Financial Crisis and Economic Growth of Pakistan by Uzair Akhtar

5/19/2018 Financial Crisis and Economic Growth of Pakistan by Uzair Akhtar

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Financial Crisis and Economic Growth of Pakistan

A Time Series Analysis

Thesis By

UZAIR AKHTAR

FA10-BEC-007

Submitted to the Supervisor Ms. RABIA SABAH,

COMSATS Institute of Information Technology Abbottabad

In partial fulfillment of the requirement for the degree of

BACHELOR OF SCIENCE IN ECONOMIC


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ACKNOWLEDGEMENT

First of all, I am grateful to The Almighty Allah for giving me strength to

complete this research.

I wish to express my sincere thanks to COMATS Institute of

Information Technology Abbottabad for providing me with all the necessary

facilities.

I place on record my sincere gratitude to HOD, DOO and PMeconomics

program for their consistent courage.

I also thank Ms. Rabia Sabah Lecturer of Economics Program. I am

extremely grateful and indebted to her for her expert, sincere and valuable

guidance and encouragement extended to me.

I take this opportunity to record my sincere thanks to all the faculty

members of Economics Program for their help and encouragement. I also thank

my parents, sister, brothers my uncle and friends for their unceasing

encouragement and support.

I also place on record, my sense of gratitude to one and all who, directly or

indirectly, have lent their helping hand in this research.


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DEDICATION

This thesis is dedicated to my parents for their love, endless support and

encouragement. I also dedicate my thesis to my beloved sisters brothers my

uncles, aunts and my friends who have supported me throughout the process. I

will always appreciate all they have done for me.


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TABLE OF CONTENTS

Page No.

ACKNOWLEDGEMENTS 02

LIST OF TABLES 06

ABSTRACT 07

1. INTRODUCTION 08

1.1 Introduction 08

1.2

Significance of the study 14

1.3 Objective of the Study 15

2. LITERATURE REVIEW 16

2.1

Review of Literature 16

3. DATA AND VARIABLES 29

3.1 Introduction 29

3.1.1 Description of Variables 29

3.1.2 Country 30

3.1.3 Variables 30

3.1.4 Defining Variable 30

3.1.5 Data Source 31

3.1.6 Sample Size 32

3.1.7 Theoretical Framework 32


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4. METHADOLOGY 33

4.1 Intro. 33

4.2 Method of Estimation 33

4.2.1 Descriptive Statistics Analysis 33

4.2.2 Unit Root Test 33-34

4.2.3 Co-integration Test 35

4.2.4 Vector Error Correction Model 35

4.2.5 Granger Casualty Test 36

5. RESULT AND INTERPRETATION 37

51. Introduction 37

5.2 DESCRIPTIVE STATISTICS ANALYSIS 37-38

5.3 AUGMENTED DICKEY FULLER TEST 39

5.4 JOHENSION CO-INTEGRATION TEST 40

5.4.1 UNRESTRICTED CO-INTEGRATED TRACE TEST 40

5.4.2 UNRESTRICTED CO-INTEGRATED MAXGIGEN TEST 41

5.5 VECTOR ERROR CORRECTION MODEL 42

5.5.1 VECM FOR SHORT RUN 42

5.5.2 LONG RUN ELASTICITIES 43

5.6 Granger Casualty Test 44-45

6. CONCLUSION AND POLICY RECOMMENDATION 46

6.1 Conclusion 46

6.2 Policy Recommendation 48

7. REFERENCES 49


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LIST OF TABLES

Table No. Table Name Page No.

Table 3.1.1 Description of Variables

Table 5.2 Descriptive Statistic Analysis

Table 5.3 Augmented Dickey-Fuller tests

Table 5.4.1 Determination of Trace test

Table 5.4.2 Determination of Maximum Eigenvalue test

Table 5.5.1 Vector Error Correction Model in Short run

Table 5.5.2 Long run Elasticitys

Table 5.6 Pair-wise Granger Causality test


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ABSTRACT

The purpose of this research is to check how major indicators of financial crisis --

inflation rate, real exchange rate, foreign direct investment and the volume of

foreign debtinfluences economic growth in Pakistan. This study also highlights

the stability of the relationship between indicators of financial crisis and economic

growth. The annual time series data ranging from 1980 to 2012 is used for the

analysis. Johansen's co-integration test is used to check the long run equilibrium

relationship between the variables used in the study. The results indicate that there

is long run stable equilibrium relationship between economic growth and the three

components of financial crisis in Pakistan. The estimates based on pair-wise

Granger Causality test show that unidirectional relationship exist between each

indicator of financial crisis considered and economic growth in study.

Key words: Economic growth, Co-Integration and Financial crises


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Chapter 1

INTRODUCTION

1.1INTRODUCTION

The word financial crisis is applied generally to a mixture of condition in which few

financial organizations or assets rapidly lose the big division of their worth. The term financial

crisis is applied broadly to a variety of situations in which some financial institutions or assets

suddenly lose a large part of their value. And this situation will lead to economic recession. The

serious factor of the crises is inflation and foreign debt, FDI and real exchange rate. The ordinary

features are the facto exchange rate hooked to the dollar and the outcome is overestimation, big

current account deficits and extreme private sectors foreign borrowing.

In existing literature there are many characteristics of financial crises in the economy. These can

be increase in inflation rates, stock market crash, the currency devaluation, increase in the

amount of foreign debt and decreasing foreign reserves of any economy or slow growth rates.

