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CHAPTER ONE:
1 INTRODUCTION
The worldwide economy has now started to increase from the effects particularly from deficient
capital movements to the economy which rose from the downfall that happened in 2008 in the
USA. The emerging economies have been harmfully hit by this, owing to decrease in the exports
and capital flows. The most treacherous of these two is a decrease in foreign capital, chiefly the
foreign private investment since it causes to encourage economic progress in poor countries. This
study will provide a useful understanding this nexus between PI, FPI, financial development, FD,
and GDP growth (Gyimah-Brempong, 1999) and Waqas (2015).
Developing countries altered their economic policies in 1980,s with the intention of capturing the
opportunities of globalization. Most of the countries adopted policies to attract foreign funds
inflows. South Asia has frequently perceived a signal for absolute benefits of globalization. Past
empirical researches abetted policymakers to realize what does and what does not work and
where and under what conditions? These research studies and guidelines helped the technique
through which foreign private investment can be attracted.
Alisena and Peroti (1996) demonstrated that political instability and foreign private investments
are inversely correlated with each other. This low investment will adversely affect the financial
development and consequently economic growth.
Veniries and Gupta (1986) and Gupta (1990) have attempted to develop the interconnection of
political fickleness and unpredictability, investment, and economic performance. There are two
reasons proposed by Drazen (2000), that why economic outcomes are affected by the political
instability. First, one suggested by him is that political instability creates uncertainty and
volatility in policy making for future, which as a result creates uncertainty for the private firms
and affects the capital build up. Secondly, it directly affects the productivity by affecting market
work and economic relations.
It has been absolutely admitted that foreign private investment is a vital growth factor of
underdeveloped and poor economies. Foreign private investment provides a chance to the host
country to invest above the level of the local or domestic savings. The advantages of foreign
investment include attracting new knowledge, new technology, higher employment, increase in
competition and above all attracting foreign capital. Low risk in the country and the low
instability are the most significant factors in attracting foreign investment flows. The political
regime stability is referred to the rule of one party without any break that ruling party may be a
single party or coalition of some parties or an authoritarian regime or military dictator. Most
important of all they rule a country for a long time without any pause or major break. The term
politically stable regime is defined differently in economics and political science. In economics,
it has nothing to do with political regime whether it is democracy or dictatorship. The stability of
political regime is an essential feature in choosing the investment amount and location in the host
country. The political instability is thought to be very harmful to the economic performance by
the economists (Tabassam, 2016).
1.2 INVESTMENT
Investment means, the acquisition of real and financial assets, when a firm acquires plant and
machinery, or stock of goods or when household buys a new property for the sake of capital
gains and rate of return on their financial resources. In simple words investment means when
someone holds financial assets from the financial market. The investment can either by an
individual, firms or even by the government in the local or international markets.
Numerous research literature focused on the international flow of funds which is responsible for
an economic upswing, prosperity, and development. Foreign investment develops the pace of
economic performance and fills the savings-investment gaps. This international flow of capital is
further split into Foreign Aid and Foreign Private Investment. Foreign private investment is
supposed to be the vibrant factor of offshore investment.
We can further split this offshore flow of capital into (FDI) and (FPI) (Chaudhry, 2014)
Phase II: Based on Financial Institutions. Literature shows the relationship between institutions
and growth. Exports based development of financial sector based on comparative advantage
financial institutions provide financial facilities and services and skills-based services. This is
undoubtedly taken in terms of value added share in the growth of GDP of a country and
contribute to employment share or level of wages (Beck et al., 2005).
The question arises how financial sector development is measured and how can its intertemporal
effects be predicted on economic development. It is observed by various academic researchers
that financial development does not directly influence economic growth only through financial
institutions.
Rather it is private sector credit in relation to GDP ratio.This is a proxy used to measure the
financial development and its effects on economic growth. Similarly, domestic credit remains
idle and has no effect on growth. In summary, we can say that fruits of growth are contributed
only by the credit lending to the corporate sector and private enterprises, whereas domestic credit
has no effect on economic development. (Levin et al., 2000), Takyi (2013) and (Beck et al.,
2009) (Beck et al., 2012) and (Samargandi et at., 2015).
