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

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  • Muhammad Arshad Khan

    (Pakistan Institute of Development Economics, Islamabad)

Abstract

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 1972–2005. 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

Suggested Citation

  • Muhammad Arshad Khan, 2007. "Foreign Direct Investment and Economic Growth: The Role of Domestic Financial Sector," PIDE-Working Papers 2007:18, Pakistan Institute of Development Economics.
  • Handle: RePEc:pid:wpaper:2007:18
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    More about this item

    Keywords

    Foreign Direct Investment; Financial Sector Development; Economic Growth; Technology Spillovers;
    All these keywords.

    JEL classification:

    • F21 - International Economics - - International Factor Movements and International Business - - - International Investment; Long-Term Capital Movements
    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
    • F43 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Economic Growth of Open Economies
    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance

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