Pakistan is facing serious economic issues like inflation, BOP and trade deficits, Poverty,

unemployment, domestic and foreign investment is very low because of the law and order

situation caused by the engagement in war on terror so only solution left for Pakistan

government is to go toward the international financial institutes like IMF or world bank. Now

Government of Pakistan is receiving loan from IMF which imposed extremely tight terms and

conditions. A fragile Pakistan economy has been facing both economic and political crisis which

predate the global financial crisis. The direct impact of the global financial crisis on developing

countries including Pakistan.


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The responsible factors of financial crises can be exchange rate, foreign direct investment,

inflation rate and increase in the amount of foreign debt. The rate of inflation is also a main

factor in financial crises. The inflation has negative relationship between inflation rate and

banking sector development and stock market activities. As inflation increases in an economy it

will decrease the lending capacity of bank because interest rate increases and borrower are

reluctant to get money from bank and also with the increase in inflation the stock market activity

also diminishes just because of the reason people are not interested in securities due to increased

market prices of stocks and securities in the market. It is found that there is strong negative

relationship between inflation and financial crisis in Pakistan.

The role of foreign debt in todays financial crises is different from historical perspectives, in

past the fiscal and monetary policies were main factors contributing towards financial crises.

Banking trouble, todays currency crises and debt crises are interrelated phenomenon and are

responsible for recent crises.

Foreign Direct Investment (FDI) as a growth-enhancing component has received great

attention of developed countries in general and less developed countries in particular in recent

decades. However, in open economy investment is financed both through domestic savings and

foreign capital flows, including FDI. The investments in form of FDI enable investment-

receiving (host) countries to achieve investment levels beyond their capacity to save. Most

developing countries now consider foreign direct investment as an important source of

development. However, many empirical studies have shown significant role of foreign direct

investment in economic growth of host developing countries, through its contribution in human

resources development, technological transfer, capital formation and international trade.


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The size of foreign direct investment inflows in Pakistan was not significant until 1991 due to

the regularity policy framework. However, under the new policy regime, it was expected to

assume a larger role in catalyzing Pakistan economic development. It is observed that there has

been a steady build up in foreign direct investment inflows in post-liberalization period. Actual

inflows have increased from $41 million in period (1970-74) to $5009 million in (199099).

However, the pace of foreign direct investment inflows to Pakistan has remained slower as

compared with other developing countries in Asia.

Inflation at very high levels is harmful for the economy. There is a wide spread

recognition that inflation results in inefficient resource allocation and hence reduces potential

economic growth. Inflation imposes high cost on economies and societies, disproportionately

hurts the poor and fixed income groups create uncertainty throughout the economy and

undermines macroeconomic stability (Economic Survey of Pakistan, 2006- 07). On the other

hand growth increases per capita income and helps in reducing poverty by providing job

opportunities to unemployed labor force and indirectly results in country s output.

The relationship of inflation and economic growth is influenced by either very high inflation or

very low inflation (Dornbusch-1993, Dornbusch and Revnoso-1989, and Levine and Zervos-

1993). Government ever tries to keep the prices of essential commodities under purchasing

power even of the rural poor. Several measures are implemented in this context. These measures

include liberal import of specifically food and other commodities of necessities including zero

rating of the imports of these commodities. Moreover the public sector tries to reduce the non-

availability problem of the essential commodities of low and fixed income groups by augmented

supplies of these commodities through outlets at utility stores.


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Exchange rate is the price of one currency in relation to another. In a slightly

different perspective, it expresses the national currencys quotation in respect to foreign ones.

Thus, exchange rate is a conversion factor, a multiplier or a ratio, depending on the direction of

conversion. It is believed that if exchange rates can freely move, it may turn out to be the fastest

moving price in the economy, bringing together all the foreign goods with it.

Pakistan adopted floating exchange rate system. By currency devaluation, the foreign goods

become expensive; therefore, people switch from the consumption of foreign goods to the

domestic goods. Similarly, the local goods will become cheaper for the foreigners and the export

will rise. Pakistan nominal exchange rate is increasing day by day this clearly indicates that more

Pakistani currency is required to buy one dollar. Hence Pakistani rupee experiences deprecation

against dollar. Moreover, Pakistani currency faces devaluation and depreciation over different

periods of time depending upon official and unofficial increase in the exchange rate. Economic

growth results in the currency appreciation and improves the living standard while failure the

economic growth leads to the depreciation of the currency. Official exchange rate of PKR

declined from PKR 10/$ in 1980 to PKR 90/$ in 2011. The exchange rate regime in Pakistan can

be seen from the table 1 clearly.

Accumulation in debt stock has been the prime problem faced by both developing and developed

countries. Developing countries face this problem more often as they need to borrow to facilitate

their development process and accelerate the pace of growth. However, the borrowed funds

required to be allocated properly for the productive expenditures and in accordance to their

repayment ability. Though debt is useful for the growth of the economy however dependence on

debt must be closely monitored and proper strategy should be adopted for enhancing the

repayment capability of the country. High and unsustainable levels of debt have serious


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repercussions for the economy in terms of heavy debt servicing and decreased developmental

expenditures, essential to carry on the growth process. Besides, availability of lesser funds for

investing in the economy and increase in taxes for repayment, hampers growth as it limits the

productive investment, resulting in shrinking of the debt repayment capacity of the economy. It

creates crowding out effect as well as has negative impact on the foreign and domestic

investment and development plans of the government.

