CHAPTER ONE:

INTRODUCTION
The worldwide economy has now started to increase from the effects particularly from deficient
capital movements to the economy which rose from the down fall that happened in 2008 in USA.
The emerging economies have been harmfully hit by this, owing to decrease in the exports and
capital flows. The most treacherous of these two is decrease in foreign capital, chiefly the foreign
private investment , since it causes to encourage economic progress in poor countries. This
study will provide a useful understanding this nexus between PI,FPI, financial development, FD
and GDP growth (Gyimah-Brempong,1999) and Waqas (2015).
Developing countries altered their economic policies in 1980,s with the intention of capturing the
opportunities of globalization. Most of the countries adopted policies to attract foreign funds
inflows. South Asia is often seen as an evidence for absolute benefits of globalization. Past
empirical researches have assisted policy makers to understand what does not work. What does
work, where and under what conditions? These research studies and guidelines helped guide the
way thruogh which foreign private investment can be attracted.
Alisena and Peroti (1996) demonstrated that political instability and foreing private investments
are inversely correlated with each other. This low ivestment will adversly affect the financial
development and consequently economic growth.
Veniries and Gupta (1986) and Gupta (1990) have attempted to develop the interconnection of
political unpredictability, investment and economic performance. There are two reasons
proposed by Drazen (2000), that why economic outcomes are affected by the political instability.
First, one suggested by him is that political instability creates uncertainty and volatility to policy
making for the future, which as a result creates uncertainty for the private firms and affects the
capital build up. Secondly, it directly affects the productivity by affecting market work and
economic relations.
It has been absolutely admitted that foreign private investment is a vital growth factor of under
developed and poor economies. Foreign private investment provides a chance to the host
country to invest above the level of the local or domestic savings. The advantages of foreign
investment include attracting new knowledge, new technology, higher employment, increase in
competition and above all attracting foreign capital. Low risk in the country and the low
instability are the most significant factors in attracting the foreign investment flows. The political
regime stability is referred to the rule of one party without any break that ruling party may be a
single party or coalition of some parties or an authoritarian regime or military dictator. Most
important of all they rule a country for a long time without any pause or major break. The term
politically stable regime is defined differently in economics and political science. In economics it
has nothing to do with political regime whether it is democracy or dictatorship. The stability of
political regime is the most important factor in choosing the investment amount and location in
the host country. The political stability is thought to be very harmful for the economic
performance by the economists.
ECONOMIC GROWTH
In the words of Todaro and Smith economic growth may be described in the following words, a
nonstop procedure of an economy to rise with the lapse of time consequently rise in national
productivity and income (Todaro and Smith, 2007).
INVESTMENT
Investment means, the acquisition of real and financial assets, when a firm acquire plant and
machinary, or stock of goods or when household buye new property for the sake of capital
gains and rate of return on their financial resources. In simple words investment means when
someone holds financial assets from the financial market. The investment can either by an
indivudual, firms or even by the goverments in the local or international markets.
Numerous research literature focused on international flow of funds which is responsible for
economic prosperity and development. Foreign investment develops the pace of economic
performance and fills the savings investment gaps. This international flow of capital is further
splitted into: foreign aid and Foreign Private Investment. Foreign private investment is
supposed to be the vital factor source of offshore investment.
We can further split this offshore flow of capital into foreign direct investment (FDI) and foreign
portfolio investment(FPI) (Chaudhry,2014)
DIRECT FOREIGN INVESTMENT (FDI)
The IMF Balance of Payment Manual describes FDI, an investment mechanism to have eternal
involvement in the managerial affairs of a corporation working in an economy other than that of
the investor. The main purpose of the investor is to have a significant expression in the
administration of a Business organisation. It is the process in which people of one country obtain
the possession of resources for the purpose of controlling business activities of in other
economies.
The United Nations 1999 world investment report ( UNCTAD,1999) describes FDI in the
following way, an investment comprising a long-term correlation and showing an enduring
power and involvement of a resident ( person or enterpise) of one country or economy in a
country or an enterprise of an other country or economy. FDI is long-term and permanent in
nature.
FOREIGN PORTFOLIO INVESTMENT (FPI)
Foreign portfolio investment along with foreing direct investment is another form of foreign
capital flow. FPI may be defined as the investment various financial assest that is securities
shares, bonds, treasury bills, mutul funds, derivative instruments and government bonds not only
in developing countries but also in developend economies in search of good profits and
returns.FPI is short-term in nature because it is considered a high return short-term investment in
highly active turnover financial assets (securities) Net portflolio investment is calculated as the
total value of assets and the total value of liabilites. Liabilites are the value of stock and debt
securities. FPI is obtained by the sale of debt instruments to foreing investors. FPI securities are
very liquid in nature and can be converted into cash quickly. (Chaudhry,2014, Baghebo 2014
and Gumus,2013).
FINANCIAL DEVELOPMENT
Financial sector or system comprises financial markets, financial intermediaries and financial
instruments. It also includes finanal liberalization. In most of the developing and emerging
economies it is considered private sector where it contributes the economic development of a
country.Development of financial system stimulates the ecnomic development and growth
through various channels.
The concept of development of financial sector can be described in two phases:
Phase I: Development of financial sector strengthens economy as a whole growth and
development through many ways. It reduces the risk of people to invest , liquidity risk
reduction,intertemporal risk and curtail interest rate of financial institutions, it encourages saving
and convert into investment this investment brings prosperity in economic growth and
development by lowering inflation and increasing employment. A well structured and sound
financail sector uses all the available economic resources efficiently. (Beck et al., 2005) and
Asghar(2014).

Phase II: Based on Financial Institutions. Literature shows the relationship between institutions
and growth. Exports based development of financial sector based on comparitive advantage
Financial institutions provide financial facilities and services and skills based services. This is
undoubtedly taken in terms of value added share in growth of GDP of a country and contribute
in employment share or level of wages (Beck et al., 2005).

