Master's Thesis, 2008, 162 Pages
This book re-examines the macroeconomic role of Foreign Capital Inflows (FCI) in Pakistan through applying vector error correction model (VECM) on annual time-series data for the period of 1972-2006.
The topic of Foreign Capital Inflows to Pakistan (and other developing countries) got a lot of consideration in empirical literature, but the existing literature on FCI about Pakistan mostly uses the customary econometric tools like OLS, 2SLS, FIML and 3SLS for analysis. However, we know that most of the macroeconomic variables are non-stationary, which mandates the reexamination of the past studies using new time-series tools like cointegartion and ECM. Thus, the current study not only re-examines these linkages (of FCI with domestic savings, investment and GDP) using Johansen Cointegartion Technique and Vector Error-Correction (VECM) Approach, but also adds some new macroeconomic variables like exchange rate, current account deficit and imports.
The present study does not find any evidence for direct positive impact of aggregate FCI on GDP growth and Investment (capital formation). However, the study finds the positive (complementary) relationship between FCI and domestic saving, thus suggesting an indirect positive impact of FCI on GDP through supplementing domestic resources. These results seem contradicting i.e. positive relation with domestic savings but negative linkages with investment and growth. However, we can interpret it as that FCI is supplementing the domestic resources and there is a need and justification for FCI in Pakistan due the shortage of domestic savings. But, these inflows of foreign capital are not transforming in the productive investment and thus not boosting economic growth. As this study shows that most of FCI are of
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entrapped in the ‘vicious circle of poverty’. They already lack the capital resources and at the same time the domestic saving ratios also remain low due to low income, resulting in low investment levels. Simultaneously, exports always remain lower than the imports in such countries. In such situations, the underdeveloped countries (UDCs) have to face saving-investment deficit as well as the deficit in balance of payments (BOP). The Two-Gap Model suggests that the developing countries have to rely on the foreign capital inflows (FCI) to fill these two gaps: the import-export gap and the savinginvestment gap. Along with these government earnings of the UDCs governments, also remains lower because of low tax-paying capacity of poor people of the country. Thus these three deficits (saving deficit, 1 | P a g e
macroeconomic variables are non-stationary, which mandates the re-examination of the past studies using new time-series tools like cointegartion and ECM. Therefore, the present study not only reexamines these linkages (of FCI with domestic savings, investment and GDP) using Johansen Cointegartion Technique and Vector Error-Correction (VECM) Approach, but also adds some new macroeconomic variables like exchange rate, current account deficit and imports. Accordingly the major objective of the present study is to analyse the macroeconomic effects of FCI in Pakistan. Thus we can define our research question as under:
The present study re-examines the relationship of FCI with GDP growth, domestic savings, investment and exchange rate in Pakistan. In addition, it also adds two other new macroeconomic variables like current account deficit and imports, that is, it also examines the impact of the FCI on current account deficit and imports in Pakistan. Thus, we can define our research question as, “to find out the long-run causal relationship of FCI with the Macroeconomic Variables in Pakistan.” For this purpose, the present study constructs the six bivariate Vector Error-Correction models to find out long-run causal links between these variables. The major objectives of the study are given as under.
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The major objective of the study is to re-examine the macroeconomic role of foreign capital inflows in the economic development of Pakistan, using modern time-series econometric tools like cointegration and vector error-correction. The definite objectives of the present research are:
¾ To analyse the past trends, composition and sector-wise analysis of the Foreign Capital Inflows (FCI) in the recent past in Pakistan.
¾ To explore the linkages between Foreign Capital Inflows (FCI) and GDP Growth in Pakistan.
¾ To analyse the linkages between the Foreign Capital Inflows (FCI) and domestic savings in Pakistan.
¾ To examine the linkages between the Foreign Capital Inflows (FCI) and capital formation (investment) in Pakistan.
¾ To investigate the linkages between the Foreign Capital Inflows (FCI) and current account deficit in Pakistan.
¾ To study the linkages between the Foreign Capital Inflows (FCI) and exchange rate in Pakistan.
¾ To explore the linkages between the Foreign Capital Inflows (FCI) and the imports of goods and services in Pakistan.
¾ To suggest the policy recommendations for effective utilization and the management of foreign capital inflows in Pakistan.