Pakistans debt dynamics has undergone substantial changes since FY2007. Higher

fiscal deficit led to accumulation of huge debt both in absolute and relative terms. Due to non-

availability of sufficient funds from the external sources, the financing focus shifted towards

domestic sources that led to shortening of maturity profile of public debt. A confluence of

unfavourable factors including lower GDP growth, devastating floods, severe energy shortages,

hemorrhaging PSEs, high inflation, weak security situation and global economic recession

resulted in higher fiscal deficits in the recent past. Effects of external debt accumulation on

investment and economic growth of the country are always remaining questionable for

policymakers and academicians alike. There is no consensus on the role of external debt on

growth. It has both positive and negative aspect, different experts are in view that external debt

will have favorable effect on economic growth because external debt will increase capital inflow

and when used for growth related expenditures can accelerates the pace of economic growth. It

will not only provide foreign capital for industrial development but will also give managerial

know how, technology, technical expertise as well as access to foreign markets for the

mobilization of a nations human and material resources for economic growth.


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Far away from the U.S. and Europe, Pakistan has been suffering from high fiscal

and current account deficits, rapid inflation, low reserves, a weak currency and a declining

economy that have put the country in a very difficult situation. There have also been worries

about issues surrounding political instability and poor law and order situation. These factors

created a perilous environment for economic growth. Furthermore, a weak institutional base and

the inability of successive governments to undertake long-term and broad-based reforms and

policies have made sustained economic growth difficult. Therefore, Pakistans economy was

already in a dire situation well before the current financial crisis hit the developed countries.

It is believed that in the short run Pakistan can survive the current global crisis as its financial

sector is weak in nature and is not strongly embedded to the global financial sector. But, in the

long run, the country will have to bear the impact of the crisis on a number of counts such as

falling of foreign direct investment, development aid, remittances and exports. Moreover, the

twin deficit, budgetary and trade, phenomenon, the plunge in stock markets, energy shortages

and rising food inflation were least linked with the global financial crisis. 3 According to the

World BanksGlobal Economic Prospects 2009, political instability and poor law and order

situation have taken a toll on Pakistans economy, while the global financial crisis added

substantial downward pressures on its financial markets. Pakistan and the IMF agreed to lower

the target for the gross domestic growth this fiscal year to 2.5 per cent from 3.5 per cent4. But,

many analysts have said that even achieving this target would be very ambitious. While the

national conference on the Impact of Global Financial Crisis in Pakistan concluded that the

country could not avert the current global financial crisis, it could exercise restraint and prudence

in facing the difficult times ahead.


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1.2 Significance of the study:

The purpose of this research is to investigate relationship between economic

growth and major indicators of financial crisis -- inflation rate, real exchange rate, foreign direct

investment and the volume of foreign debt-- in Pakistan. The findings of this study may provide

guidance for the achievement of target of sustained economic growth through controlling the

inflation rates, exchange rate, foreign direct investment, and increase in the amount of foreign

debt.


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1.3 OBJECTIVES OF THE STUDY

To find out how Financial Crisis affect economic growth of Pakistan.

So the sub objectives of this study are as below;

1. To find the short run and long run relationship between gross domestic product and

inflation rate, foreign debt, real exchange rate and foreign direct investment in Pakistan

during the period of 1980-2012.

2. To find the casual relationship between foreign debt, inflation rate, FDI, and gross

domestic product (GDP).


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Chapter 2

LITERATURE REVIEW

2.1 LITERATURE REVIEW

The responsible factors of financial crises can be real exchange rate, foreign direct investment,

inflation rate and increase in the amount of foreign debt.

Haung et al. (2003) by applying the unit root test and dickey fuller test discussed in his

paper both the beginning of the financial crisis in 1998 and the striking economic recovery

afterwards in Russia and other Former Soviet Union (FSU) economies. Before the crisis banks

do not lend to the real sector of the economy and firms use non-bank finance, including trade

credits and barter trade, to finance production.

Kwack (2000) by using the Johansen's co-integration test illustrated it as a quick

exchange rate depreciation or sharp fall in international reserves. He used the annual time series

data ranging from 1972 to 2010 is used for the analysis. According to Kwach a rise in foreign

debt must increase interest payment on external debt and non-performing loans and on the other

hand a huge current account surplus will decline the number of non- performing loans.

Kwack (2000) also find that inflation has negative relationship growth rate. He found

these negative relationship by applying the augmented dickey fuller (ARDL) test of unit root,

Johansens co-integration test and Granger-causality tests, by using the time series data from

1972-2010. As inflation increases in an economy it will decrease the lending capacity. It is found


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that there is strong negative relationship between inflation and financial intermediary

development.

Firdausy (2002) by applying the Dickey Fuller Test talk about the Indonesian financial

predicament which turn into a great economic crisis, transformed the country from one of the

worldsfastest growing economies into one of its slowest growing economies. It also shows that

the data given from the variables is non stationary. The economic crisis had a critically effects

the Indonesian economic system, extensively the rise in unemployment.

As Krznar and Kunovac (2010) reported that changes in external factors like change in

world prices produced significant spillover effects on producer and consumer price indices in

domestic economy of Pakistan. The role of external shocks in determining inflation and other

macroeconomic variables in small open economies like Pakistan is very frequently addressed

question in recent empirical research.

