (Gujarati, 5th Edition).

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International Journal of Applied Economic Studies Vol. 5, Issue 5, October 2017

Table 1: presents descriptive statistics of all the variables

FDI ER GDP VER TO CA
Mean 0.940773 4.784803 4.706472 1.082958 -2.018029 -2.018029
Median 0.641482 4.713456 4.832817 1.057754 -2.228000 -2.228000
Maximum 3.668323 5.433653 7.920764 2.519026 4.538000 4.538000
Minimum 0.102667 4.540338 1.014396 -0.368759 -8.120000 -8.120000
Std. Dev. 0.847447 0.259567 1.973115 0.653043 2.381674 2.381674
Skewness 1.981197 1.324592 -0.024518 0.162632 0.417348 0.417348
Kurtosis 6.278645 3.533342 2.095060 3.335145 4.616146 4.616146
Jarque-Bera 38.57303 10.64967 1.197759 0.318091 4.825108 4.825108
Probability 0.000000 0.004869 0.549427 0.852957 0.089586 0.089586
Sum 32.92706 167.4681 164.7265 37.90353 -70.63100 -70.63100
Sum Sq. Dev. 24.41763 2.290743 132.3682 14.49982 192.8607 192.8607

Observations 35 35 35 35 35 35
Source: Auther’s estimation

5.2. Correlation matrix and Variance inflation Factors

Table 2 indicates the correlation matrix of variables while Table 3 indicates variance inflation factors β of variables used
in this study. The values of correlation between variables from tables 2 suggest that no problem of multicollinearity
among the variables used in our study. Similarly, in table 3 the values of VIFs of all variables are less than 10 which
shows no multicollinearity exist among the variables γ.

Table 2: present Correlation Matrix

FDI LNER GDP LNVER LNTO CA
FDI 1.000000
LNER -0.495505 1.000000
Ln GDP -0.144731 0.509602 1.000000
LNVER -0.529994 0.722387 0.283570 1.000000
LNTO 0.128365 0.176424 0.080969 0.074631 1.000000
CA -0.430607 -0.065471 0.209946 -0.168157 -0.549665 1.000000
Source: Auther’s estimation

Table 3: present Variance inflation factors

Variables VIF
LNER 2.738372
GDP 1.524064
LNVER 2.266631
LNTO 1.586084
CA 1.701554
Source: Auther’s estimation

5.3. Unit Root Test

Before applying the ARDL bound test it is crucial to test the order of integration of all variables. Even though, the
ARDL technique does not require the pre-testing of the order of cointegration of the variables but in the presence of I
(2) ARDL produce spurious result. The Augmented Dickey Fuller test has been employed to examine the stationarity
property of the variables. The result of ADF test is reported in the following table 4. The result shows that half of the

β
Variance inflation factors (VIFs) are a method of measuring the level of collinearity between the regressors in an
equation. VIFs show how much of the variance of a coefficient estimate of a regressor has been inflated due to
collinearity with the other regressors.
γ If the value of VIF exceeds to 10 there is strong multicollinearity problem Gujrati (2004).

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An analysis of exchange rate volatility and FDI inflow in Pakistan; using ARDL bound testing
technique (1981-2015), Usman ullah Khan, Farhad Sultan, Zia Ur Rehman

variables are stationary at 10% level mean no unit root whereas the remaining half is non-stationary at level but become
stationary at first difference. Thus, the order of co-integration is mix which implies that we can apply the ARDL
technique.

Table 4: Present Unit Root Test Results

Variables Level 1st difference Conclusion
FDI -2.698350* -3.793109*** I(1)
Ln ER -3.878134*** -------- I(0)
Ln GDP -3.542255** -------- I(0)
Ln VER -3.440251** -------- I(0)
TOPEN -------- -8.858618* I(1)
CAB -------- -5.151481*** I(1)
Note: *, **, *** significant at 10 percent, 5 percent and 1 percent level respectively.
5.4. Bound test result
Table 5 showing results of F-statistic, as F-statistic value is (4.18599) is more than the upper bound of bounds values at
5%, which is suggesting that there is long run relationship between propose variables. In a nutshell, the determinants of
FDI move together in long run.