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The contribution and significance of the present study can be explained as under:
¾ There are so many form of the FCI but, according to the existing literature, some researchers included the only the FDI, and Aid , some used FDI, Aid and Portfolio Investment, some used only the FDI or Aid, some other used loan and grants only etc. While the present study uses a comprehensive definition of FCI and includes all form of FCI.
¾ According to the available literature on Pakistan, the relationship of the FCI with GDP, domestic savings and the investment is addressed a lot. While, the present study adds the linkages of FCI with additional macroeconomic variables like Current Account Deficit, Exchange Rate and Imports.
¾ All of the studies on Pakistan, except Ahmad and Ahmed , use econometric tools like OLS, 2SLS, FIML or 3SLS to analyze the role of FCI in Pakistan. But, we know that most of the macroeconomic variables are non-stationary in nature, which mandates the re-examination of the past studies using new timeseries tools like cointegration and ECM. Therefore, the present study uses the Johansen cointegration technique and vector error-correction model (VECM) for the macroeconomic analysis of the FCI in Pakistan.
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¾ In addition to econometric analysis, the present study also
presents the trends, composition, sector-wise distribution and need-based analysis of the FCI in Pakistan.
The organisation of the rest of the book follows as; the next chapter (chapter 2) critically reviews the empirical literature on the foreign capital inflows, while the Chapter 3 describes the complete research design and methodology for econometric analysis. The Chapter 4 presents the trend, composition, sector-wise analysis and need-based analysis of the FCI in Pakistan. Chapter 5 gives the details of results and findings of the econometric estimations. While, the Chapter 6 concludes the study, presents the summary of findings and also suggests the policy recommendations.
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T he relationship of FCI with domestic savings, investment, growth and other macroeconomic indicators has received much attention and a lot of research has been carried out both for and against the role of FCI in economic growth and development. The debate about the relationship of FCI with macroeconomic variables like domestic savings, investment, exchange rate and growth remained controversial both in theoretical and empirical terms. According to relevant literature, FCI may supplements domestic resources, promotes growth and reduces poverty of the recipient country. On the other hand, FCI may distort domestic savings, increase the debt burden of the recipient country, cause to appreciate the domestic currency and may create the boom in some sectors of the economy.
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Therefore, the current chapter aimed at reviewing this controversy in the existing literature on FCI. The chapter is divided into five subsections; section 2.1 reviews the literature on FCI and Growth relationship, while section 2.2 reviews the literature on FCI and Domestic Savings relationship, section 2.3 reviews the literature on FCI and Investment relationship, section 2.4 reviews the literature on FCI and Exchange Rate relationship, and the last section (2.5) reviews various other aspects of FCI discussed in literature.
The relationship between the FCI and Growth has debated a lot in the empirical literature. There is a controversy about this relationship; some studies found the positive relationship between FCI and GDP, while some others found a negative relationship.
A large body of literature found the positive relationship between FCI and Growth, for example, North  argued that Long-term foreign capital played an important role in meeting the capital requirements during the periods of development. Similarly, some further studies [like Chenery and Strout (1966); cited by Mahmood (1997)] also argued that foreign economic assistance stimulate the economic growth and concluded, on the basis of empirical evidence that foreign capital has a positive effect on the economic growth. Chen  applied simultaneous-equation (2SLS) model on panel data of the seven Asian
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important driver of income growth in case of contemporary China and India. Similarly, Carkovic and Levine  used dynamic panel model with data averaged over five-year periods and re-evaluated the relationship between economic growth and FDI for a panel data of 72 countries (1960-95). Carkovic and Levine found that FDI inflows do not exert an independent influence on economic growth.
Likewise, Frimpong and Oteng-Abayie  utilized Toda-Yamamoto Granger causality test and found no causality between FDI and growth for the total sample period and pre-SAP period in Ghana. Prasad, Rajan and Subramanian  also found that there is no any evidence that an increase in foreign capital inflows directly boosts growth. Consequently, the literature remained inconclusive about the relationship between the FCI and GDP growth, most of the studies found positive relationship while some found negative linkages between FCI and GDP.
