International Research Journal of Finance and Economics ISSN 1450-2887 Issue 47 (2010) © EuroJournals Publishing, Inc. 2010 http://www.eurojournals.com/finance.htm Analyzing the Relationship between Foreign Direct Investment Domestic Investment and Economic Growth for Pakistan Ahmad Ghazali Applied Economics Research Centre, University of Karachi, Karachi E-mail: ahmad.economist@yahoo.com Tel: 0321-6805926 Abstract The paper empirically identifies the causal relationship between foreign direct investment (FDI), domestic investment and economic growth (GDP) in Pakistan over the period 1981 to 2008. The main findings of the paper are as follows: a) There is bidirectional causality between FDI and domestic investment, domestic investment and economic growth; unidirectional causality between FDI and economic growth in the long run. b) High degree of positive correlation found between FDI, domestic investment and economic growth; great economic growth spurs large domestic investment, and vice versa. c) Co-integration results show that there is positive long run relationship between FDI inflow, domestic investment and economic growth. From all these evidences it is clear that FDI inflow in Pakistan supplements domestic investment and stimulates economic growth. So for Pakistan careful policy should be adopted about FDI which not only attract foreign investors but also influence them to play their role in promoting domestic investment and economic growth in Pakistan. 1. Introduction Foreign direct investment (FDI) has played a glorious and profit-oriented role in several countries of the world. In the recent past ASEAN countries have been big beneficiaries. In recent years many developing countries have increasingly turned to FDI as a source of the capital, technology, managerial skills and market access needed for sustained economic growth and development. The growing balance-of-payment difficulties as well as decline in concessional aid have forced many developing countries to reassess their stances on FDI and have taken substantial unilateral steps to liberalise their inward FDI regimes. As there is shortage of capital in the developing countries, which need capital for their development process, the marginal productivity of capital is higher in these countries. On the other hand, investors in the developed world seek high returns for their capital. Hence there is a mutual benefit in the international movement of capital. The foreign direct investment (FDI) inflow into Pakistan increased from US $ 322.4 millions 1 in 2000-01 to US $ 5,153 million in 2007-08. Important areas of FDI are: i) telecom ii) energy (oil and gas, power, petroleum refineries) iii) banking and finance iv) food and beverages. These four groups accounted for over 80 percent of FDI inflows in Pakistan. The magnitude of the foreign investment reflected the confidence of global investors on the current and future prospects of Pakistan’s economy. Pakistan is now the most investment-friendly nation in South Asia. Business regulations have been profoundly overhauled along liberal lines, especially since 1999. Most barriers to the flow of capital 1 All statistics in this section are calculated from Pakistan Statistical Yearbook, except the ranking of countries for FDI of the developing countries, which is obtained from World Bank Report, 2006.