Exchange rate crises can trigger or amplify a financial crisis if financial institutions

have liabilities in foreign currency (Diaz-Alejandro 1984; Calvo and Talvi 2008). However, not

all exchange rate crises turn into financial crisis. For instance, while the collapse of the European

Exchange Rate Mechanism in the early 90s was something policy makers at the time did not

desire, in most cases there was no spill over to the broader financial system. In this respect,

Kaminsky and Reinhart (2000) propose that it is useful to focus on episodes in which an

exchange rate and a financial crisis take place simultaneously. The combination of criteria filters

out episodes such as the ERM crisis as well as episodes in which financial crises did not have

any real effect.

Jaffri (2010) investigated the impact of real exchange rate misalignment on CPI

inflation in Pakistan by using monthly data from 1993-7 to 2010-3. In his study he apply the


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ARDL approach for estimating the long-run and short-run relationship among the variables. The

study found that foreign inflation significantly affects inflation in Pakistan. Misalignment was

found insignificant for the overall period, however, under managed exchange rate regime

overvaluation reduces inflation significantly in contrast to flexible exchange rate regime in

Pakistan.

King and Levine (1993) and Rajan and Zingales (1999) provide empirical evidence by

applying the Ordinary least square method and used the time series data from 1972-2007. And

his findings indicates that countries with highly developed financial markets grow faster and that

financial development is particularly helpful in enhancing the growth of industries that, for

technological reasons, rely heavily on external funds to enable their investment. In short,

financial markets are important to the well-being of the real economy, especially businesses and

enterprises.

Nanto (2009) the study uses quarterly time series data between 2007 and 2009 which

were tested and found to be stationary as well as co-integrated. Ordinary Least Square regression

was used in the analysis and it was found that there is a negative relationship between gross

domestic product and stock market during this crisis period. Study also observes that financial

crises of some kind have occurred sporadically virtually every decade and in various locations

around the world. Financial crises have occurred in countries ranging from Sweden to Pakistan,

from Russia to Korea, from the United Kingdom to Indonesia, and from Japan to the United

States.

Fischer (1993) used both cross-section and panel data that included both industrialized

and developing economies to present a seminal contribution to the literature in exploring the

possibility of a non-linear relationship between inflation and economic growth in the long-run. In


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his study, he found that the existence of significant negative association between inflation and

economic growth. He also observed that inverse relationship dampens inflation rates after 40% in

addition to establishing the existence of non-linearitysin the inflation-growth nexus.

Quartey, (2010) using the Johansen co-integration methodology, investigated whether

the revenue maximizing rate of inflation is growth maximizing in Ghana. He found that there is a

negative impact of inflation on growth. Furthermore, the study found a revenue maximizing rate

of inflation at 9.14 percent over the period 1970-2006 using the Laffer curve. He further

established that the rate of inflation that is growth maximizing is not a single digit one.

Fountas et al (2000) examined the relationship between inflation and inflation

uncertainty using a GARCH model that allows for simultaneous feedback between the

conditional mean and variance of inflation. They also derive a number of theoretical econometric

results and illustrate the relevance of these results with an empirical example of the US monthly

inflation process. The results show that there is strong evidence in favor of a positive bi-

directional relationship between inflation and inflation uncertainty in agreement with the

predictions of economic theory expressed by the Kukierman-Meltzer theory and the Friedman-

Ball view.

Agarwal (2000) in his research analyzed the impact of foreign direct investment inflows on GDP

growth. The study had time series cross section analysis of panel data from five South Asian

countries which included India, Pakistan, Bangladesh, Sri Lanka and Nepal. The results indicated

that foreign direct investments in these countries are linked with national investors and existence

of complementarity between the two was also confirmed. The results also indicated negative

impact of foreign direct investment inflows on GDP growth rate before 1980 then the study

indicated positive impact after 1980. The study suggested, since foreign direct investment


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contributed more to GDP growth then foreign borrowing in South Asia so foreign direct

investment should be preferred over foreign borrowing.

Bonato (2007) in his paper titled, Money and Inflation in the Islamic Republic of

Iran, encountered in adhering to the monetary targets as the main reason for the persistence of

double digits inflation in Iran. This conclusion is supported by the finding of a long run

relationship between the price level, money, output, the rate of return on money and the

exchange rate. The paper also presents estimates of Parsimonious Error Correction model of

inflation, which explains the short- run inflation dynamic in terms of deviations from the long

run price level, current and lagged money growth, current output growth and exchange rate

depreciation and changes in the rate of return on deposits. According to the model, the decline in

inflation experienced up till the first quarter of 20062007 is mostly due to a slowdown in M1

growth in previous quarters and likely to be reversed once the current acceleration in money

growth feeds through to inflation. Moreover the results suggest that controlling money growth is

a key to the success of the disinflation effort in Iran.

Khan and Senhadji (2001) examine threshold effects of inflation on growth separately for

industrial and developing countries. The data set covers 140 countries from both groups and non-

linear least squares (NLLS) and conditional least squares methods are used. The empirical results

verify the existence of a threshold beyond which inflation exerts a negative effect on growth.

Significant thresholds at 1-3 percent and 11-12 percent inflation levels for industrialized and

developing countries have been found. The view of low inflation for sustainable growth is

strongly supported by this study.


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Ghosh and Phillips (1998), using large panel dataset, covering IMF member countries over 1960

to 1996, found that at very low inflation rates (less than 2-3 per cent) inflation and growth are

positively correlated. However, they are negatively correlated at high level of inflation.

Similarly, the empirical results of Nell (2000) suggest that inflation within the single-digit zone

may be beneficial, while inflation in the double-digit zone appears to impose slower growth.