Table 5: present Bound test results

F- Statistic 4.18599
Critical values bounds
Significance I0 bounds (lower bounds) I1 bounds (upper bounds)
10% 2.08 3
5% 2.39 3.38
1% 3.06 4.15
Source: Auther’s estimation

5.5. ARDL model Long Run results for the impact of exchange rate volatility on FDI inflow in Pakistan.
The long run estimation of equation (v) is reported in table 6. The ARDL estimates show that exchange rate has positive
relationship with the foreign direct investment inflow. The coefficient of exchange rate is statistically significant and its
value is 0.52 indicating that 1 unit increase in exchange rate, it would increases FDI by 0.52 units. This result is similar
to the findings of Ellahi (2011) and Yousaf et al, (2013), they found the same relation between these two variables. This
positive relationship reveals that the country currency appreciate this can increase the return on investment for foreign
investors, so that exchange rate can attract FDI in Pakistan. Exchange rate volatility which is the main variable in our
study has significant negative impact on FDI. The similar finding is supported by Ullah et al, (2012). As the volatility
can raises the exchange rate risk which can discourage the FDI inflow in Pakistan. So stability of exchange rate is
needed to attract more FDI. GDP used as a proxy for market size and find that GDP is positive and significant impact
on FDI. One unit increase in GDP increases FDI by 0.41 units. This finding is within line of Azma et al, (2015), this
suggest when market size is large enough attracting more foreign direct investment. The coefficient of trade openness is
positive and significant which show that 1 unit increase in Trade Openness raising FDI by 0.66 units. This result was
also supported by the researchers Sharifi-Renani and Mirfatah, 2012; Danmola, 2013; Ullah et al, 2012. Trade
Openness refers to the country do trade with rest of the world including both imports and exports to GDP. In developing
country such as Pakistan the trade openness indicate the degree to which country’s borders has no restriction on imports
and exports, as it is favourable for encouraging FDI. So trade liberalization can attract more FDI. Current account
balance is insignificant impact on FDI inflow. This outcome is similar to the finding of Upadhyaya et al, (2011) have
found insignificant impact of current account balance on FDI in case of Pakistan out of South Asian countries.
The result of diagnostic tests are shown in the bottom of table 6, the estimated value of F-statistics is highly significant
which indicate that our model is goodness of fit. The values of Durbin-Watson Stat and LM test confirm that our model
is free from serial correlation. The p-value of chi-square statistic of Hetero skedasticity test (i.e. Breusch-Pagan-
Godfrey test) is higher than 5% i.e. 0.108 which confirm that there is no heteroskedasticity in the data. Histogram test is
applied for checking the normality of data; the p-value of Jarque-Bera is greater than 5% shows that the data is normally
distributed. Furthermore, the graph of cumulative sum of recursive residuals Cusum and Cusum of Square test are
applied to test the stability of parameters of the model as given in figure 1 and 2. The straight lines are significant at 5%.
As it can be seen in the figures that the movement path of the test statistics is always between the straight lines, so the
model is necessary stability.

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International Journal of Applied Economic Studies Vol. 5, Issue 5, October 2017

Table 5: present long run ARDL test result

Dependent variable = FDI inflow
Regressors Coefficient t-test p-values
Constant 0.7548 1.24 0.037
(40.183)
lnER 0.5209 -2.45 0.000
(11.055)
lnGDP 0.4161 2.85 0.000
(11.09)
lnVER -0.6469 -1.85 0.02
(3.974)
lnTO 0.66 2.78 0.000
(0.192)
CA 0.50 0.66 0.347
(1.64)
Diagnostic Tests

F-Statistic (Over all significance of model) 222.23 {0.000}

Durbin-Watson Stat 1.89
Serial correlation LM test 2.235 {0.126}
Hetero skedasticity: Breusch-Pagan-Godfrey 2.000 {0.108}
Histogram test ( Normality) 1.578 {0.454}
Cusum and Cusum of Square test Stability proved

Note: values in (), {} are standard errors and p-value respectively.

