Analyzing the Relationship between Domestic Interest Rates and FDI Inflows: Evidence from Pakistan

Abstract

The aim of this study is to examine the influence of domestic interest rates on foreign direct investment in Pakistan. Specifically, the research seeks to assess the effects of domestic interest rates, gross domestic product per capita, merchandise exports, and unemployment on FDI inflows. By analyzing these factors, the study aims to provide insights into the determinants of FDI in Pakistan's economy. Understanding how domestic interest rates interact with other macroeconomic variables can offer valuable information for policymakers and investors alike. To estimate the relationship between domestic interest rates and foreign direct investment in Pakistan, this study utilizes various econometric techniques. Firstly, the Augmented Dickey-Fuller (ADF) test is employed to assess the stationarity of the variables involved in the analysis. This test helps ensure that the data used in the regression analysis is suitable for further analysis. Subsequently, the study employs the Autoregressive Distributed Lag (ARDL) model to estimate the long-run and short-run effects of domestic interest rates, Gross Domestic Product (GDP) per capita, merchandise exports, and unemployment on FDI inflows. The ARDL model is particularly useful for analyzing the dynamic relationships among variables over time. In addition to these main techniques, the study conducts various diagnostic tests to assess the robustness of the results obtained from the ARDL model. These diagnostic tests may include tests for autocorrelation, heteroscedasticity, and multicollinearity, among others. These tests help ensure the reliability and validity of the regression results. The secondary data used in this study covers the period from 1972 to 2014 and is collected from reputable sources such as the economic survey of Pakistan and the World Bank database. By employing rigorous econometric techniques and conducting thorough diagnostic tests, the study aims to provide robust insights into the relationship between domestic interest rates and FDI in Pakistan. The findings of the study suggest that several factors influence foreign direct investment (FDI) in Pakistan. Firstly, domestic interest rates, Gross Domestic Product (GDP) per capita, and unemployment exhibit a positive and significant relationship with FDI inflows. This implies that lower interest rates, higher GDP per capita, and lower unemployment rates tend to attract more foreign investment into the country. Conversely, the study finds that merchandise exports are significantly and negatively associated with FDI. This could indicate that higher levels of merchandise exports may be perceived as reducing the attractiveness of Pakistan as an investment destination, possibly due to concerns about competitive pressures or economic stability. Based on these results, the study concludes that policymakers should focus on regulating interest rates to optimize FDI inflows. Maintaining interest rates at a level that is conducive to attracting foreign investors, while also considering the needs of domestic investors, can help maximize the benefits derived from FDI for Pakistan's economy. By implementing policies that foster a favorable investment climate, Pakistan can enhance its ability to attract and retain foreign investment, thereby promoting economic growth and development.