Impact of Foreign Capital inflows on domestic saving of Pakistan:

Submitted By: Fumaira Javeed 07010621-013 Farheen Mariam 07010621-034 BS (Eco) Submitted TO: Miss Salma Shaheen Lecturer of Department of economics

Acknowledgment
Authors are very thankful to Miss Salma Shaheen Lecturer of Department of economics University of Gujrat, Pakistan for appreciation and encouragement in research activities.

Abstract
This study analyze the effect of foreign capital inflow on domestic saving rate along other variable by using an advance co-integration technique auto regressive distributed lag (ARDL) on time series data for the period of 1980-2010. In this study four variables used, dependent variable is domestic saving rate and explanatory variables are current account deficit, Per capita GNP at constant market price and foreign direct investment. The result shows that foreign capital inflow as measured by current account deficit has negative impact on domestic saving rate, foreign direct investment also negatively linked with dependent variable. Per capita GNP positively associated with domestic saving rate.

Keywords: Domestic saving rate, foreign capital inflow, current account deficit, foreign
direct investment, ARDL

Impact of Foreign Capital inflows on domestic saving of Pakistan:

1. Introduction:
It has been widely accepted that Foreign Capital Inflow (FCI) stimulates economic growth in the developing world. FCI enables countries to achieve investment levels beyond their own domestic savings. More importantly, FCI is an important means of transferring modern technology and innovation from developed to developing countries. However, there is convincing evidence that the growths enhancing effect of FCI varies from country to country and for some countries FCI can even adversely affect the growth process (Ali, 1993, Balasubramanyam et al., 1996, Borenstein et al., 1998, De Mello, 1999, and Lipsey, 2000). Developing countries like Pakistan heavily depend on foreign capital as the primary mean to achieve rapid economic growth. The need of foreign capital normally arises when there is shortage of capital in host country and her domestic resources are unable to minimize the gap between domestic saving and investment need. Do inflows of foreign capital enhance the saving rate in developing countries? The answer to this question is widely thought to be disruptive. In past 30 years researchers paid more attention on the relationship between foreign capital flows and domestic saving. Because there is a controversy at theoretical and empirical levels over the effects of foreign capital on both economic growth and national saving. The insertion of foreign resources via free grants, aid, loans, direct investment etc. in to develop economy set in a motion a causal chain of positive influences in the following broad manner, Aid leads to increase in investible resources which leads to increase in domestic investmen and finally more repid rate of growth. But large part of the latter,the available avidence pointed to negative relationship between aid and and domestic saving (Khan and Raheem 1993). Theories and empirics emerge to provide uncertain evidence regarding the impact of foreign capital on developing economies. Mostly study has the purpose to determine either foreign capital inflow or domestic saving is complementary or substitute. A number of studies in Pakistan have been conducted during the early 1990s to look at the correlation between saving and foreign capital inflow. Mostly studies show the inverse relationship between foreign capital inflows and saving rate.

Basically mostly macroeconomic time series are non stationary there mean and variance are not constant so if apply OLS then it produce spurious result or non sense regression. When a time series is not stationary but become stationary by taking first difference then we apply co integration. Economically speaking two variables will be co integrated if they have long term or equilibrium relationship between them. But if time series are not same order of integration then valid inference are drawn by applying a recent co integration technique, auto regressive distributed lag (ARDL) method. ARDL method has two conditions, I (1) and I (0) exist and dependent variable must be I (1). In this study, we examine the impact of foreign capital inflow on domestic saving along with other variables by using ARDL technique on time series data for the period of 1980-2010. Strategy of the paper is as follows: in Section 2 briefly review the relevant empirical literature, Section 3 presents theoretical framework, section 4 have variable description, the methodology and data source, analysis and empirical results discuss in section 5 and section 6 presents a concluding summary.