Bruno and Easterly (1996) find no evidence of any relationship between inflation

and growth at annual inflation rates of less than 40 percent. They find a negative, shorter to

medium term relationship between high inflation (more than 40 percent) and growth by applying

the Granger Causality analysis. Furthermore, the results shows that there was no lasting damage

to growth from discrete high inflation crises, as countries tend to recover back toward their pre-

crisis growth rates.

Mallik and Chowdhury (2001) conducted cointegration analysis of inflation on

economic growth for four South Asian countries (Bangladesh, India, Pakistan, and Sri Lanka)

and report two interesting points. First, inflation and economic growth are positively related.

Second, the sensitivity of inflation to changes in growth rates is larger than that of growth to

changes in inflation rates.

Najid Ahmad (2012) who investigates the relation between GDP and foreign direct

investment in the country by using time series data for the period of 1971-2011 by applying the

Ordinary Least Squares Method(OLS). He uses ordinary least squares method for his study. He

finds positive and significant relation between them. He views that foreign investors are the

major source of the prosperity of Pakistan. He suggests that investment is necessary for the

economic growth of Pakistan.


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Zahoor Hussain (2009) investigate in his studies that there are controversial views of the

economists about the relation between exchange rate and economic growth. Exchange rate

means how much unit of other currency you are getting with one unit of your national currency

while exchange rate volatility shows how demand and supply of one nations currency settled

exchange rate. There exists positive relation between exchange rate volatility and economic

growth in the long run.

Najid Ahmad (2012) finds the relation between inflation and gross domestic product of

Pakistan. He uses time series data for the period of 1971-2011. He finds positive relation of

inflation with GDP of Pakistan. Inflation encourages productivity as well as the output level. But

inflation must be moderate otherwise results can be worse. Some are in a view that there is a

positive and significant relation and some think that there is an inverse relation between inflation

and economic growth.

Shazad Hussain (2011), Nasir Iqbal (2009), Naseer (2012) and Mubarik (2005) find

positive relation between inflation and economic growth in their studies. He used the unit root

test method in his research. Some economists find negative and significant relation between

inflation and economic growth like Bruno and Easterly (1998), Huybens (1999), Quartey (2010),

Atish Gosh (1998) and Barro (1995). Here is Farhan Ahmad (2012) who did not find any relation

between inflation and economic growth.

Thus, Bruno and Easterly (1998) by applying the autoregressive analysis examined that

empirically investigated relationship among inflation rate, exchange and GDP in case of

Pakistan. The relationship of inflation with GDP was found significant and verifies the results.

They also analyzed and concluded that economic growth of any country decreases gravely

during high inflation and then get better immediately when there is decrease in inflation.


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Inflation does not only matter to individuals but it creates difficulties and problems in the whole

sector of the economy of a country.

Similarly Bruno and Easterly (1995) by applying the Multivariate regression test

examine the determinants of economic growth using annual CPI inflation of 26 countries which

experienced inflation crises during the period between 1961 and 1992. In their empirical

analysis, inflation rate of 40 percent and over is considered as the threshold level for an inflation

crisis. They find inconsistent or somewhat inconclusive relationship between inflation and

economic growth below this threshold level when countries with high inflation crises are

excluded from the sample. In addition, the empirical analysis suggests that there exists a

temporal negative relationship between inflation and economic growth beyond this threshold

level.

Mubarik (2005) estimates the threshold level of inflation for Pakistan using an annual data set

from the period between 1973 and 2000. He employed the Granger Causality test as an

application of the threshold model and finally, the relevant sensitivity analysis of the model. His

estimation of the threshold model suggests that an inflation rate beyond 9-percent is detrimental

for the economic growth of Pakistan. This in turn, suggests that inflation rate below the

estimated level of 9-percent is favorable for the economic growth. Moreover, the sensitivity

analysis performed for the robustness of the threshold model also confirms the same level of

threshold inflation rate.

Joshua and Delano (1990) by using the span series data from 1975 to 1985. To test the long-term

nexus among level of income, interest rate and investment mainly Johansen Co-integration test is

employed. He conducted a study on determinants of private investment in Less Developing

Countries (LDCs) on 23 less developing countries for the span 1975 to 1985. They confirm the


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result that the real interest rate is inversely related to investment. And his outcomes confirm

economic theory and a number of other studies that investment has significantly inverse

association with real interest rate in Pakistan.

Khan et al. (2009) checked the determinants of inflation in Pakistan by using data from 1972-73

to 2005-06 by applying Ordinary Least Square (OLS). The study incorporates all important

demand side and supply side policy variables while modeling inflation dynamics. Their

quantitative analysis reveals that the most significant factor in explaining inflation in 2005-06

were inflation expectations, private sector credit and rising import prices, whereas fiscal policys

contribution to inflation was very low. Adaptive expectations become very dominant at that time

when people started expecting higher prices in future as the land prices, house rents and food

prices rise.

Faria and Carneiro (2001) investigate the relationship between inflation and economic growth in

the context of Brazil which has been experiencing persistent high inflation until recently.

Analyzing a bivariate time series model (i.e., vector auto regression) with annual data for the

period between 1980 and 1995, they find that although there exists a negative relationship

between inflation and economic growth in the short-run, inflation does not affect economic

growth in the long-run. Their empirical results also support the super neutrality concept of

money in the long run. This in turn provides empirical evidence against the view that inflation

affects economic growth in the long run.

