Foreign Direct Investment and Economic Growth: The Role of Domestic Financial Sector

Muhammad Arshad Khan
PIDE Working Papers 2007:18
JEL codes: 
Recent theoretical and empirical literature suggests that foreign direct investment (FDI) exerted positive impact on economic growth through the process of technological diffusion. The literature also suggests that the development of the domestic financial system of the host country is an important pre-condition for FDI to have a positive impact on economic growth. A welldeveloped domestic financial sector enhances efficient allocation of financial resources and improves the absorptive capacity of a country with respect to FDI inflows. Particularly, a more developed financial system positively contributes to the process of technological diffusion associated with foreign direct investment. In this study, we examine the link between FDI, domestic financial sector, and economic growth for Pakistan over the period 19722005. Empirical analysis is based on the bound testing approach of cointegration advanced by Pesaran, et al. (2001). The results suggest that FDI inflows exerted positive impact on economic growth in the short-run and the long-run if the domestic financial system has achieved a certain minimum-level development. The results further suggest that better domestic financial conditions not only attract foreign companies to invest in Pakistan, but also allow maximising the benefits of foreign investment.