The question arises how financial sector development is measured and how can its intertemporal
effects be predicted on ecnomic development. It is observed by various academic researhes that
financial development does not directly contribute to the economic growth only through financial
institutions.
Rather it is the credit to the private sector relative to GDP ratio a proxy used to measure the
finacial development and its effects on economic growth. Similary, domestic credit remain idle
and has no effect on growth. In summary we can say that fruits of growth are contributed only by
the credit lending to the corporate sector and private enterprises, whereas domestic credit has no
effect on economie development.. (Levin et al., 2000), Takyi (2013) and (Beck et al., 2009)
(Beck et al., 2012) and (Samargandi et at., 2015).
Despite the government efforts for the development of financial sector Pakistan is still far
behind the advanced countries. Hence, the optimum benefits of financial development on
country’s ecnomic growth are yet to be explored by encouraging market capitalization, private
credit lenging in relation to GDP and by curtailing low inflation rate, high level of employment ,
low interest rate credit to private and household sector, improving education and reducing
poverty.
PROBLEM STATEMENT:
It is always said that a profound political, financial and economic environment is supposed to be
the heaven not only for individuals but also for the business sector either local or foreign. This
sound systme ensures enormous foreign private investment, higher return on investment and
sustainable economic growth of a country.Politically stable financial and economic system
encourages financial development, high foreign private investments both FDI and FPI and
higher economic growth. Due to this all the sectors of an economy are flourished. It raises the
emplyment level which inturn increases the income level of the people. Consequently, per capital
income and savings of the people increases credit to private sector also rises.

Unfrotunately, in Pakistan continues political instability hampere financial and economic

policies which lead to an inefficient economic and financial sectors. A frequent and fickle
government plans could not realize the ideal level of FDI, FPI and GDP over decades despite
every effort. This increased volatility adversely affected the financial and economic performance
of the country. Political instability is measured by different factors, like coups, regime type,
terrorism, elections, assassinations and corruption which is one of the major cause of such chaos.
Undeniably, political choas and uncertainty is the major enemy of the investors’ confidence It
makes the investors to hold their capital in the nest and makes the capital idle which makes the
investment opportunities wasted and as a loss to the over all economic and financial activities.
The political instability is like the chain effect which gives birth to different kinds of bad things
to the economic prosperity. The Capital movement, rising unemployment, increasing inflation,
low investment and poor financial development have been seen in Pakistan.

This study profoundly focuses on the nexus between political instability,foreign private
investment (FDI,FPI) financial development (FD) and economic growth (GDP) to bridge the gap
of the desired and the current level of both economic and financial factors. Nevertheless, an
exciting issue is still leftover and under discussion that why, if political system is stable
,financial development is so good for growth and foreign investment, have so many countries
remained financially under-developed poor?
Unfortunately, due to political instability Pakistan is facing low foreign private investment which
causes poor financial sector and ultimately poor economic growth. Although the foreign private
investment is the key determinat of economic prosperity and financial sector development.
In Pakistan, it has been observed that due to political instability, terrorism, corruption, poor
governance and energy crisis a large number of investors have stampede their capital. This
volatile situation not only curtailed the level of foreign private investment but also damaged the
economic performance and financial development during the last few decades.
The purpose of this study is to investigate this very nexus empirically with the view to link
between political instability, foreign private investment, financial development and economic
growth of Pakistan.
 PURPOSE
The purpose of conducting this researh with reference to Pakistan is as, Pakistan has been facing
the problem of low productivity, low employment, high inflation, high poverty, low literacy
rate,high imports, high imports and low foreign investmetns. As a rusult a poor financial as well
as economic sectors due to political instability, corruption, poor governance, lack of
technological skills, terrrorism, sectarion vilolence. The main purpose of the study is, if a country
is political stability strong it can attract foreing investors which can develop the financial as well
as economic sectors. These developed Fiancial and economic sectors can bring the prosperity in
the country. The former will provide credit to enterprise and household sectors. This will
enhance the aggregate demand and aggregate out put by providing the employment level and
income level of all the sectors. Consequently, the living standard of the people will improve due
to low infaltion, high exports. Govt revenues will increase and the all deficits will reduce. This
study will unvail the factors causing underdeveloped and financial and ecnomic performance.

SCOPE OF WORK
This research study will endeavour in context to Pakistan. As if it is always claimed by the
governments that Pakistan’s economic and financial sectors are deemed remarkable. But in
reality when it is compared with other countries of the world it lagd far beyond in almost every
aspect characterized by political turmoil, under developed financial sector, underprivileged
economic performance and along-with low foreign capital inflows either direct foreing capital
inflows or foreign portflio inflows. Therefore, the study will evisage the PI, FPI, FD and GDP
nexus by taking data from 1975 to 2017. As there is a circular flow of all political,
investment,financial and economice activties of an economy in a country. Therefore, an
improved financial and economice enviornment will bring prsperity in evey sector of the
country. This study will help other researchers in future for students, teachers and other policy
makers to use it for reference and guidelines while conducting research ontime series data.

RESEARCH TITLE
Nexus between Political Instability, Foreign Private Investment (FDI & FPI), Financial
Development, and Economic Growth : Evidence from Pakistan from 1975-2017.
 KEYWORDS
PI, FPI, FDI, FPI, FD,GDP,PCA. ECM,ARDL, G, K,

STUDY RATIONALE/SIGNIFICANCE
The issue of political chaos, foreign investments flows, financial sector’s performance and
economic uprising has been a hot issue under discussion amongst different researchers, policy
makers, academicians and governmmment and business heads since decads. They immensely
emphasized on the political chaos, foreing flow of investment, financial development and
economic performance in an economy which are considerd the key to economic prosperity and
development. In reality, political instability results in decrease in foreign private investment and
economic growth ( Tabassam,2016).
The different political events used by the different researchers included government turn over,
government uncertainty, social unrest, property right executions and political assassinations,
terrorism, corruption, regime changes and frequent elections etc.
This study has incorporated some new variables to fulfill the gap identified above to track the
impact of political instability, In this connection, with these variables political instability index
will be used by using PCA. Later on, in this research this PI Index will be used to develop nexus
between political instability, investment, financial development and economic growth in Pakistan
by using time series data and will provide useful insight about this nexus.
Hence, this study will contribute and divulge the facts that despite enormous efforts still
Pakistan is struggling to achieve an impressive growth rate and why it has been failed to develop
a sound financial system? Why Pakistan has not been considered heaven for foreign investors
and businesses to invest consistently and frequently on massive scale? Contribution to the
empirical literature on PI, FDI, FPI, FD and GDP growth nexus is to provide evidence, whether
political instability is the only cause of low investment, under developed financail sector and
economic growth As if, high foreing investment, financial development and high growth rate
ensure prosperity of a country which raises the living standarad of the people, reduce poverty at
large.
 RESEARCH QUESTIONS

RESEARCH QUESTION 1
What are the causes of low productivity and low GDP in developed economies even they are
financially strong, having sound financil sector, high FPI and PI ?