Jaffri (2010) by applying the ARDL test investigated the impact of real exchange rate

misalignment on CPI inflation in Pakistan by using monthly data from 1993-7 to 2010-3. The

results found that foreign inflation significantly affects inflation in Pakistan. Misalignment was

found insignificant for the overall period, however, under managed exchange rate regime


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overvaluation reduces inflation significantly in contrast to flexible exchange rate regime in

Pakistan.

Bashir et al. (2011) investigated the determinants of inflation in Pakistan using Johansens co -

integration approach for the data period 1972-2010. The study investigated the demand side and

supply side determinants of inflation and causal relationship among some macroeconomic

variables in Pakistan. Study found that money supply, gross domestic product, imports and

government expenditures are positively affecting consumer price index.

Shabbir and Mahmood (1992) find that although foreign investment has a positive relationship

with the growth rate of GNP in Pakistan, but it has eroded the domestic saving rate. In a more

recent study for Pakistan, Khan (1997) finds that the inflow of capital in the form of aid and

loans has an adverse effect on the growth performance because it introduces inefficiency and

leakage in the use of resources and retards domestic saving efforts.

Campa and Goldberg (1993) found a negative impact of exchange rate volatility growth rate by

applying the unit root test and co-integration test. Whereas Aizenman (1992) finds positive

relationship. While Campa and Goldberg (1995) find almost no impact by applying Granger

Causality test (1969) to see the cause and effect relationship between variables, (how much of

the current value of a dependent variable can be explained by past values of that variable and

testing whether adding lagged values of independent can improve the explanation). Results

suggest a direct link between exchange rate volatility and economic performance in the presence

of open economies. In such state of affairs the aim of the study is to find out the nature of this

relationship, i.e. positive or negative or even insignificant.


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Krguman (1988), defined the debt overhang as a situation in which the expected

repayment on foreign debt falls short of the contractual value of the debt. Likewise, Borensztein

(1990), defined the debt overhang as a situation in which the debtor country benefits very little

from the return to any additional investment because of the debt service obligations.

Safia and Shabbir (2009) investigated the impact of external debt on economic growth in 24

developing countries from 1976 to 2003.The study applied random effect and fixed effect

estimation by using the ordinary least square regression method. The results showed that debt

servicing to GDP negatively affect the economic growth and may leave less funds available to

finance private investment in these countries leading to a crowding out effect.

W.A Adesola (2009) examined the effect of external debt service payments on the economic

growth in Nigeria by using ordinary least square multiple regression method for his analysis. It

was found out that debt service payments have negative impact on economic growth.

Cholifihani (2008), analyzed the short run and long run relationship between external debt and

income in Indonesia from 1980 to 2005 using the unit root test method. The findings showed that

GDP, DSR, capital stock, labour force and human capital inputs have a long run equilibrium

relationship. External debt servicing showed a significant negative relationship with GDP, which

indicated that debt overhang phenomenon, has occurred in Indonesia in the long run. While

labour force and human capital was main supporting variables of GDP in the long run; however

capital stock is significant variable in boosting economic growth.

Hasan and Butt (2008) explored the association between external debt and economic

growth in Pakistan for the period of 1975-2005 using Auto Regressive Distributed Lag (ARDL)


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approach to co-integration. Results indicated that labor force and trade both in the long run and

the short run mainly determined economic growth in Pakistan. Total debt was not to be an

important determinant of economic growth either in the short-run or the long run mainly due to

inefficient use of external debt.

Boopen et al (2007), investigated the relationship between external public debt and the economic

performance for state of Mauritius over the period 1960-2004. The results suggested that external

debt have been negatively associated with the output level of the economy in both short and long

run. Bi-Causality between public debt and economic development was also reported. Moreover,

there were also evidences that public debt have negative impact on both private and public

capital stock of the country thus confirming the debt overhang and crowding out hypotheses.

Cunningham (1993) studied for the period 1971 to 87 for the growth and debt burden in sixteen

heavily indebted developing nations. Interestingly he found a dichotomy between two segments

of his considering time period. A strong negative relationship between growth and debt burden

was found during the 71-79 periods but no significance in 80-87 periods. Though same

methodology was used for both the periods, the divergent result indicates the importance of the

state of economy.

Arshad Hasan and Safdar Butt (2008), using ARDL (autoregressive distributive lag) model for

period 1975 to 2005 found that external debt has no effect in the long and short run. The study

probed that Labor force and trade are important determinant of growth but not the debt. It is

concluded that the debt has not been productively and efficiently used which is a cause of slow

economic growth in Pakistan. Debt would be a growth promoting factor if it`s potential

utilization is ensured.


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Ramesh Chandra Paudel and Nelson Perera (2009) studied the co-integrated relation of

real GDP growth and foreign debt for the period 1955 to 2006 from the evidence of Sri Lanka.

The result of the study reveals that all the variables positively affect the real GDP growth. If debt

is optimally used to achieve the potential returns of the resources, it may expedite economic

growth. To mobilize resources of Bangladesh, debt can play a pivotal role as it has a large share

in GDP. In the line of these studies, an econometric study is completed to investigate the real

cases for Bangladesh.


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Chapter 3

DATA AND THEORETICAL MODEL

3.1 Introduction

This chapter describes about the data and theoretical model used in this study. Data description

is containing information about selected country, variables, sources and sample size of data.

Along with data description, this chapter briefly describes the design of study that is explained in

theoretical model.