The relationship between the FCI and domestic savings has been discussed a lot in the literature. There is also a controversy about this relationship, some studies found the positive relationship between FCI and domestic savings, while some other studies found a negative relationship.
Some studies found a positive (complementary) relationship between FCI and domestic savings, like, Islam  found that foreign 12 | P a g e
The existing literature on the relationship between the FCI and Investment shows both positive as well as negative links. As most of the studies found positive relationship like North  argued that Long-term foreign capital played an important role in meeting the capital requirements by directing real resources towards the needed social overhead investment and making possible an import surplus of consumer and capital goods during the periods of development. Similarly, Islam  found that foreign assistance helped to attain a higher rate of savings and investment in Pakistan.
Walt and Wets , by employing both a single equation regression and macro-econometric model, found that foreign capital inflow complemented domestic resources to finance investment and generating growth. Khan  concluded that foreign aid has played an extremely important role in influencing the pace of development in Pakistan, especially investments and imports largely depended upon the amount of foreign aid. Bosworth, Collins and Reinhart  applied a regression analysis on sample of developing economies andfound that that FDI is strongly linked to aggregate investment, and had a more positive impact, on domestic savings and investments, than any other form of FCI like loans, portfolio investment and borrowings. Similarly, Hansen and Tarp  run a regression and found that aid continues to impact on growth via investment.
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In recent past, the relationship between exchange rate and FCI got some attention and a few researchers addressed this issue. Like, Ag´enor  found that a permanent fall in world interest rate leads to a steady-state reduction in net capital inflows and a real depreciation. Ag´enor also found that the real exchange rate appreciates in the net debtor case, but may either appreciate or depreciate in the net creditor case. Kosteletou and Liargovas, applying causality tests on data for EU countries as well as for the USA and Japan over the period 1960-1997, found that in large countries, with freely floating currencies such as the USA, the UK and Japan, causality runs from the real exchange rate to FDI, while Causality runs two-ways in small countries with fixed or quasi-fixed currencies, such as the EU countries.
Mafusire  developed a computable general equilibrium (CGE) model for Zimbabwe and found that foreign capital inflows resulted in the appreciation of the exchange rate. Athukorala and Rajapatirana  found that the degree of appreciation in real exchange rate associated with capital inflow is uniformly much higher in Latin American countries as compared to Asian countries, despite the fact that the latter experienced far greater foreign capital inflows relative to the size of the economy. Thus, according to the most of literature the causality runs from FCI to exchange rate, that is, FCI causes exchange rate appreciation. Whereas, the Kosteletou and Liargovas 17 | P a g e
 found that, in small countries with fixed or quasi-fixed currencies, causality may run in both directions, i.e. exchange rate may also cause the FCI.
The studies discussed above explain the relationship of FCI with domestic savings, investment, economic growth and exchange rate, but some studies also find the other aspects of FCI in literature. Thus, the present section presents the mixed literature on FCI.
Hong  quantified the contributions by various types of foreign capital inflows towards the growth of individual Korean industries during the last 20 years (1990-1990) and suggested that the foreign capitals played a vital role in the success of Korea's manufacturing sector, which served as the engine of economic growth. FDI had more statistically significant effects on the factor productivity than either commercial or public loans. Marjit, Broll and Mitra  using a model with trade and unemployment found that the inflows of foreign capital deliver the expected results when it inflows to protected intermediate-goods sector.
Khan  concluded that, if the countries implement the necessary macroeconomic policies and realize the structural transformations that build up their financial system that will not only be helpful in managing the capital inflows but will also reduce the risks of the reversal of these capital flows. Sin and Leung  used panel data 18 | P a g e
T his chapter describes the complete research design and procedure for empirical analysis. However, before going to the empirical investigation of the linkage among FCI, Savings, Investments, Economic Growth, Current Account Deficit and Exchange Rate it will be notable to review the some basic theoretical framework for linkage between FCI and Macroeconomic Indicators. This framework will help in modelling the relationship between the variables. Thus, in this chapter, first of all, we discuss a theoretical framework in the section 3.1. The next section 3.2 formulates the hypothesis. Section 3.3 describes the data specifications, the variable description and sample period, section 3.4 provides the information about the model specification and the last section (3.5) gives the procedure for estimation (methodology) of the models formulated in section 3.4.
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