Despite the government efforts for the development of the financial sector, Pakistan is still far
behind the advanced countries. Hence, the optimum benefits of financial development on
country’s economic growth are yet to be explored by encouraging market capitalization, private
credit lending in relation to GDP, by curtailing inflation rate, keeping a high level of
employment, low-interest rate credit to private and household sector, improving education and
reducing poverty.
This study profoundly focuses on the nexus between political instability, foreign private
investment (FDI, FPI), (FD) and (GDP) to bridge the gap of the desired and the current level of
both economic and financial factors. Nevertheless, an exciting issue is still leftover and under
discussion that, despite political stability, strong financial development high foreign investment,
why most of the countries have remained poor and underdeveloped both economically and
financially ?
Unfortunately, due to political instability, Pakistan is facing low foreign private investment
which causes poor financial sector and ultimately poor economic growth. Although the foreign
private investment is the key determinant of economic prosperity and financial sector
development.
In Pakistan, it has been observed that due to political instability, terrorism, corruption, poor
governance, and energy crisis a large number of investors have to stampede their capital. This
volatile situation not only curtailed the level of foreign private investment but also damaged the
economic performance and financial sector growth and development in Pakistan.Therefore, this
study will envisage and try to develop an association between PI,FPI, FD and GDP in Pakistan.
1.7 PURPOSE
The purpose of conducting this research with reference to Pakistan is as, Pakistan has been
facing the problem of low productivity, low employment, high inflation, high poverty, low
literacy rate, high imports, high imports and low foreign investments. As a result of a poor
financial as well as economic sectors due to political instability, corruption, poor governance,
lack of technological skills, terrorism, sectarian violence. The main purpose of the study is if a
country is a political stability strong it can attract foreign investors which can develop the
financial as well as economic sectors. These developed Financial and economic sectors can bring
the prosperity in the country. The former will provide credit to enterprise and household sectors.
This will enhance the aggregate demand and aggregate output by providing the employment
level and income level of all the sectors. Consequently, the living standard of the people will
improve due to low inflation, high exports. Govt revenues will increase and all deficits will
reduce. This study will unveil the factors causing underdeveloped and financial and economic
performance.
2 LITERATURE REVIEW
It is strongly argued that a stable political system or strong governments either democratic or
military are contributing an ample share in raising the foreign private investments. If a strong
political environment prevails in the country then it will not only encourage the domestic
investors to come out of the shelters and invest in the economy to earn a better return but also to
attract foreign investment. Undoubtedly, the stable political system attracts investors to invest in
their home country rather than shifting and investing abroad. This economic activity will
increase the level of productivity, rise in income level of the society and ultimately raise the
consumption and savings in the economy, which would accelerate aggregate demand and
consequently the economy will grow positively.
There are deleterious consequences of political instability on financial and economic activities of
a country. Due to political instability, the inflation rate is going higher and higher, accompanied
by falling foreign investment and ultimately declining growth rate. The current study will mainly
endeavour to develop finance-growth nexus via political turmoil and foreign capital inflow in
Pakistan. Although, the past literature showed a noticeable nexus of investment, financial
development, economic growth and political instability. This may be investigated in two ways.
1. The politically wobbly environment creates uncertainty and volatility which reduces foreign
private investment which undoubtedly adversely affects financial development and reduces
growth.
2. Political uncertainty changes the nature of investment and changes the demand for factors
and the pattern of spending which is directly affecting the investment in a country and then
economic growth.
The previous literature demonstrates that political instability spreads fear among foreign
investors of losing their capital. This low investment will lead to economic and financial
disasters.
For, risk-averse agents the high probability of change of governments threaten future policies
and they would like to invest somewhere else in the safe place rather than to invest in a risky
environment Alisena et al. (1996). Recent studies regarding this issue show that there are so
many growth variables as suggested as political variables such as political violence, democracy
and government stability (Barro, 1996).