3.1.1 Data Description:

Seri al No. Var iables Data Source

01 Gross Domestic Product (GDP) World Bank

02 FDI The Global Economy

03

04

05

Inflation Rate

Real Exchange Rate (ER)

Foreign Debt

World Bank

World Bank

The Global Economy


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3.1.2 Country:

To examine the financial crisis, the country selected for this purpose is Pakistan. Pakistan is

selected because it is one of the important countries having trade links with many developed and

developing countries so the impact of financial crisis effect is analyzed.

3.1.3 Variables:

The variables used in this model are financial crisis indicator, foreign debt, foreign direct

investment, inflation rate, real exchange rate,and real GDP. These variables are defined as given

below.

3.1.4 Defining Variables

Real Gross Domestic Product (RGDP) is themarket value of all officially recognized final

goods and services produced within a country in a year, or other given period of time. GDPper

capita is often considered an indicator of a country'sstandard of living.The GDP is especially

useful when comparing one country to another because it shows the relative performance of the

countries.

The Real Exchange Rate is the purchasing power of a currency relative to another at current

exchange rates and prices. The real exchange rate is the nominal exchange rate times the relative

prices of a market basket of goods in the two countries.

The weighted average of a country's currency relative to an index or basket of other major

currencies adjusted for the effects of inflation. Real exchange rates are thus calculated as a

nominal exchange rate adjusted for the different rates of inflation between the two currencies.
http://en.wikipedia.org/wiki/Market_valuehttp://en.wikipedia.org/wiki/Per_capitahttp://en.wikipedia.org/wiki/Per_capitahttp://en.wikipedia.org/wiki/Standard_of_livinghttp://en.wikipedia.org/wiki/Standard_of_livinghttp://en.wikipedia.org/wiki/Per_capitahttp://en.wikipedia.org/wiki/Per_capitahttp://en.wikipedia.org/wiki/Market_value


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Inflation Rate is the rate at which the general level of prices for goods and services is rising,

and, subsequently, purchasing power is falling. Central banks attempt to stop severe inflation,

along with severe deflation, in an attempt to keep the excessive growth of prices to a minimum.

Inflation is a sustained increase in the general price level of goods and services in an economy

over a period of time.

Foreign Direct Investment (FDI) are the net inflows of investment to acquire a lasting

management interest in an enterprise operating in an economy other than that of the investor. It is

the sum of equity capital, reinvestment of earnings, other long-term capital, and short-term

capital shown in the balance of payments.

Foreign Debt is an outstanding loan that one country owes to another country or institutions

within that country. Foreign debt also includes due payments to international organizations such

as the International Monetary Fund (IMF). Foreign Debt is an amount a country owes to other

countries, either directly as result of government-to-government loans or indirectly because of a

negative balance of trade.

3.1.5 Data source:

Time series data was used of all variables. All the data was obtained from.

World Development Indicators (WDI)

The Global Economy

State Bank of Pakistan (SBP)


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3.1.6 Sample size:

To estimate financial crisis on Pakistans economy, data over annual frequencies from 1980-

2012 was used on various variables that was obtained from above mentioned sources. Data was

smoothed out through natural log.

3.1.7 Theoretical framework

To understand the relationship between independent and dependent variables we form a

framework. The frame work is given below, that clears idea about model of this research study.

The Gross domestic product is our dependent variable while the foreign debt, real exchange rate,

inflation rate and foreign direct investment is independent variables.

Real GDP Real Exchange Rate

Inflation Rate

FDI

Foreign Debt


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Chapter 4

METHODOLOGY

4.1 Introduction

This chapter defines the methodology being followed by this study. The methodology

contains tests which are essential for getting empirical results. This chapter is consisting of

Descriptive Statistics, Unit Root Test, Co-integration and Causality test.

4.2 Methods of Estimation:

4.2.1 Descriptive statistics

In order to get basic information about variables we apply descriptive statistics. Basic

information is known by mean, median, standard deviation, skewness, and kurtosis, which is

present in descriptive statistics.

4.2.2 Unit Root Tests:

The time series data frequently shows the property of non-stationarity in levels and the

resulted estimates usually give spurious results (Granger, 1981). Hence, the initial step in any

time series empirical analysis is to check the presence of unit roots to remove the problem of

inaccurate estimates. The next important step taken was to check the order of integration of each


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variable in a data series in the model to establish whether the data under hand suffers unit root

and how many times it is needed to be differenced to gain stationarity (Yousaf et al 2008).

The ADF equation are defined mathematically as follows, given an observed time series Y1,

Y2, ......, YN Dickey and Fuller consider three differential-form auto regressive equations to

detect the presence of a unit root: equation (1) is consist of only constant ADF analysis, equation

(2) is consist of trend analysis and equation (3) is consist of trend and intercept analysis.

Yt= Yt-1 + (jYt-j) + t (1)

Yt= + Yt-1+ (jYt-j) + t (2)

Yt= + t + Yt-1+ (jYt-j) + t (3)

Where,

t is the time index,

is an intercept constant called a drift,

is the coefficient on a time trend,

is the coefficient presenting process root, i.e. the focus of testing,

p is the lag order of the first-differences auto regressive process,

etis an independent identically distributes residual term.

The difference between the three equations concerns the presence of the deterministic

elements (a drift term) and t(a linear time trend).