2. Literature Review:
There are large number of studies that measure and show the relationship between foreign capital inflow and domestic saving. As previously told that foreign capital inflow takes various forms e.g. FDI, Foreign aid, grants etc. The impact of foreign debt on savings and investment in Pakistan and the impact of debt and its servicing on savings and investment explored by Chaudhry et al. (2009) by using time series econometric tools for the period 1973-2006. With the help of Multivariable regression analysis, the study suggested that foreign debt itself does not have any significant adverse effect on national saving efforts. However, servicing of the foreign debt creates burden on the current resources, thereby adversely affecting national saving efforts. The relationship between domestic saving and foreign aid investigated by Griffin (1970) by using data from 32 LDCs for the period 1962-64. With the help of ordinary least square method, study stress that there is negative relationship between domestic saving and foreign aid. He measured current account deficit with the help of current account deficit and estimated gross domestic saving as the difference between gross domestic investment and the capital account balance.

The relationship between domestic savings and foreign capital inflows in Pakistan investigated by Ahmad et al. (2002) by applying three different methods (Engle-Granger two step method, unrestricted vector Error correction method and Johnson maximum likelihood method) to test the co integrating relationship between the variables for the time series data for the period of 19722000. The analysis suggested that there is a valid long-run inverse relationship between domestic savings and foreign capital inflows. The Unrestricted Error Correction Model found short-run significance inverse relationship between domestic savings and foreign inflows but Short-Run Dynamic Engle-Granger procedure found insignificant inverse relationship between these two variables. The empirical results support that foreign capital inflow and domestic saving are substitute to each other. The impact of foreign capital inflows on domestic saving examine by Weisskopf (1972) and his sample is 44 underdeveloped countries. He used a model, which consist of seven equations and nine variables. The study stresses that foreign capital inflow with all available resources to a country has the capacity to increase total amount of domestic expenditure. The numerical results indicate that impact of foreign capital inflow on domestic saving is significantly negative. Quantitative avidence on the relationship between foreign aid, domestic saving and economic growth explored by Khan and Raheem (1993) by stated that 1 percent increase in loan will cause 1/3 percent decline in average saving on the basis of single equation model. Study indicate that different type on foreign aid have different effect on domestic saving. Aid in the form of outright grant has not measured effect on domestic saving but foreign direct investment and loans are inversly related with domestic saving. Size of the coefficient on the FDI is much larger and insignificant as compare to size of the coefficient on the foreign loan that is not only smaller but also significant. The impact of foreign financial inflows such as foreign private investment and aid on economic growth and domestic savings of Pakistan is evaluated by Shabbir and Mahmood (1992) over the period of 1959-60 to 1987-88. By using the Two Stage least square method for estimation of simultaneous equations study stress that foreign capital is a substitute for domestic saving due to two reason. One is due to foreign capital inflow government feel relaxation about its revenue generation efforts that could adversely affect the nation and second one is saving determined by available investment opportunities, foreign private investment could cause domestic savings to fall by crowding out domestic investment.

The relationship between saving rates and foreign capital inflows along with various other variables (GNP at market price and inflation rate) is illustrated by Kemal (1992). The result shows that foreign capital inflow adversely affects Pakistan saving effort. Interestingly study show that negative and significant relationship between private saving and foreign capital inflow and positive and insignificant relationship between public saving and foreign capital inflow. Study also indicates that foreign capital inflows have entirely been used to finance consumption in Pakistan and not have dominant impact on saving. The impact of foreign capital inflows along with other variable (real per capita income, GDP growth rate, trade, dependency ratio and foreign aid to GNP ratio) on the national saving rate of Pakistan estimated by Khan et al. (1992) by using time-series data for the period 1959-60 to 1987-88. The authors estimates the model with OLS techniques and find that in Pakistan foreign capital inflow is the major reason behind low domestic saving rate. There are many other factors that affect the saving rate in Pakistan. Real interest rate and growth rate of real income are positively related with saving rate. Study confirms foreign capital inflows and dependency ratio have depressing effect on national savings in Pakistan. According to the results, a one percent increase in the inflow of foreign capital reduces savings by 0.21 percent. The role of foreign capital in the context of savings and investment for Pakistan for the period of 1963-64, 1984-85 analyzed by Aslam (1987) by using multiple regression analysis. In statistics, it is a mathematical method of modeling the relationships among three or more variables. It is used to predict the value of one variable given the values of the others. Model has been used to test the impact of foreign capital inflows on domestic savings and investment. Domestic saving depends on foreign capital inflow, inflation rate, national income and growth rate of income. National income and inflation rate as independent variable exercise positive and significant effect on domestic saving. Public capital inflow inversely relate with domestic saving and is significant at conventional levels which show that domestic saving and foreign capital inflow are substitute to each other. FCI negatively related with domestic saving. The impact of foreign aid on domestic resource mobilization (stock of entrepreneurial skill is given) was studied by Taslim et al. (2000) through applies co integration analysis with time series data of Bangladesh. The study shows that there is inverse relationship between foreign aid and domestic resource mobilization due to entrepreneurial constraint. Many developing countries like Bangladesh suffer from an acute shortage of entrepreneurial skill. Given the existing stock