RESEARCH QUESTION 2
Is there any nexus between PI. FPI, FD and GDP. Does a politically risk-free economy ensure
high level of FPI, both FDI and FPI,which leads to growth in FD and GDP?

RESEARCH OBJECTIVES
In the past numerous empirical researches have been done on the political instability minutely
with other factors. No separate study has been done yet develop the nexus of the political
instability, FPI,FD, and growth in Pakistan. The studies conducted before have discussed the
effect of these variables in panal studies with other political and macroeconomics variables
separately. In pakistan still there is a need of composite nexus of these important finance,
macroeconomic and political factors. That’s why this new contribution to the research work in
Pakistan’s perspective is a struggle to bridge the gap while conducting time series study covering
a period of more than 40 years. There are few important objectives will be tried to explore in this
research;
1. To explore the causal correlation between Foreign Private Investment (FI) political
instability (PI) in Pakistan.
2. To establish the connection between Foreign Portfolio Investment (FPI) and political
instability in Pakistan.
3. To analyse the association between Foreign Direct Investment (FDI) and political
uncertainty in Pakistan.
4. To study the influence of political instability on Financial Development (FD) in Pakistan.
5. To explore the relationship between Foreign Private Investment (FPI) and (GDP) in
Pakistan.
6. Determine the link between Foreign Portfolio Investment (FPI) and growth (GDP) of
Pakistan.
7. To determine the correlation between Foreign Direct Investment (FDI) and growth rate
(GDP) of Pakistan.
 8. To identify the nexus between Financial Development (FD) and (GDP) of Pakistan.
9. Create a unique political instability index with different variables which cause PI.
10. To suggest likely strategic repercussions to attain sustainable growth via foreign capital
flows in Pakistan.

POSSIBLE LIMITATIONS OF THE STUDY

They are the possible weaknesses of the study related to decision made in the research
study.Sometimes these limitations are difficult to contain but some may be addressed in the
study..Consequences associated with choices made in a study are :

Sampling techniques,data collection strategies, instrument used,population chosen interms of

assessiblity, time and resources. How would the chellanges be addressed. As this study is based
on time series from the period of 1975 to 2017 limited to 42 years. The availablity of data
before partition is not available for all variables. Therefore, conclusions and results may be
confusing to some extent. Thre data regarding terrorism and other political instibility factors may
be another problem. As this is an acadamic study so time is also a problem which limits the
significance of the study.

EXPECTED UTILIZATION OF RESEARCH RESULTS

This research study will be helpful for the government of Pakistan, policy makers and business
managers for decision making and use the directions and guidelines given in this research to
take advantage of the results and suggestions given in this research to promote financial
development and attain suitable growth and economic performance in Pakistan. This study is
also beneficial for acadamicians, research students and other researchers to use for their futher
research.

COST / BUDGET REQUIREMENTS

Undoubtedly, some expenditures will be borne by the researchers himself during this research
either by downloading data, articles or requirements of the university as pr rule.

ETHICAL CONCERNS
There is no specific ethical issues in this research. As all the work is done by the researcher with
some important references and quotations used by other researchers and it has been tried to give
the reference of those honestly.
TIMELINES
This study will be covered within a period of 6 to 8 months positively by the researcher.
CHAPTER TWO:
LITERTURE REVIEW

It is strongly argued that a stable political system or strong governments either democratic or
military are contributing an ample share in raising the foreign private investments. If a strong
political environment prevails in the country then it will not only encourage the domestic
investors to come out of the shelters and invest in the economy to earn better return but also to
attract foreign investment. Undoubtedly, the stable political system attracts investors to invest in
their home country rather than shifting and investing abroad. This economic activity will
increase the level of productivity, rise in income level of the society and ultimately raise the
consumption and savings in the economy, which would accelerate aggregate demand and
consequently the economy will grow positively.
There are deleterious consequences of political instability on financial and economic activities of
a country. Due to political instability the inflation rate is going higher and higher, accompanied
by falling foreign investment and ultimately declining growth rate. The current study mainly
focuses on the nexus between political instability, foreign private investment both FDI and FPI,
financial development and economic growth in Pakistan. Although, the past literature showed a
noticeable nexus of investment, financial development, economic growth and political
instability. This can be analyzed in two ways.
1. Politically wobbly environment creates uncertainty and volatility which reduces foreign
private investment which undoubtedly adversly affects financial development and reduces
growth.
2. Political uncertainty changes the nature of investment and changes the demand of factors and
the pattern of spending which is directly affecting the investment in a country and then
economic growth.
Previous literature demonstrates that political instability creates fear among the foreing investors
of losing their capital. In this way foreign investors will not invest their money if there is a
political crisis in a country, which inturn distorts economic and financail enviornment.
For, risk averse agents the high probability of change of governments threaten future policies and
they would like to invest somewhere else in the safe place rather than to invest in a risky
environment Alisena et al. (1996). Recent studies regarding this issue show that there are so
many growth variables as suggested as political variables such as political violence, democracy
and government stability (Barro, 1996).
Kiprop M. J. et al., (2015) developed a unique nexus financial development and economic
growth rate via investment and saving mechanism. In this study the researchers have attempted
to develop the short-run as well long-run perspective of the finance growth nexus by addressing
the issue of endogeneity.In the Past numerous theoritical and empirical studies have been
conducted using panel or cross section studies. But this is a country specific study where time
series data have taken for analysis. This study has been conducted in Kenya perception.The
study used ARDL bounds test by taking suitable lags to discuss short-run, long-run correlation
between financial development and growth rate and the issue of endogeneity and
autocorrelation/serial correlation.The cofficient “Credit To Private Sector” a Proxy used to
measure Financial Development is positive which is significant at 1% leavel of significance
showing that the Financial development causes economice growth to increase in a country,
which is in accordance with theory (Adeniyi, O., Oyinlola, A., Omisakin, O., & Egwaikhide, F.
O. 2015).
Anwar (2014) used OLS regression model to capture the effect of terrorism on foreign direct
investment and concluded that terrorism inversely affects foreign direct investment in Pakistan’s
circumstances are concerned. It means that Terrorism is the major obstacle for the foreign
investors to invest in Pakistan because of the security risk and low return on investment i.e. ROI.
Moreover, this study also shows that Pakistan has been facing political instability since decades
which threatened the overseas investors to invest in such a risky environment. Investors are
hesitant to invest. They are only comfortable to invest when they are sure for return on their
investment. This study endorses the inverse association of political instability and FDI. But this
study did not discuss the association between political instability, investment, financial sector
development and economic growth simultaneously.
Alisena and Perotti (1996) and Cukeirman (1992) argued that of all such that political instability
creates instability in economic growth by creating instability of inflation, dipping investment,
increased foreign debt, and budget deficit respectively. Pakistan has faced variations in growth
rate since 1970, where a down turn in economic growth experienced due to political instability
aftershocks of 1971 war. During this war Pakistan has lost an ample share of financial as well as
human resources. From late 1970 Pakistan has enjoyed a sustainable growth rate till the year
1988, due to Afghan war, consistent and sustained economic policies. After 1988 down turn has
been seen in Pakistan’s economic growth rate due to only political instability, inconsistent and
irrational political and economic policies. After 2000 again an upward and positive trend in GDP
and growth has been seen (Hussain, 2009).
(Gyimah-Brempong, K., & Traynor, T. L. (1999) used simultaneous equations model, to study
the connection between political instability, investment and growth rate in Africa.