Kiprop M. J. et al., (2015) developed a unique finance-growth nexus via investment and saving
mechanism. In this study, the researchers have attempted to develop the short-run as well long-
run outlook of the finance-growth nexus by addressing the endogeneity problem.Past numerous
theoretical and empirical studies have been conducted using panel or cross-section studies. But
this is a country specific study where time series data have taken for analysis. This study has
been conducted in Kenya perception. This study focuses on the issue of endogeneity,
autocorrelation/serial correlation using ARDL bounds times series technique to invisage the
short run and long run assocation of financial sector development and growth. To measure FD
private sector credit in relation to GDP is taken as a proxy. It is obvious from the results that
there is a positive association between FD and GDP which causes economic growth to increase
in a country, which is in accordance with theory (Adeniyi, O., Oyinlola, A., Omisakin, O., &
Egwaikhide, F. O. 2015).
Anwar (2014) used OLS regression model to capture the consequences of terror on international
inflow of capital and concluded that terrorism inversely affects foreign direct investment in
Pakistan’s circumstances are concerned. It means that Terrorism is the major obstacle for the
foreign investors to invest in Pakistan because of the security risk and low return on investment
i.e. ROI. Moreover, this study also shows that Pakistan has been facing political instability for
decades which threatened the overseas investors to invest in such a risky environment. Investors
are hesitant to invest. They are only comfortable to invest when they are sure for return on their
investment. This study endorses the inverse association of political instability and FDI. But this
study did not discuss the association between political instability, investment, financial sector
development and growth (real GDP) simultaneously.
(Alisena and Perotti,1996) and (Cukeirman ,1992) argued that of all such that political instability
creates instability in economic growth by creating instability of inflation, dipping investment,
increased foreign debt, and budget deficit respectively. Pakistan has faced variations in growth
rate since 1970, where a downturn in economic growth experienced due to political instability
aftershocks of 1971 war. During this war, Pakistan has lost an ample share of financial as well as
human resources. From late 1970 Pakistan has enjoyed a sustainable growth rate until the year
1988, due to the Afghan war, consistent and sustained economic policies. After 1988 downturn
has been seen in Pakistan’s economic growth rate due to only political instability, inconsistent
and irrational political and economic policies. After 2000 again an upward and positive trend in
GDP and growth has been seen (Hussain, 2009). (Gyimah-Brempong,1999) used system of
equations, to study PI, Investment and growth in Africa.
It has been detected in various studies by researchers that a strong and well developed financial
sector exerts a positive influence on the economic performance of various economies of the
world, Kiprop M.J.et al., (2015), Tabassam(2016) and Moradbeigi (2017). When financial and
economic resources are efficiently used in a country then it will promote productivity and
economic growth with the help of the strong financial institutions and financial market.
Economic prosperity can not merely achieve by financial development directly, however, there
are other indirect channels are also responsible for achieving economic growth. Foreign
Investment, savings.and exchange of goods and services also influences economic growth
indirectly. When the investment in the country increases it creates more jobs and employment,
which raises the income of the people and it increases aggregate demand which ultimately opens
the room for investment projects. This investment promotes and develops financial sector which
causes economic growth to rise, Bagehot (1873), Ranis (1961) Schumpeter (2003), Levin (2004),
and Asghar (2013).These studies strongly argued that a strong financial system will certainly
encourage economic activities such a rise in investment and productivity, which leads long-run
enhancement in growth.
Yang (2008) investigated in their research study as Financial Development and growth are
unidirectional by applying superexogeneity approach. The study has been conducted in Korean
by using time series data from 1971–2002. The empirical analysis supports the notion that “
Finance affects Growth” but not the vice versa in case of Korea. The study focused on various
financial reforms and restructuring of financial sector rather than growth. It has been observed
that only restructuring of the financial sector can speed up the short and long-run growth in
Korea.
Takyi (2013) predicted in a unique fashion showing the causation of financial development and
growth by measuring financial development first. This investigation examined that a sound
financial sector i.e financial markets and financial institutions have a substantial influence on
economic performance in Ghana. Moreover, this research also critically evaluated the disparity
of financial development in various economies. Few economies with well functioning and
developed financial institutions and financial markets have poor financial sector contributed to
the growth rate. Besides, this examination also raised the question of what are the reasons that
some countries have very good financial sector but others have not. This study raised a question
that why few financially developed countries have very low economic growth. The study
employed the cointegration and ARDL specification for measuring the long-run relationship of
financial development with its determinant and Error Correction Model for measuring short-run
relationship (Voghouei, et al.,2011). and (Voghouei, 2011).