of entrepreneurial skill, these nations are unable to invest any more than a small proportion of their income. Foreign aid permitted a relaxation in saving effort and encouraged an increase in Consumption.

3. Theoretical framework:
Out of the literature review we need to develop the theoretical framework for our study because it is necessary to make logical sense of the relationships between variables and factors that have been relevant to the problem. Primarily this should revolve around the theories that have been put forward for the relationship between variables. A considerable number of theoretical and empirical studies have been undertaken to establish a relationship between external resources and domestic savings rates. Debate on the relationship between foreign capital inflow and domestic saving started with the well-known two-gap model of Chenery & Strout (1966). According to this model domestic saving rate and insufficient foreign exchange earnings is the major hurdles in the way of growth and these hurdles can be reduced with the help of foreign resources which ultimately lead to desired level of growth. The assumption that foreign resources (especially in the form of foreign aid) supplements domestic savings was almost instantly challenged by Rahman (1967), Griffin (1970), Griffin & Enos (1970) and Weisskopf (1972), who argued that foreign aid would be a substitute for domestic savings. By using 1962 cross-country data of 31 countries, Griffin and Enos (1970) and Rahman (1976) established a significant negative relationship between savings and foreign capital inflow regarding the economy size. Any inflows of external resources help to augment the extent of domestic expenditures. Domestic savings may go down if private and public economic agents choose to spend the incremental resources to increase consumption (Weisskopf, 1972). The role of foreign capital in the development process was generally regarded as supplementing domestic investment, thus making possible an increase in domestic investment over domestic saving (Chen, 1977). Ahmad et al. (2002) findings hold the Substitution thesis hypothesis that foreign capital may in fact replace domestic saving. One clarification is when resources are easily available then

external flows will reduce the effort originate for domestic saving and encourage consumption level with in a country.

Foreign capital inflow

consumption

domestic saving rate

Per capita income positively related with domestic saving. People mostly distribute their income in two parts one is consumption and second one is saving so Y=C+S. When per capita income increase then people have more money to save and further utilize this saving for different purposes. Ahmad et al. (2002) found that there is positive impact of GNP per capita income at constant market price on domestic saving rate.

GNP per capita income

domestic saving rate

Okafor et al. (2010) investigate that that FDI has positive correlation with domestic savings in the medium term, but have negative linkage in the long run. Khan & Raheem (1993) stated that foreign direct investment and loans are inversly related with domestic saving.

Foreign Direct investment

domestic saving rate

4. Description of Variables: Current account deficit:

When revenue from export of goods & services and income flows is less than the expenditure on the import of goods & services and income flow over a given time period. It is used as a proxy of foreign capital inflow by Ahmad et al. (2002) & Khan et al. (1992) & Griffin (1970).

Domestic saving rate:

Income not used for current consumption. Saving rate is calculated by using growth rate formula.

Foreign direct investment:

Foreign investment with the consent of domestic government in domestic country. Foreign direct investment can include buying shares of an enterprise in another country, then reinvesting earnings of a foreign- owned enterprise in the country where it is located. According to International Monetary Fund (IMF) guidelines consider an investment to be a foreign direct investment if it accounts for at least 10 percent of the foreign firm's voting stock of shares. However, many countries set a higher threshold because 10 percent is often not enough to establish effective management control of a company.