It has been observed in various studies by researches that a strong and well developed financial
sector exerts positive influnce on the economice performance of various economies of the world,
Kiprop M.J.et al., (2015), Tabassam(2016) and Moradbeigi (2017). When financial and
economic resources are efficiently used in a country then it will promote productivity and
economic growth with the help of the strong financial institutions and finanical market.
Economic prosperity can not merely achieved by financial development directly, however, there
are other indrect channels are alos responsible for achieving ecomic growth. Foreign Investment,
savings.and exchange of goods and services also influences economic growth indirectly. When
the investment in the country increases it creates more jobs and employment, which raises
income of the people and it increases aggrgate demand which ultimately open the room for
investment projects. This investment promotes and develops financial sector which cause
economic growth to rise, Bagehot (1873), Ranis (1961) Schumpeter (2003), Levin (2004), and
Asghar (2013).These studies strongly argued that a strong financial system will certainly
encourage economic activities such as increase in investment and productivity, which leads
economic growth to rise in the long run.
Yang (2008) investigated in their research study as Financial Development and growth are
unidirectional by applying superexogeneity approach. The study has been conducted in Korean
by using time series data from 1971–2002. The empirical analysis supports the notion that “
Finance affects Growth” but not the vice versa in case of Korea. The study focused on various
financial reforms and restructuring of financial sector rather than growth. It has been observed
that only restructuring of financial sector can speed up the short and long run growth in Korea.

Takyi (2013) pridicted in a unique fashion showing the causation of financial dvelopment and
growth by measuring finanial development first. This investigation examined that a sound
financail sector i.e finanical markets and finanical institutions have substantial influence on
economic peroformance in Ghana. Moreover, this research also critically evaluated the disparity
of financial development in various economies. Few economies with well functiong and
developed financial institutions and finanical markets have poor financial sector contribution to
the growth rate. Besides, this examination also raised the question of what are the reasons that
some countries have very good financial sector but other have not. This study raised a question
that why few financially developed countries have very low economic growth. The study
employed the conintegration and ARDL specification for measring long run relationship of
financial development with its determinant and Error Correction Model for measuring short run
relationship (Hatra Voghouei, M. Azali, and Mohammad Ali Jamali, 2011).To check the
stationarity among the variables the write used unit root test.

Ali (2016) tried to develop the finacial development-goth nexus through private private credit
booms by focusing on a cross country phenomenon. In the study the researchers have
developend a financial development index by using a sophisticated tool called Principle
Compnent analysis which is used for growth later on. This study has been conducting by
grouping few less developed and few developed economies by applying panel co-integration
econometric technique. This study merely focused on banking efficiency and ignored many other
important determinants of the financial development. Since, the study is panel and various
countries have different political, economical and financial cicumstances. That’s why the
different estimation results have been observed in this study, Christopoulos (2004) and Levine
(1997).

The variables in the study have been tested and the stationarity of the variables have been
confirmed and integrated at firt difference using unit root test and presence of co-integration is
presented. The regression estimates revealed the positive association between financial
development index and growth (GDP), also supported by Kiprop M. J.et al., (2015) and Asghar
(2014). The findings of the study backings the estimates of Kiprop M.J.et al., (2015) and Céline
Gimet and Thomas Lagoarde-Segot (2012).

Asghar (2013) endeavoured to estimate empirically the robust casality between Finance and
economic performance and analysed emiprically.The study has been initiated by taking data of
some developing economies from 1978 to 2012. The study attempted to provide evidences of
long-run causality between the variables by using foreign direct investment, trade and trade
oppenss through which Financial development influences economic performance. The financial
development index has been constructed by including numrous variables to capture the effect of
maximumu variables.The study also attepmted to give the measures that how different countries
can avoid financial crisis like 1997 and 2007-8 which has been experienced due to imperfect
financial markets and weak financial sectors which caused economic growth to fall. The study
applied panal unit root, panel cointegration tests to present interconnection of long-run and
connection among variables. Estimates presented the weak cointegration among variables due to
the under developed and inefficient financial system in various countries, due to inefficient
financial and economic resource allocation which causes weak influence of financial
development on economic performance.
Hasan (2008) used ARDL approach to analyse the long run casaulality of Pakistani stock prices
and major macroeconomic variables. The study indicated that FPI has a important short-run and
long-run influences on stock market and growth.
Chaudhry et al. (2014) endeavoured to examin the nexus between a few macroeconomic
variables and growth. This tudy describes that foreign portflio investment (FPI) is the major
compoent of foreign private investment which is deemed a key factor of improving economy
and growth. This study uses the net portfolio investment as a proxy of FPI. Despite of its volatile
nature and high risk in Pakistan FPI is considered to be the most important factor of enhancing
foreing private investment. This investment causesd to rise in economic activities even in 1997
Asian crisis. The major contribution of FPI is to brigdge the gape between investment and
savings. This will help be the cause of over all prosperity of economy and the masses as well.
HYPOTHESIS:
H1a: Political instability is negatively associated with foreign direct investment (FDI).
H1b: Countries having lower foreign direct investment has poor economic performance(GDP).
H2a: Political instability is negatively associated with foreign portfolio investment (FPI).
H2b: Countries having lower foreign portfolio investment (FPI) has poor economic
performance(GDP).
H3a: Political instability is negatively associated with financial development (FD).
H3b: Countries having poor financial development (FD) has poor economic performance (GDP).
 RESEARCH METHODOLOGY
Theoretical perspective that has been taken in analysis of data in this research work is 2SLS and
3SLS technique to determine the nexus between political instability, foreign private investment
and growth. Initially at first stage, political instability index will be constructed with the help of
PCA using political instability factors. In second stage the influence of political instability on
private investment will be determined. At third stage the effect of FPI on growth will be
analyzed. Finally, financial development will be measured and later on its nexus with growth
will be analysed. In this study investment analysis and portfolio management, corporate finance,
financial management, international trade, macroeconomics books and research articles are taken
as reference and to cite the important concepts related to the study. As this study is a time series
so to check the over all nexus between PI, FPI, FD and GDP time series econometric
methodology will be applied to judge the short-run and long-run association of the mentioned
variables among themselves. For this unit root test, co-integration test, error correction model
and ARDL test will be applied.