To check the stationarity among the variables the write used unit root test.
Ali (2016) tried to develop the financial development-goth nexus through private credit booms
by focusing on a cross-country phenomenon. In the study, the researchers have developed a
financial development index by using a sophisticated tool called Principle Component analysis
which is used for growth later on. This study has been conducting by grouping few less
developed and few developed economies by applying panel co-integration econometric
technique. This study merely focused on banking efficiency and ignored many other important
determinants of the financial development. Since the study is a panel and various countries have
different political, economic and financial circumstances. That’s why the different estimation
results have been observed in this study, Christopoulos (2004) and Levine (1997).
The variables in the study have been tested and the stationarity of the variables have been
confirmed and integrated at first difference using unit root test and presence of co-integration is
presented. The regression estimates revealed the positive association between financial
development index and growth (GDP), also supported by Kiprop M. J.et al., (2015) and Asghar
(2014). The findings of the study backings the estimates of Kiprop M.J.et al., (2015) and Céline
Gimet and Thomas Lagoarde-Segot (2012).
Asghar (2013) endeavored to estimate empirically the robust causality between Finance and
economic performance and analyzed empirically.The study has been initiated by taking data of
some developing economies from 1978 to 2012. The study attempted to provide evidence of
long-run causality between the variables by using foreign direct investment, trade and trade
openness through which Financial development influences economic performance. The financial
development index has been constructed by including numerous variables to capture the effect of
maximum variables.The study also attempted to give the measures that how different countries
can avoid a financial crisis like 1997 and 2007-8 which has been experienced due to imperfect
financial markets and weak financial sectors which caused economic growth to fall. The study
applied panel unit root, panel cointegration tests to present interconnection of long-run and
connection among variables. Estimates presented the weak cointegration among variables due to
the underdeveloped and inefficient financial system in various countries, due to inefficient
financial and economic resource allocation which causes weak influence of financial
development on economic performance.
Hasan (2008) used ARDL approach to analyze the long run causality of Pakistani stock prices
and major macroeconomic variables. The study indicated that FPI has an important short-run and
long-run influences on stock market and growth.
Chaudhry et al. (2014) endeavored to examine the nexus between a few macroeconomic
variables and growth. This study describes that foreign portfolio investment (FPI) is the major
component of foreign private investment which is deemed a key factor in improving economy
and growth. This study uses the net portfolio investment as a proxy of FPI. Despite its volatile
nature and high risk in Pakistan FPI is considered to be the most important factor of enhancing
foreign private investment. This investment caused to rise in economic activities even in 1997
Asian crisis. The major contribution of FPI is to bridge the gap between investment and savings.
This will help be the cause of overall prosperity of economy and the masses as well.
2.1 HYPOTHESIS:
H1a: Political instability is negatively associated with a foreign direct investment (FDI).
H1b: Countries having lower foreign direct investment has poor economic performance(GDP).
H2a: Political instability is negatively associated with foreign portfolio investment (FPI).
H2b: Countries having lower foreign portfolio investment (FPI) has poor economic
performance(GDP).
H3a: Political instability is negatively associated with financial development (FD).
H3b: Countries having poor financial development (FD) has poor economic performance (GDP).
3 RESEARCH METHODOLOGY
The theoretical perspective that has been taken in the analysis of data in this research work is
2SLS and 3SLS technique to determine the nexus between political instability, foreign private
investment, and growth. Initially, at first stage, political instability index will be constructed with
the help of PCA using political instability factors. In the second stage, the influence of political
instability on private investment will be determined. A third stage, the effect of FPI on growth
will be analyzed. Finally, financial development will be measured and later on its nexus with
growth will be analyzed. In this study investment analysis and portfolio management, corporate
finance, financial management, international trade, macroeconomics books and research articles
are taken as reference and to cite the important concepts related to the study. As this study is a
time series so to check the overall nexus between PI, FPI, FD and GDP time series econometric
methodology will be used to predict the short-run and long-run association of the mentioned
variables among themselves. Time series econometric modellings, OLS method and systeme of
equations will be used in this study.
