GMJACS Volume 6 Number 2 2016 10 Exploring the Causal link between Country Risk and Foreign Direct Investment Inflows: Evidence from Pakistan Assad Ullah 1 , Yang Qingxiang 2 and Zahid Ali 3 Abstract Development economics literature widely acknowledges that foreign direct investment (FDI) inflows play a vital role for the growth-dynamics of developing countries. This study explores the causal relationship between country-risk and FDI inflows in Pakistan for the period 1990-2013. We applied the methodology of ARDL bounds testing to co integration to analyze the long-run association among variables. For checking the stationarity properties of series, we used Phillips-Perron unit root test. To detect the direction of causal relationship among the series, Modified Wald (MWALD) test, developed by Toda and Yamamoto (1995), and Dolado and Lütkepohl (1996) has been utilized. Empirical evidence exhibits co-integration among country risk, market size growth, and FDI inflows in Pakistan, thereby, it validates the presence of long-run association among variables. Country-risk has a significant negative relationship with the inflows of FDI in Pakistan, both in the long and short-run. Furthermore, we observed a significant positive relationship between market size growth and FDI inflows in long-run; whereas, in the short run, no association has been found between the two. The MWALD test for causality confirmed a unidirectional causal relationship among country-risk, market size growth, and FDI inflows. To attract more FDI towards Pakistan, full protection should be provided to foreign investors. Maintaining proper law and order situation, and prevention of other terrorist activities are indispensable in this regard. Keywords: Country Risk, FDI Inflows, Co-integration and Causality, Pakistan. 1. Introduction Some of the developing countries adopted a cautious and rather a negative stance towards foreign direct investment (FDI) in the years of 1960s and 1970s. However, the years of 1980s turned to being trend changer and the countries once opposing FDI started adopting friendly policies towards FDI. This change was mainly forced by the economic problems being faced by developing world. It is generally believed that FDI is a catalyst for the economic growth of the host countries (Wang, 2009). With the help of FDI governments can reduce their budget deficit through the collection of tax from foreign companies. Developing countries are of the view that foreign direct investment alleviates the evil of poverty (Brooks et al., 2010). Foreign companies develop innovative products because technologically they are sound than the local companies, thereby lead to enhanced competition. FDI flows to a specific country are mostly dependent on macroeconomic factors, policies of government, and long term strategies of MNEs. Based on empirical research market size, human capital, efficient and reliable financial system, macroeconomic environment, perceptions of governance, natural resources, infrastructure and law and order situation are some of the critical factors for the attraction of FDI. In developing countries like Pakistan, FDI helps in reducing the gap between savings and investment, introduce new managerial and marketing techniques, create employment opportunities, provides job-training facilities, alleviate poverty, increase the level of productivity thereby, enhancing the economic growth. The economy of Pakistan has a potential for attracting FDI due to its geographic location. FDI is considered as a backbone of the country. Pakistan is a country blessed with natural resources and varied climate. Pakistan can attract foreign direct investment in a context of tourism, agriculture products, leather goods and especially mineral extraction projects. Despite policy reforms still Pakistan has not been able to attract a significant level of foreign direct investment in comparison with India and China. Numerous factors account for this fact. The main factor nowadays is that of country risk. Sectarian violence has increased many folds in Pakistan the economy has suffered a lot. Foreign companies feel themselves insecure in Pakistan and invest very minimally in comparison with our neighbor countries such as India and China. 1 School of Management Huazhong University of Science and Technology (HUST) Wuhan, China, assadullah333@yahoo.com 2 School of Management Huazhong university of Science and Technology (HUST) Wuhan, China, yqx0102@1026.com 3 School of Accounting Zhongnan University of Economics and Law (ZUEL) Wuhan, China, Zahidzady@yahoo.com