RESEARCH PROCESS
In this research study, the data will be quantitative in nature. The study will be conducted on the
basis of secondary data.In this research study explanatory research design will be used, because
it will discuss the cause and effect relationship among the variables. Therefore this study will
follow the quantitative –deductive approach. Because in this we move from theories to data as
we are evaluating our theories to our data. Quantitative approach is about examining relationship
between variables . In this research we use computer software ie STATA, Eviews, Excel
MINITAB and many more and inferential statistics for analysis.
Description of the Sample Size
For the research the total sample will be taken from 1975 to 2017 of Pakistan. But for this study
the author will try to developm the nexus between political instability, foreign private
investment, Financial Development and economic growth with reference to Pakistan .

POSSIBLE SOURCES OF DATA

This study will use monthly,quarterly and annual time series data from 1975-2017. Major
possible sources of data are World Development Indicators (WDI), World Economic Outlook
(WEO) as well as Penn World Tables ( 6.3, 7.1, 8.0) Quandle Financial And Economic Data
Base, Trading Economics, Global Financial Data Base, Fact Fish, Global Financial Index, SBP,
SECP, Business Recorder, International Financial Statistics, Data Market, OECD Stat, The
Global Economy, FAOSTAT, KNOEMA Data Base, UNCTAD’s Statistical, Federal Reserve
Economic Data, Govt of Pakistan Ministry of Finance. The data will be obtained was deflated by
GDP deflator to convert them into real values in order to remove inflationary effects. Original
stock prices and market indices are published in the daily newspaper and the website of PSE so
information on stock price and market indices will be taken from the respective source.
Once the data will be collected it will be analysed and estimated by using different time series
ecnonometric techniques. The estimated results and findings will be properly interpreted and will
be presented through graphs whereever required for to make the reader’s understanding more
and more clear and understandable. The conclusion will be drawn from the findings from the
analysis of research and recommendation will be made.After estimations and interpretations of
models the study will be concluded and recommendations will be given to the government,
businesses, policiy makers and other researchers.

POSSIBLE DATA COLLECTION METHODS

Major variables in our research model are PI, Financial Development (FD), Foreign Private
Investment (FDI, FPI) and Real Growth Rate GDP. In the first step we develop political
instability index by using principal component method (PCA). PI is not an easy task to measure
so we take numerous political instability factors for this inex. These factors may be terror,
regime changes, corruption, chaos, assassination of political leaders, military c’oups, coilation
party system, cabinet changes, frequent elections,fractionlisation and secession movements,
guerrilla warfare etc. After developing this index we measure will measure the growth rate of
GDP “g” in Pakistan. Here growth is taken as investment/GDP ratio, investment, laged value of
real gdp, rate of exports, growth rate of labour etc.
PI index will be created by giving random numbers to the political instability factors by using by
using STATA 13. (Gyimah-Brempong, et al., 1999).
 POSSIBLE DATA ANALYSIS METHODS
In this research, regression analysis, 2SLS and 3SLS technique, simultaneous equations, unit root
test, co-integration, ECM and ARDL methodology will be used as a tool for analysis. The
reason for using this technique is it gives more weight to present data. It is more analytical and
scientific.
In this study PI, Foreign Private investment,both PDI and FPI, Financial Development and real
growth rate of GDP are the foremost variables of the study. The Nexus between these will be
analyzed by using the following simultaneous equations. . Initially at first stage, political
instability index will be constructed with the help of PCA using political instability factors. In
second stage the influence of political instability on private investment will be determined. At
third stage the effect of FPI on growth will be analyzed. Finally, financial development will be
measured and later on its nexus with growth will be analysed.
In this study investment analysis and portfolio management, corporate finance, financial
management, international trade, macroeconomics books and research articles are taken as
reference and to cite the important concepts related to the study. As this study is a time series so
to check the over all nexus between PI, FPI, FD and GDP time series econometric methodology
will be applied to judge the short-run and long-run association of the mentioned variables among
themselves. For this unit root test, co-integration test, error correction model and ARDL test will
be applied.

POLITICAL INSTABILITY EQUATION

To measure the PI growth relation, PI has been taken as dependent variable and all other political
instability factors are taken as independent varibles discussed in the past literature. we developed
PI and growth function, power of military action (mil), the legal governmental procedure (lgsl),
country head (gen, pres) and the level of fractionalisation of state (frac). So we can write PI
model as:
PI = β0 + β1 g + β2 mil + β3 frac + β4 pres + β5 gen + β6 lgsl + β7 yt−1 + β8 PIt−1 + ɛ … … … .1
where “ɛ" is a residual term.
GROWTH EQUATION
G = α + α1 K + α2 Lab + α3 EXP + α4 yt−1 + α5 PI + ϵ ………………………………2
Where "G" is an explained variable which denotes the GDP growth rate, “Lab” is the labour
growth rate, "K" denotes investment variable, “EXP” denotes gowth of exports. “PI” is political
instability, yt−1 is lagged value of per capita real GDP and "ϵ" is residual term. “K” is being
used as an input factor which is expected to be positive. Neoclassical growth theory describes
that rise in population leads GDP pre capita growth to fall, at ceteris paribus (Gyimah-
Brempong,et al., 1999).
INVESTMENT EQUATION:
In this section investment equation has been developed to see the effect of savings and PI and
investment. The anticipated deleterious influence of PI on investment will be analysed in this
model propagated by Gyimah-Brempong and Traynor (1996), Devereaux and Wen (1996), Osler
and Rderik (1992), and. This investment equation is written as:
𝐾 = 𝛾0 + 𝛾1 𝑔 + 𝛾2 𝑃𝐼 + 𝛾3 𝑃𝐼𝑡−1 + 𝛾4 𝑚 + 𝛾5 𝑓𝑑 + 𝛾6 𝑆 + 𝛾7 𝐾𝑡−1 + ɛ … … … 3