Where “m” denotes the ratio of imports to GDP, “fd” denotes the ratio of real foreign debt
service/GDP ratio, “s” denotes savings, 𝐾𝑡−1 is the lage value of investment “ɛ” is the residual
term. It is expected that the coefficients of g and s may be positive.
3.3.2 INFLATION
It is the rise in the average price level of goods and services in a country for a specified period
world bank (2011). Inflation can be calculated by the annual % price change. It is said, inflation
is inversely correlated with financial development.
Where
𝒍𝒏𝒀𝒕 = Per capita growth of Real GDP.
𝒍𝒏𝑶𝑷𝒕 = Trade openness ( Total worth of exports & imports relation to GDP)
𝒍𝒏𝑪𝑷𝑺𝒕 = Private sector credit in relation to GDP (Proxy for financial development)
𝑰𝑵𝑽𝒕 = Real private Investment
𝒍𝒏𝑮𝑺𝒕 = Government size in relation to growth of GDP
𝒍𝒏𝑻𝑶𝑻𝒕 =Terms of trade
𝒍𝒏𝑭𝑫𝒕−𝟏=Measure of Financial Sector Development
𝒍𝒏𝒚𝒕−𝟏= lag value of Per capita growth of Real GDP
𝐥𝐧𝐌𝐚𝐫𝐤𝐞𝐭 𝐂𝐚𝐩= Market Capitalization
ln =Natural log
𝛃′𝐬= Parameters to be estimated
𝜀𝑡 , µ𝑡 and 𝜈𝑡 are white noise process
Where ∆ shows change symbol, lag length is “k” and “𝜀𝑡 " error term expected there is no serial
correlation. ARDL technique encompasses two stages. In first step, 𝐻0 is establised to show no
co-integration given as 𝐻0 = 𝜶𝟏 = 𝜶𝟐 = 𝜶𝟑 = 𝜶𝟒 = 𝜶𝟓 = 𝟎 and is tested against the
alternative hypothesis 𝐻1 ≠ 𝜶𝟏 ≠ 𝜶𝟐 ≠ 𝜶𝟑 ≠ 𝜶𝟒 ≠ 𝜶𝟓 ≠ 𝟎 of the presence of co-integration
association.
After confirmation of co-integration, ARDL long-term and ECM estimations are estimated.
The investigative test of ARDL may be observed short-run approximations. The error correction
“ECM” depiction can be written as:
k k k
The variable FD model is financial development representing the private sector credit in relation
to GDP is a proxy has been taken to estimate financial sector development whereas, variable “
γECMt−i " estimates capture long-run connection. Theoretically, the term γECMt−i 𝑡ℎ𝑒 variable is
supposed to be negative and less than one to indicate the re-adjustment process to correct itself to
bring back to long-run equilibrium from disequilibrium.
4 CONCLUSION
This research study will envisage and endeavour to develop the finance-growth nexus via PI and FPI
in Pakistan context using time series data set. As Pakistan has been remaining under terrorists attacks
since 2002 and due to this it has faced the problem of low foreign investment and low economic
performance. Owing to this Pakistan’s economy can not be compared with other developing
economies of the world. This study will explore the finance-growth nexus via foreign capital inflow
and political instability factors. Literature shows an inverse association of financial development and
growth in the presence of political instability and low foreign inflows either direct investment or low
market capitalization and private sector credit in relation to GDP, as these are proxies used to
determine financial sector performance and its development.
5 RECOMMENDATIONS
This study will expectedly investigate then nexus between PI, FDI, FPI and GDP growth in Pakistan,
which will guide the investors, governments, multinationals and policymakers to reshape their
investment strategies and look beyond the local markets. They will definitely look around in the
countries where a politically stable environment prevails for their investments. The foreign investors
and investment can be attracted due to this mechanism and it will raise the prosperity of the countries.
Literature shows that India is a comparatively better for foreign private investment than Pakistan. So
to attack this capital Pakistan’s policymakers, governments, institutions and other elite groups have to
make investor’s friendly policies.
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