Foreign capital inflow and economic growth: A theoretical investigation and a case study of Pakistan

This dissertation evaluates the role of foreign capital inflow in economic development by examining its impact on the output growth rate. At the theoretical level, a critique of the two-gap growth model is presented. It is argued that the model\u27s predicted positive impact of foreign capital on the growth rate is undermined by the following factors: the adverse effect on domestic savings; the decline in the productivity of capital; the burden of debt service and other payments obligations; and the capital flight-inducing effect of foreign capital inflows. A revision and extension of the two-gap model is subsequently undertaken by incorporating these factors. The reformulated model is then used to determine empirically the impact of foreign capital inflow on the growth rate of Pakistan, using data for the period 1972 to 1990. The empirical analysis is conducted in two stages. First, the effects of foreign capital inflow on capital flight, on the productivity of capital (the incremental output-capital ratio) and on domestic savings are econometrically estimated. Next, the parametric estimates are consolidated and combined with other data pertinent to the model to arrive at a final estimate of the impact of foreign capital on the growth rate. The main results derived are: (1) foreign capital inflow has been a significant determinant of capital flight; (2) while foreign capital has led to a deterioration in capital productivity, the evidence for this is not strong; (3) there is clear and strong confirmation of the hypothesis that foreign capital leads to a decline in domestic savings; and (4) the overall estimated impact of foreign capital on the growth rate is significantly negative. From a methodological standpoint, this dissertation is a departure from the conventional approach of previous empirical studies on the subject. By deconstructing and disaggregating the growth impact of foreign capital inflow, the technique developed and applied here delineates the channels through which the influence of foreign capital on the growth rate is transmitted. The relative importance of each effect also becomes apparent