Where “m” denotes the ratio of imports to GDP, “fd” denotes the ratio of real foreign debt
service/GDP ratio, “s” denotes savinggs, 𝐾𝑡−1 is the lage value of investment “ɛ” is the residual
term. It is expected that the coefficients of g and s may be positive.

SYSTEM OF EQUATIONS:
From above individual equations we develop a composite system of simulataneous equations that
will be estimated in econometric model as:
𝑃𝐼𝑡 = 𝛽0 + 𝛽1 𝑔𝑡 + 𝛽2 𝑚𝑖𝑙𝑡 + 𝛽3 𝑓𝑟𝑎𝑐𝑡 + 𝛽4 𝑝𝑟𝑒𝑠𝑡 + 𝛽5 𝑔𝑒𝑛𝑡 + 𝛽6 𝑙𝑔𝑠𝑙𝑡 + 𝛽7 𝑐𝑜𝑟𝑝𝑡 + 𝛽8 𝑡𝑒𝑟𝑟𝑜𝑟𝑡
+ 𝛽9 𝑒𝑙𝑒𝑐𝑡 + 𝛽10 𝑟𝑒𝑔𝑡 + 𝛽11 𝑌𝑡−1 + е𝑡 𝑃𝐼𝑡 + 𝜇𝑡
𝑘𝑡 = 𝛾0 + 𝛾1 𝑔𝑡 + 𝛾2 𝑃𝐼𝑡 + 𝛾3 𝑃𝐼𝑡−1 + 𝛾4 𝑚𝑡 + 𝛾5 𝑟𝑒𝑠𝑡 + 𝛾6 𝑆𝑡 + 𝛾7 𝑘𝑡−1 + 𝜀𝑡
𝑔𝑡 = 𝛼0 + 𝛼1 𝑘𝑡 + 𝛼2 𝑙𝑡 + 𝛼3 𝑋𝑡 + 𝛼4 𝑌𝑡 + 𝛼5 𝑃𝐼𝑡 + е𝑡
FINANICA DEVELOPMENT:
After going through the finance and economics empirical and theoratical studies Financial
Development model is presented and with the help of this model FD is measure by using
different important determinants of FD.
Fin. Development = f (TO, PCI, INF, INT, RR, GB, M CAP, Private Credit/ GDP …....(I)
In this model Financial Development is FD, openness to trade TO, per capita income PCI, INF
denotes rate of inflation, INT is rate of interest, RR reserve requirement, government borrowing
G.B, Market Capitalization is M. Cap and Private Credit/ GDP a proxy to measure FD . This
functional form of economic equation written above as Eq (I) is transformed to an econometric
form :
MODEL SPECIFICATION
FDt = β0 + β1 TOt + β2 INFt + β3 PCIt + β4 INTt + β5 RR t + β6 GBt
+ β7 MCapt+ β8 Private credit/ GDP + εt … … … . (2)
Wher 𝛽1 ,𝛽2 ,𝛽3 , 𝛽4 , 𝛽5 , 𝛽6, β7 and β8 coefficients of each variable used in the above
econometric model. In this model“𝛽"0 is a fixed at each level of other coefficients. The symbole
“t” denotes that the study is time series in nature which will be conducted in Pakistan perspectiv
for the period of 1975 to 2017. At the end of the model the term “εt ” shows the random error
term.
MAJOR FACTORS/VARIABLES OF THE ABOVE MODEL
FINANCIAL DEVELOPMENT
Financial sector development is the process of developing financial markets improved financial
institutions, insurance companies, which provides credit to the enterprises and to the households.
This process enhances the growth process of a country.Moreover, it facilitates each segments of
businesses and society. A developed system helps in reducing inflation, poverty and
unemployment by raising income level, the level of credit to businesses and providing technical
skills and services.The proxies privatre sector credit in relations to GDP and market
capitalization are considered suitable measusres of FD. This improved and developed financial
sector also strenghtens the efficency of finacial institutions.
INFLATION
It is the rise in general price level of goods and services in an country for a specified period
world bank (2011). Inflation can be calculated by annual % price change. Is is said, inflation is
inversly corrleated with financial development.
OPENNESS TO TRADE
Trade openess is the percentage total value of exports and the value of imports as a percentage
of GDP. Due to free trade and globalization the world is kniteed in a net and came close to each
other enjoying the fruits of trade and in this way total trade volume is increasing. This increased
in trade due to open trade opportunitrs financial development of an economy getting better.
PER CAPITA INCOME
Per capita income is considered an indicator living standard of a country. It is calculated by total
GDP divided by total population. A higher living standard is an indicator of higher financial
needs..
INTEREST RATE
It is the cost or price of money. This is an annual rate of interest charged by financial institutions
for their loans or lendings to meet the fleet fleeting deficiencies of financial resources. If banks
keep interest rate high than normal rage it cuts the amont of banks advances to the private
demanders. The interest remains in a normal range due to the inter bank competition.To promote
financial sector development it is appropriate to keept the interest rate low.
RESERVE RATIO
The can be defined as “the minimum reserve or cash requirement set by the central bank that the
commercial banks should keep (rather than lend out) of the money deposited by the customer.
This proxy is used to determine the performance of the financial institutions. Sometimes small
amount is used a an instsrument to improve the performance financial intermediaries to stimulate
financial sector growth.
GOVERNMENTS BORROWED FUNDS
Money borrowed from by the government from the intermediaries to spend on government,
defense as well as public expenditures. This proxy is alos used to measure financial
development. It is calculated as government credit as percentage of GDP.
PER CAPITA REAL GDP
The per capita real GDP growth is the ratio of real GDP to total population.It will be used in this
study to capture the aggregate demand conditions in the country. This variable was chosen since
it considers the effects of population. The data for this variable will be obtained from WDI data
base.
PRIVATE INVESTMENT
Private Investment as a ratio to GDP is a powerful indicatort for modernization, growing
productivity as well as creating new prospects for obtaining efficient tecniques of production and
increae the capital accumulation thereby improving the productive capability of a country.It is
projected that there is a positive effects of private investment, financial sector development and
ultimately growth rate ie GDP. The investment data will be collected from world devlopment
indicator (WDI).
GOVERNMENT SIZE.
Government size is taken another independent variable. Due to increaseed govt size plenty of
resource will be diverted to the govt and less resources will be allocated to development which is
significant for growth of a country. that will be used in this study. Thus the increased govt
consumption causes declines in the GDP of a country.
TERMS OF TRADE
Terms of trade “TOT” are another key variables that defines growth. TOT is used as a proxy for
outside tremors to the counrty. It is the value of exports need to buy imports. if the exchage rate
in unfavourable may be harmful for current account deficit, that is considered a key indicator for
economic volatility. It can negatively affect foreing investments and economic growth to fall.
MARKET CAPITALIZATION:
Market capitalization represents the total value of issued share capital or number of outstanding
shares of a business in the markt. It is called as "market cap,". Market cap is calculated by
multiplying total outstanding shares by the market price per share “MPS” in the market.Market
cap is an excellent “Proxy” to measure the value of a company.
PRIVATE CREDIT\GDP RATIOS:
“Private Sector Credit percentage of GDP” a Proxy has been taken to measure the Financial
sector Development as it is supposed to be the suitable meausure of Financial development.
Moreover this financial development causes economice growth to increase in a country, which
is in accordance with theory.
NEW PRODUCT REGULATIONS
MEASUREMENT OF FINANCIAL DEVELOPMENT & ECONOMIC GROWTH:
MODEL SPECIFICATION
Following theoretical as well as empirical literature, financial development will be measured by
using the proxy private sector credit in relation to GDP ratio.This proxy is considered the best
estimate FD.In this regard, therefore, the empirical model will be estimated to measure the FD
and growth nexus in Pakistan,
𝒍𝒏𝒀𝒕 = 𝜷𝟎 + 𝜷𝟏 𝒍𝒏𝑪𝑷𝑺𝒕−𝟏 + 𝜷𝟐 𝒍𝒏𝑶𝑷𝒕−𝟏 + 𝜷𝟑 𝒍𝒏𝑮𝑺𝒕−𝟏 + 𝜷𝟒 𝒍𝒏𝑰𝑵𝑽𝒕−𝟏 + 𝜷𝟓 𝒍𝒏𝑻𝑶𝑻𝒕−𝟏
+ 𝜷𝟔 𝒍𝒏𝒀𝒕−𝟏 + 𝜷𝟕 𝒍𝒏𝑭𝑫𝒕−𝟏 + 𝜷𝟖 𝒍𝒏𝑴. 𝑪𝑨𝑷 + 𝜷𝟖 𝒍𝒏𝒄𝒓𝒆𝒅𝒊𝒕 𝒕𝒐 𝑮𝑫𝑷 + ɛ𝒕

