EMPIRICAL ANALYSIS OF THE DETERMINANTS OF ECONOMIC GROWTH IN PAKISTAN,

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1 Sarhad J. Agric. Vol.25, No.2, 2009 EMPIRICAL ANALYSIS OF THE DETERMINANTS OF ECONOMIC GROWTH IN PAKISTAN, MUHAMMAD AZAM* and NAEEM UR RAHMAN KHATTAK** * Department of Economics, University of Peshawar, Peshawar, Pakistan ** Faculty of Social Science, University of Peshawar, Peshawar, Pakistan ABSTRACT In this research paper the impacts of domestic investment, foreign direct investment, human capital and trade openness on economic growth of Pakistan have been analyzed. For this purpose secondary data have been taken from Federal Bureau of Statistics and Pakistan Economic Survey for the years ranging from 1971 to The method of Least Square was used for estimating the linear regression equation. The results showed that domestic investment, FDI, and trade openness have positive effect on economic growth and the coefficients are statistically significant. The human capital found significant with negative sign. It,s concluded that domestic investment, foreign direct investment, and liberalization of trade are key factors affecting the level of economic growth of Pakistan. Key Words: Economic Growth, FDI, Pakistan Citation: Khan, M.A. and Naeem-ur-Rahman Khattak Empirical analysis of the determinants of economic growth in Pakistan, Sarhad J. Agric. 25(2): INTRODUCTION Many economists and researchers have been studying the ways to achieve higher level of economic growth in order to provide welfare to the masses. This is economic growth that leads to greater economic prosperity and similarly, increasing overall prosperity improves the livelihoods of those able to participate in the system. This rising prosperity is empirically linked to higher overall levels of human happiness and betterment. But the economic growth is not an automatic birthright for an economy; therefore, for an economy to grow, it has to create the right conditions for growth. In order to increase economic growth, developing countries trying to enhance foreign capital due to meager domestic savings and it can not finance their investment requirement. Frequently FDI is carried out through multinational corporations (MNCs) and technology may be traded indirectly in the form of advanced machinery. Technology in the form of ideas and techniques cannot be traded from one country to another easily. Once a foreign investor invests in a host country, however, advanced technologies and new ideas from the source country can be directly transferred and eventually diffused to a host country through the establishment of MNCs. The transfer may also improve the production techniques in a host country. Moreover, technology from abroad can help to upgrade the existing technology in a host country and can also lead to innovative research in the host country create new ideas and develop new technologies (UNCTAD, 1999). Obviously higher amount of foreign direct investment (FDI) contributes to achieving higher level of economic growth. Consequently high growth performances would attract further FDI inflows, that is called virtuous circle (Virtuous Circle means higher amount of FDI contributed to achieving higher economic growth. Consequently high growth performances would attracted further capital inflows that is called virtuous circle of capital flows and economic growth share in GDP still accounts for 21.6 % of GDP during Growth in the services sector in was mainly due to sound growth in the finance and insurance sector, enhanced performance of wholesale and retail trade, as well as transport and the communications sectors) of FDI flows and economic growth and it is indeed an important for the socio-economic development of Pakistan. Explicitly without economic growth, economies become stagnant and nations are unable to provide for the well-being of their citizens. A number of studies have been carried out to examine whether FDI impacts positively on economic growth or negative. Early studies on FDI, such as Singer (1950) claimed that the host countries of FDI receive very few benefits, because most benefits are transferred to the source country. Wang et al., (1992) viewed that FDI can lead to positive technology spillovers to domestic firms in the host country. Balasubramanyam et al., (1996) showed that FDI has a positive