GNP per capita:

A country's gross national product (GNP) divided by its population. If GNP equally divided then income of each person is called income per capita. GNP per capita is a useful measure of economic productivity, but by itself it does not measure people's well-

being or a country's success in development. It does not show how equally or unequally a country's income is distributed among its citizens.

4. 1 Methodology and Data:

Study intends to estimate the impact of foreign capital inflow on domestic saving along with other variables. DSR= 0+ 1 FCI +2 Yp+3 FDI The variables use in this study are domestic saving rate as an dependent variable and independent variable include foreign capital inflow measured by current account deficit, per capita GNP at constant market price, Foreign direct investment. The sample period covers annual data from 1980 to 2010. The GDP deflator (on the basis of 2000) is used as price deflator for all nominal series to deflate the inflationary effect. In the end of this section few words regarding data sources are, domestic saving, per capita GNP at constant market price are taken from Handbook of Statistics on Pakistan Economy 2010. Domestic saving rate are generated by using

Where: PR=Percent rate VPresent=Present or Future Value VPast = Past or Present Value Data on current account deficit are taken from the international monetary fund (2010). Data on current account deficit are given in US dollar but we multiply this with average exchange rate of respective year and data on exchange rate is obtained from International Financial Statistics (2010). Finally data on FDI is obtained from Handbook of Statistics on Pakistan Economy 2010.

ARDL Co-integration Approach:

To determine the short run as well as long run relationship between domestic saving and foreign capital inflow along other variables, we used the autoregressive-distributed lag (ARDL) cointegration introduced by Pesaran et al. (2001). ARDL the new advanced technique for testing co-integration has many advantages on other conventional co-integration techniques such as that of Engle and Granger (1987) and Gregory and Hansen (1996). ARDL do not entail pre testing for unit root, the realization of unit root test are necessary only for check that none of the variable integrated of order 2 because bounds test is based on the assumption that the variables are I(1) or I(0). It is more efficient in the case of small sample size. Other co-integration techniques has the problem of endogeneity, where as ARDL can make a distinction between dependent and independent variables. In ARDL technique, after checking stationary and examination of lag order we apply Wald test (F statistics) to find out long run relationship between variables. One lag is selected for estimation according to Schwarz criteria. dDSR= 0+ 1 FCI t-1 +2 Ypt-1 +3 FDIt-1 + t H0 = 1 = 2 = 3= 0 H1 1 2 3 0 (There is no long run relationship) (Existence of long run relationship) 4dFCI t-1+ 5dY t-1+ 6dFDI t-1+

If F-test statistic exceeds the upper critical value, null hypothesis of no long run relationship can be rejected otherwise not. If there is long run relationship between variable exist, then we estimate the error correction model (ECM) which is a mean of reconciling the short run behavior of economic variable with its long run behavior. The short-run behavior of variables is examined by the following model: dDSR= 0 +ECMt-1 + 4dFCI t-1 5dY t-1 6dFDI t-1+ t

Result Interpreting Design:

Sezgin and Yildirim (2002) stated that ARDL can be applied without worried about stationary property of variable under consideration. In contrast according to Quattara (2004) in the presence of I(2) variables the computed F-statistics provided by Pesaran et al. (2001) become invalid due to the assumption of bound test that is variables should be I(0) and I(1). Therefore, the

realization of unit root test is necessary to insured none of the variable are I (2) or beyond.

Table 1: Augmented Dickey-Fuller (ADF) Test

Series in model Level First Difference DSR FCI Yp FDI -1.286601 -4.817511 -0.165772 -2.962811 -6.188399 -4.677278 -5.532018 -4.322783

We can apply ARDL bound test to investigate long run relationship among variables because we have integration order zero and one, 1(0) and I (1). We apply F-statistics to examine existence of long run relationship between variables.

Table 2:
F-statistics 7.41855 Significant level 1% 2.01 Significant level 5% 2.46 Decision rule Reject null Lag hypothesis 1

(co-integration exist) Note: Level of significance of the critical bound values resolute by Pesaran et al. (2001).

As F-statistics proves that variables are co integrated, we now investigate the impact of independent variable on dependent variable not only in the long run but also in the short run.