Where
𝒍𝒏𝒀𝒕 = Per capita growth of Real GDP.
𝒍𝒏𝑶𝑷𝒕 = Trade openness ( Total value of exports & imports relation to GDP)
𝒍𝒏𝑪𝑷𝑺𝒕 = Private sector credit to GDP ratio (Proxy for financial development)
𝑰𝑵𝑽𝒕 = Real private Investment
𝒍𝒏𝑮𝑺𝒕 = Government size in relation to growth of GDP
𝒍𝒏𝑻𝑶𝑻𝒕 =Terms of trade
𝒍𝒏𝑭𝑫𝒕−𝟏=Measure of Financial Sector Development
𝒍𝒏𝒚𝒕−𝟏= lag value of Per capita growth of Real GDP
𝐥𝐧𝐌𝐚𝐫𝐤𝐞𝐭 𝐂𝐚𝐩= Market Capitalization
ln =Natural log
𝛃′𝐬= Parameters to be estimated
𝜀𝑡 , µ𝑡 and 𝜈𝑡 are white noise process
JUSTIFICATION AND MEASUREMENT OF VARIABLES
FINANCIAL DEVELOPMENT
The poxy credit to private sector to GDP is taken as a measure of financial development This
measure is considered to be the most appropriate measure of financial intermediation to the
private sector (Favara, 2003). It is expected that this measure will provide accurate information
of growth finance nexus and its effects on growth. Because it is argued by (Akinboade, 1998)
and (Levin et al., 2000) that private sector credit is more productive and efficient and it has
strongly been affected financial sector and growth than other meausre of financial sector
development (Levin et al., 2000) and (Roe,2011).
ANALYSIS TECHNIQUES
To determind the finance-growth nexus and its over all effects on economy, appropriate
econometric methods are used for analysis, estimation and interpretation. In this study co-
integration and ECM modelling ARDL bounds test and Unit root econometric modelling have
been applied to test the uni-directional or sometimes bi-directional causality both in short-run as
well as long-run. The (ARDL) bounds test investigation method of co-integration is a
contemporary and marvellous econometric modelling of time series studies, Pesaran et al. (2001)
and Pesaran and Shin (1999). This methods overcome the short-comings of Engle-Granger
(1987), Johansen (1991) and Johansen and Juselius(1990) Co-integration methods. as given
below:
First: ARDL can be used with out prior testing the order of integration of series. This can be
used either of order I(0) or I(1).
Second: This technique uses the maximum numbers of lags to analyse the data processing of
general to specific framework (Jalil et al. 2008).
Third: In time series data analysis endogeneity problem is observed on and off. ARDL approach
handles this issue comprehensively. In this approach Pesaran and Shin (1999) used ARDL
modelling to discuss endogeneity and autocorrelation problems by introducing suitable numbers
of lags.According to Jalil et al. (2008), endogeneity is less of a problem if the estimated ARDL
model is free of autocorrelation. Jalil et al. (2008), claimed that when ARDL estimation is free of
autocorrelation then endogeneity problem becomes less and less.
Fourth: In recent emerging studies ARDL technique is widely used in this kind of empirical
studies as it is a addresses the small samples whereas Johanson. Hence, ARDL model can be
specified as:
𝑘 𝑘 𝑘