2 M. Azam and Naeemur Rahman Khattak. Empirical analysis of economic growth in Pakistan 308 effect on growth for export promotion countries, while having no influence on growth for import-substituting countries. Borensztein, et al., (1998) found that FDI has a marginal, yet significantly positive effect on economic growth. The result of Asheghian (2005) study suggests that the major determinants of economic growth are total factor productivity, and domestic investment growth and there is no causal relationship between FDI growth and economic growth. Mariam (2005) found that investment has a significant and positive relationship with real income per capita, irrespective of any human capital requirements. However, the coefficient on the FDI variable is considerably larger than that of the domestic investment variable, suggesting a potentially large role for FDI. The objective of this research paper is to investigate the impacts of selected determinants on economic growth empirically, particularly to investigate the role of foreign direct investment on economic growth of Pakistan. Comparison of Regional Real Gross Domestic Product (GDP) Growth (%) Performance The economic growth of Pakistan was 1.2 % in 1971, 7.3 % in 1980, and 8.4 % in 2005 (Federal Bureau of Statistics, Pakistan, volumes 1980, 1990, 2000, 2006). Though agriculture sector is still the sole leading sector of the Pakistan economy but unfortunately the performance of this sector were fragile during 2005 as it grew by only 2.5 %, as against 6.7 % of last year and the 4.2 % target for the year. The slower performance was due to bad weather conditions, although its Table I: A comparison of regional real GDP growth (%) performance from Region/Country World GDP Developed Countries United States Euro Area Canada Germany Japan Developing Countries China Hong Kong SAR Korea Singapore Vietnam ASEAN Indonesia Malaysia Philippines Thailand South Asia Bangladesh India Pakistan Sri Lanka Middle East Egypt Iran Kuwait Saudi Arabia Africa Algeria Kenya Morocco Nigeria South Africa Tunisia Source: World Economic Outlook (IMF), (2000, 2006) --- shows data are not available

3 Sarhad J. Agric. Vol.25, No.2, Percentages Time Period Fig. 1: Annual gross domestic product (GDP) growth rate of Pakistan, Table I reveals that the economic growth performance of a few regional different economies from Table I show that in emerging Asia and China s growth performances remained very strong and growth in India was appreciable. Due to high domestic demand, and healthy global economic expansion, Pakistan s growth performance in emerging Asia has been strong. Further in ASEAN region, Indonesia, Malaysia, Thailand and Philippines posted growth in the range of %. South Asia remained a strong performer due to persistent rise in growth in Pakistan 6.6% and India 6.4%, but growth in Sri Lanka 5.9% and Bangladesh 6.0% were also appreciable. Although in Egypt and Iran growth performance has been not bad while in Kuwait and Saudi Arabia posted a modest economic growth of 3.2 % and 3.3 % despite rising oil revenues. Fig. 1 shows estimated Pakistan s economic growth 8.5 % in , and has grown at an average rate of almost 7.0% per annum during the last four years, to , thus it means that Pakistan s economy is one of the fastest growing economies of the Asian region. MATERIALS AND METHODS Model Specification Till 1920, the economic growth model was simply consisting of a production function where economic output was of the result of the sum of two inputs namely labour and capital. According to the Solow (1956) model, the inputs physical capital and labour did not explain the growth potential of a particular economy. Therefore Solow added technology to the production function exogenously (Mankiew et al., 1995). That is why this is called exogenous growth theory. Later on, in 1980s, the long term economic growth was considered endogenously. Romer (1986) described that a firm s production function is defined by firm specific variables (i.e. capital services, labour and R&D inputs). The model use in this study followed by Ahmad and Hamdani (2003), Barro and Sala-I-Martin (1995), Borenztien et al., (1998) and Eli Ado (2006) which is based on a simple endogenous growth model. Assume that in general form the production function can be expressed as follows; Y= f (L, K, A) (1) Where Y= economic growth/total output, L= labour, K= capital, and A= technology. In equation (1) the capital (K) is the combination of two capital i.,e domestic and foreign capital. In addition incorporates the trade openness (export plus import to GDP ratio) in the model in order to explore its impact on economic growth. Thus the new production function can be written as; Y=f (L, FDI, DI, TO, A) (2)