Table 3:
Long run coefficient using the ARDL technique

Dependent variable : domestic saving rate Variable FCI Income FDI Coefficient -40450.64 4.742806 -156.1833 T statistics -8.29867 8.99495 -8.89544

Table 3 indicates that in the long run foreign capital inflow that measured by current account deficit has negative and significant impact on domestic saving rate. Per capita GNP at constant market price positively associated with domestic saving rate with significant coefficient. Foreign direct investment negatively related with domestic saving rate. I rupee increase in fdi will cause 0.43 increase in domestic saving.

Table 4:
Short run coefficient using the ARDL technique Dependent variable : domestic saving rate(DSR) Variable FCI Income FDI DSR Coefficient 28.53213 -0.008113 0.434291 -0.179170 T statistics 0.08579 -0.14863 0.30219 -0.56446

Table 4 shows that in the short run foreign capital inflow has negative and insignificant effect on domestic saving rate. Per capita GNP at constant market price has positive and insignificant effect on domestic saving rate in the short run. Foreign direct investment negatively associated with domestic saving rate with insignificant coefficient. So in the long run coefficient are significant but in the short run coefficient are insignificant.

Table 5:
Short run coefficient using the ARDL technique D(SAVING) Constant 206.3021 (171.645) D(DEFICIT) 0.120185 (0.15262) D(INCOME) 1393.665 (849.556) D(FDI) -5.013163 (49.1584)

[ 1.20191] ECMt-1 -0.014654 (0.00922) [-1.58912]

[ 0.78750] -2.62E-05 (8.2E-06) [-3.20109]

[ 1.64046] 0.024069 (0.04564) [ 0.52735]

[-0.10198] -0.003687 (0.00264) [-1.39594]

R-squared F-statistic

0.203094 1.172326

0.598877 6.867794

0.101681 0.520676

0.399184 3.056255

Note: Values in parentheses show standard error while values in [ ] shows t-values at the 5% level of significance.

The coefficient of error correction term ECMt-1 shows how quickly the variables return to the long-run equilibrium, has a negative sign and is statistically significant ensuring that long-run equilibrium can be restored. Table 4 indicates that error correction term for domestic saving rate bears the correct sign i.e. it is negative and statistically significant at 5 percent significant level. It shows 1.46 percent speed of convergence toward equilibrium state if any disequilibrium occurs. The coefficient of error term for FCI and FDI has correct sign i.e. negatively and statistically significant and have convergence speed of 2.62 percent and 3.68 respectively toward equilibrium. The coefficient of error term for income has wrong sign i.e. positively and statistically insignificant with the divergence speed 2.41% toward equilibrium.

Table 6:
Sensitivity Analysis Test Statistics A: Serial Correlation B: Functional Form C: Normality D: Heteroscedasticity LM Version F Version

Conclusion:
Developing countries like Pakistan heavily depend on foreign capital inflow to meet the gap between domestic saving and investment, but it is observed that foreign capital inflow reduce domestic saving. Foreign capital inflow becomes a source of expansion in foreign saving and domestic consumption. In this study we analyzed short run and long run relationship between dependent variable and independent variable by applying auto regressive distributed lag (ARDL) the new advanced technique for testing co-integration developed by Pesaran et al. (2001). We found that there is negative relationship between domestic saving rate and foreign capital inflow not only in the short run but also in the long run, same is the case with foreign direct investment. Per capita GNP positively associated with domestic saving rate. In the context of policy recommendations, there is need to focus on the national economic policies, as foreign capital inflow can be more helpful in boosting domestic saving rate of the country in the existence of suitable national economic policies like monetary, fiscal and trade. Saving is a key macro variable with micro foundations which can play a significant role in economic growth and also can perform important role in other macro economic variables e.g. inflation stability and promotion of employment especially if seen in the context of a developing country but Pakistan performance with regard to domestic resource mobilization is poor. Pakistan should focus on the per capita GNP because it will increase domestic saving rate in the country. There is strong support that governance mechanism for the use and monitoring of foreign capital inflow needs much improvement. Finally it is suggested that if foreign direct investment properly used for the expansion of domestic saving then it will cause to boosting of domestic investment in certain field that lead to economic growth.

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