∆𝑙𝑛𝑌𝑡 = 𝛽0 + ∑ β1i ∆𝑙𝑛𝐶𝑃𝑆𝑡−1 + ∑ β2i ∆𝑙𝑛𝑂𝑃𝑡−1 + ∑ β3i ∆𝑙𝑛𝐺𝑆𝑡−1

𝑖=1 𝑖=1 𝑖=1
𝑘 𝑘 𝑘

+ ∑ β4i ∆𝑙𝑛𝐼𝑁𝑉𝑡−1 ∑ β5i ∆𝑙𝑛𝑇𝑂𝑇𝑡−1 + ∑ β6i ∆𝑙𝑛𝑌𝑡−1 + 𝛼1 𝑙𝑛𝐶𝑃𝑆𝑡−1

𝑖=1 𝑖=1 𝑖=1

+ 𝛼1 𝑙𝑛𝐶𝑃𝑆𝑡−1 + α2 lnOPt−1 + α3 lnGSt−1 + α4 lnINVt−1 + β5 lnTOTt−1 + εt

Where ∆ shows change symbole, lag length is “k” and “𝜀𝑡 " error term expected there is no serial
correlation. ARDL technique encompasses two stages. In first step, 𝐻0 is establised to show no
co-integration given as 𝐻0 = 𝜶𝟏 = 𝜶𝟐 = 𝜶𝟑 = 𝜶𝟒 = 𝜶𝟓 = 𝟎 and is tested against the
alternative hypothesis 𝐻1 ≠ 𝜶𝟏 ≠ 𝜶𝟐 ≠ 𝜶𝟑 ≠ 𝜶𝟒 ≠ 𝜶𝟓 ≠ 𝟎 of the presence of co-integration
association.
After confirmation of co-integration, ARDL long-term and ECM estimations are estimated.
The investigative test of ARDL may be observed short-run approximations. The error correction
“ECM” depiction can be written as:
k k k

∆lnYt = β0 + β1 lnFD + ∑ β2i ∆lnOPt−i + ∑ β3i ∆lnGSt−i + ∑ β4i ∆lnINVt−i

i=0 i=0 i=0
k k

+ ∑ β5i ∆lnYt−i + ∑ β6i ∆lnTOTt−i + γECMt−i + νt

i=0 i=0

The variable FD in model is financial development representing the private sector credit in
relation to GDP is a proxy has been taken to estimate financial sector development whereas,
variable “ γECMt−i " estimates captures long-run connection. Theoretically, the term
γECMt−ivariable is supposed to be negative and less than one to indicate the the re-adjustment
process to correct itself to bring back to long-run equilirbium from disequilibrium.
UNIT ROOT TEST
In Financial econometric modellings it has been envisaged, in time series studies in an
autoregressive process the estimates are not true and reliable due to the poblems of non-
statinarity. It means that the data series is not stationary. It shows that the forecasting in future
may not be valid. This very problem can be dealt by transforming the data series to stationary
one so that the problem of unit root may be avoided. Unit root means that the variables is
stationary and has unit root. It means that in time series data series a trend exists. The estimates
of such data series having trend gives the spurious one.
The unit root test is conducted to in time series to test null hypothesis for presence of unit root.If
unit root exists in the data it signifies t-tests will not be valid and the estimates are ambiguous
and deceptive. It means that there is a problem of autocorrelation/serieal correlation in an
autoregressive process. Due to non.stationarity of data the estimators are deceptive and the
results are spurious with high R-Square and unreliable estimators. There are two major test for
testing unit root in econometric literature. Famous ADF and Pillips Perron unit root tests are
performed to test the presence of data series. In bound test of co-integration there is no need to
test unit root. But to make the ARDL valid it is compulsory to check unit root.
MEASUREMENT OF GROWTH :
For the measurement of Growth rate ∆ 𝑌 is taken as dependent variable in the model where as
investment, labour, export, laged variable 𝑌𝑡−1 of growth, political instabiblity PI, financial
development,FD, foreign prifvate investment ( FDI, FPI) are taken as explanatory variables. It is
argued that if there is political instability in an economy then it will cause productivity to
decline, either PI may cause investment to fall Fosu (1992). Moreover, additional variables are
added in the regression model to estimate the over all change in growth due to these explanatory
variables. Finally the growth regression modl can be specified as:
∆Y = β0 + β1 Invstment + β2 Lab + β3 Exp + β4 Yt−1 + β5 PI + β6 FD + β7 FDI + β8 FPI + µ
Where ∆ Y is the GDP growth rate, Labour growth rate is “lab” investment, exports growth rate
is exp, political Instability is PI, lag per capita real GDP, Yt-1, , FD, financial development
FDI, direct foreign investment is FDI, FPI, foreign portfolio investment and µ is residual. Where
βs are coefficients of of the respective variable. (Roe,2011)

END NOTES

CONCLUSION
This research study will envisage and endeavour to develop the finance-growth nexus via PI and FPI
in Pakistan context using time series data set. In this study OLS model, Principal component analysis
and time series data methodology will be used to investigate the effects of political instability on
economic growth through foreign private investment and financial development in Pakistan using
time series data. Using a more comprehensive measure of political instability than has been used in
earlier studies, it is expected that PI has a negative and statistically significant impact on FPI, FDI, FD
and on GDP growth in Pakistan. It is also expected that PI will affect economic growth both directly
as well as indirectly through a reduction in capital formation.
We expect that there is a bi-directional causal relationship between economic growth and political
Instability slow economic growth causes PI which will in turn lead to further economic stagnation.
We will use Principal Component Methodology to develop PI Index which is a better measure of PI.
This Index is a better measure of PI to capture the effects of PI on economic growth and
investment.Similarly, for the measurement of Financial Development we’ll use Financial
Development Index and its determinants.

RECOMMENDATIONS
This study will expectedly investigate then nexus between PI, FDI, FPI and GDP growth in Pakistan,
which will guide the investors, governments, multinationals and policy makers to reshape their
investment strategies and look beyond the local markets. They will definitely look around in the
countries where a politically stable environment prevails for their investments. The foreign investors
and investment can be attracted due to this mechanism and it will raise the prosperity of the countries.
Literature shows that India is a comparatively better for foreign private investment than Pakistan. So
to attack this capital Pakistan’s policy makers, governments, institutions and other elite groups have to
make investor’s friendly policies.
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