16 1.4

12 1.2

1.0
8
0.8
4
0.6
0
0.4
-4 0.2

-8 0.0

-12 -0.2

-0.4
-16
88 90 92 94 96 98 00 02 04 06 08 10 12 14
88 90 92 94 96 98 00 02 04 06 08 10 12 14
CUSUM of Squares 5% Significance
CUSUM 5% Significance

Figure 1: CUSUM test for parameters stability Figure 2: CUSUMSQ test for parameters stability

5.6. ARDL short run result for the impact of exchange rate volatility on FDI
Short run result of ARDL is given in table 7. SIC is use for lag selection. The coefficient of lagged ECM (ecmt-1) is
negative and highly significant. The coefficient of ECM (-1) indicates disequilibrium is corrected or adjusted with the
speed of 34% in one year. The significance of ECM (-1) also confirmed the long run relationship of variables as
estimated earlier. According to the short run result, exchange rate has positive relationship with foreign direct
investment. Exchange rate volatility has negative effects on FDI. This result is in line with the study by Yousaf et al,
(2013). The coefficient of GDP contain positive sign and highly significant at 1% level. Volatility of exchange rate has
negative impact on FDI in the short run. This result is similar to Wang (2013). Trade openness positively contributes to
FDI. This suggests that by entering the international trade, a country can attract more foreign direct investment. This

7
An analysis of exchange rate volatility and FDI inflow in Pakistan; using ARDL bound testing
technique (1981-2015), Usman ullah Khan, Farhad Sultan, Zia Ur Rehman

result is in line with the study by Azma et al, (2015). Current account balance has negative impact on FDI in the short
run. The same result is also found by Upadhyaya et al, (2011).
Durbin-Watson Stat is applied which indicate that no serial correlation in the model. The value of F-statistic is highly
significant that showing overall significant of the model.

Table 7: Present short run estimates of the model

Dependent variable = ΔFDI inflow
Regressors Coefficient t-test p-values
Constant 0.4754 1.98 0.027
(0.983)

ΔlnERt-1 0.5761 2.78 0.05

(0.055)

ΔlnGDP t-1 0.2544 2.36 0.000

(0.693)

ΔlnVER t-1 -0.3174 2.043 0.03

(2.974)

ΔlnTO t-1 0.5823 -3.515 0.000

(2.582)

ΔCA t-1 -0.4564 2.99 0.05

(2.99)

ECM (-1) -0.3483 -5.75 0.000

(1.79)

Diagnostic Tests

F-Statistic 12.238 {0.000}

Adjusted R2 0.675
SIC 73.543
Durbin-Watson Stat 1.89

Note: values in (), {} are standard errors and p-value respectively.

6. Conclusion and Policy Recommendation

This study applied ARDL bound testing technique and examine the impact of exchange rate volatility on foreign direct
investment in Pakistan for the period of 1981 to 2015. The result in general is summarized as the overall estimation
findings are consistent with theoretical prediction. We examine that exchange rate volatility has negative impact on
FDI inflow in short run as well as in long run. Volatility of exchange rate increased risk and uncertainty facing foreign
investors. Thus exchange rate volatility affects FDI in Pakistan. This suggests the policy, to attract more FDI in Pakistan
the government need to make policies such as monetary policy to maintain the stable exchange rate. GDP and Trade
Openness are the main factors in Pakistan which can encourage more FDI. Trade liberalization and reduction of trade
barriers has an important economic policy of developing country like Pakistan. In Pakistan to motivate domestic
economy employment generation for every increase in population, seek new technology and modern managerial skills
FDI play a very crucial role.

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