4 M. Azam and Naeemur Rahman Khattak. Empirical analysis of economic growth in Pakistan 310 Equation (2) indicates that economic growth is depends on human capital, foreign direct investment, domestic investment, openness and technology respectively. More the equation demonstrates the importance of FDI in the process of growth through technological diffusion. Generally it is says that technological diffusion via knowledge transfer and adoption of best practice across border is arguably a key ingredient in rapid economic growth. Further FDI also may stimulate knowledge transfer both in terms of man-powers training & skill acquisition and by introduction of alternative management practices and better organizational arrangement. Notwithstanding increase in trade openness (export plus import to GDP ratio) mean that rise in exports and rise in necessary imports of the economy can equally contribute to better technology. Thus making the technology variable a linear function of FDI and openness, so the variable technology (A) has eliminated from the model and introduced also error term to capture the others factors effect. Equation (2) can be written as; Growth = β 0 + β 1 (DI) + β 2 (FDI) + β 3 (School) +β 4 (TO) + µ (3) Where FDI=foreign direct investment, DI=domestic investment, School=human capital, TO=trade openness (export plus import to GDP ratio), and µ = error term Equation (3) states that economic growth (Growth) is a positive function of the domestic investment, foreign direct investment, human capital proxy primary school enrollment, and trade openness of the host country. Secondary data ranging from 1971 to 2005 was used. For economic growth uses gross domestic product growth rate in percentages, for FDI uses FDI inflows from all sources countries and for domestic investment uses gross domestic investment. Like wise for trade openness uses export plus import to GDP ratio and for human capital uses proxy primary school enrollment. The data on domestic investment and FDI have been taken from Federal Bureau of Statistics Pakistan (various issues). Such as the data on trade openness and human capital have been taken from various issues of Pakistan Economic Survey (various issues). For empirical analysis of the determinants of economic growth, a linear regression model has been derived from the general production function. The method of Least Square was used as an analytical technique for empirical estimation. Due to nonlinearity of the data, log linear model was used. Statistical software (E. View) was used for deriving the results. RESULTS AND DISCUSSION The empirical results of economic growth model are given in the following Table II. The estimated economic growth model is; Growth = DI School TO FDI (4) The results reveals that the impact of domestic investment (DI) on economic growth i.e., gross domestic product growth rate is positively significant at five percent (5%) level of significance. The coefficient size of this variable found 0.716, so this amount of change will occur in the total economic growth rate. Table II. OLS estimates of determinants of economic growth Dependent Variable: Growth (GDP Growth rate) Method: Ordinary Least Squares Explanatory Variables Coefficients (t-statistics) Constant ( ) Domestic investment (DI) ( )** trade openness (TO) ( )* human capital (School) ( )** foreign direct investment (FDI) ( )*** R-squared (R 2 ) Adjusted R-squared S.E. of regression Akaike info criterion Schwarz criterion F-statistic Durbin-Watson statistic N 35 Note: (i). The asterisks *, **, *** shows that estimates are significant at 1%, 5%, and 10% level of significance respectively. (ii). The figures in parenthesis are t-statistics

5 Sarhad J. Agric. Vol.25, No.2, Another variable that is trade openness (TO) has found positively statistically significant at five percent level of significance. The coefficient of this variable found is 1.179, which is large and indicates that this unit of change will occur in the economic growth. It shows that more export and by importing essential input for more production is of course contributing in the process of economic growth. While human capital found significant with unexpected negative sign. This study also found FDI positively significant at 10% level of significance. It shows that the impact of foreign direct investment on economic growth is important. While the inflows of foreign direct investment always considered the main channel of technological progress in the theoretical framework. However, the effect of technological progress on growth does not happen immediately after a host country receives the foreign direct investment inflows since the adoption of technology takes some time. FDI inflows in lagged period tend to affect the economic growth performance in current and later periods. Therefore estimated FDI with one year previous period but the study found insignificant result as given in Table III. The estimated equation is; Growth = DI TO -1.59School FDI FDI (-1) (5) Table III OLS estimates of determinants of economic growth Dependent Variable: Growth (GDP Growth rate) Method: Least Squares Explanatory Variables Coefficients (t-statistics) Constant ( ) domestic investment (DI) ( )** trade openness (TO) ( )*** human capital (School) ( )** foreign direct investment (FDI) ( ) foreign direct investment one year lagged (FDI -1 ) ( ) R-squared (R 2 ) Adjusted R-squared S.E. of regression Akaike info criterion Schwarz criterion F-statistic Durbin-Watson statistic N 35 Note: (i). The asterisks *, **, *** shows that estimates are significant at 1%, 5%, and 10% level of significance respectively. (ii) The figures in parenthesis are t-statistics CONCLUSION The objective of this paper is to investigate the determinants of economic growth empirically. Achieving higher level of economic growth is very essential for the provision of economic prosperity and welfare to the society. The results revealed that the impact of domestic investment on economic growth rate is positively statistically significant over the period from It means that due to encouragement of domestic investment economic growth of the country would increase. Trade openness has been found statistically significant. It shows that more export and importing essential input for more production are certainly contributing in the process of economic growth. Human capital found significant with unexpected negative sign, while the FDI has been found significant too. To improve welfare of the society-the policy makers should encourage the domestic investment, foreign direct investment and liberal trade because these are the key factors affecting the level of economic growth.

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