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The focus of testing is whether the coefficient equals to zero, which means that the

original process has a unit root; hence, the null hypothesis of = 0(random walk

process) is tested against the alternative hypothesis < 0of stationarity. More detailed, the null

and alternative hypotheses corresponding to the models above are:

4.2.3 Co-integration Test: The Johansen-Juselius (JJ) Method

Johansen (1988, 1991, 1992) and Johansen-Juselius (1990, 1992) proposed a technique that helps

in finding more than one co integration vectors if we have variables number more than two. Such

technique is used because sometimes variables might form several equilibrium relationships in

the model. So Johansen approach is used for multiple equations.

4.2.4 Vector Error Correction Model:

If the time series are I(1), then one could run regressions in their first differences. But, by taking

first differences, we lose the long run relationship that is store in the data. This implies that one

needs to use variables in levels as well. Advantage of the Vector Error Correction Model

(VECM) incorporates variables both in their levels and first difference. By doing this, VECM

captures the short-run disequilibrium situations as well as the long-run equilibrium adjustments

between variables. VECM term having negative sign and value between 0 to 1 shows

convergence of model towards long-run equilibrium and shows how much percentage

adjustment takes place every year.

D(RGDP) = o+ 1D(FDI)t+ 2D(FD)t+ 3D(EXR)t+ 4D(INFL)t+ ..(1)


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Where D stands for the first difference, is the error correction term / adjustments coefficient.

The coefficients 1to 4shows, short-run elasticities of the independent variables on Real GDP.

4.2.5 Granger Causality test:

The standard Pairwise Granger causality test observes the casual relationships among

more than two variables. It examines that whether current changes in variable y can be explained

by past changes in other variables like u, v, and w along with the explanations provided by past

changes in y itself. The variables are interchanged to see the causality in other directions. There

are possible few relationship types,

Unidirectional causality: independent variables cause the dependent variable.

Bidirectional causality: different variables causing in two directions.

Independence: neither variable causes each other.

Granger causality indicates causality in the prediction rather than in a structural sense. It

begins with an assumption that the future cannot cause the past


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Chapter 5

RESULTS AND INTERPRETATION

5.1 Introduction

Descriptive statistics is used to know basic information of selected variables consisting of mean,

standard deviations, skewness and kurtosis. Augmented Dickey Fuller has been used to check the

stationarity of the data while co-integration has been included to determine long run relationship

between variables. If long run relationship is proved among variables of model then we check

causality test to know causal relationships of all variables. Following are the results of above

mentioned tests..

5.2 Descriptive Statistics:

We apply descriptive statistics to determine basic information. Table 5.1 shows the results of

descriptive statistics.


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Table 5.2: Descriptive statistics analysis

Variable Mean Median St. deviation Skewness Kurtosis

RGDP 0.635388 0.685436 0.239089 -0.81564 3.017659

INFL 0.936891 0.939343 0.22672 -0.157267 2.935428

FDI 8.643949 8.624308 0.584034 0.074989 2.407828

FD 0.430986 0.424244 0.029031 0.766636 2.357336

EXR 2.103420 2.064592 0.121896 1.069633 2.731781

Source: E-views 6

The results of descriptive analysis of above variables are satisfactory. As RGDP has mean

0.635388 and standard deviation of 0.239089. INFL has mean 0.936891 and standard deviation of

0.22672. FDI has mean 8.643949 and standard deviation of 0.584034. FD has mean 0.430986

and standard deviation of 0.029031. EXR has mean 2.103420 and standard deviation of

0.121896. RGDP and INFL are negatively skewed but FDI, FD, EXT are positively skewed. The

values of kurtosis show that data is reliable. Similarly, the normality test used in this table

supports normal distribution of all variables.

5.3 Testing Unit Root

All the data series were tested for statianarity to avoid the possibility of drawing conclusion

based on the spurious relationship. The Augmented Dickey Fuller unit root test is used, and

results of the test are below in table 5.3.


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5.3. Unit Root Tests Results:

We apply Augmented Dickey fuller test to determine the stationarity of the variables. Table 5.2

shows the results of ADF tests.

Table 5.3 Augmented Dickey Fuller (ADF) Test

Variable Name 1st

DIFFERECE

Intercept and

TrendT value/p value Stationary at

GDP Intercept

-7.635293

(0.0000) I(1)

Exchange RateIntercept +Trend -4.964048

(0.0003)I(1)

Foreign Debt Intercept-5.252561

(0.0002)I(1)

Inflation RateIntercept+ Trend -4.433228

0.0014I(1)

Foreign Direct

InvestmentIntercept

-4.546794

(0.0010) I(1)

Based on the ADF test, all variables on constant appear to be non-stationarity at levels but

stationarity at first difference. Hence, it is concluded that these variables are integrated of order 1

i.e. I (1).The integration of order I (1) means that data is having constant mean, variance and

autocorrelation etc. after taking difference of data.


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5.4 Johansen Co-integration Analyses:

If all the variables are stationary at first difference or higher order we use co-integration. The

relationship between Financial Crisis and economic growth in the model was determined using

co-integration methodology given by Johansen and Juselius (1990). The study finds that there

exists statistically significant relationship between financial Crisis and economic growth. Table

5.3 shows results of Johansens test for co-integration test.

Null Hypothesis H0: There is no co-integrating in the data

Alternative Hypothesis H1: There is co-integrating in the data

5.4.1 Unrestricted Co-integration Rank Test (Trace)

Hypothesized Trace 0.05

No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

None * 0.697390 99.87963 60.06141 0.0000

At most 1 * 0.630491 64.02027 40.17493 0.0001

At most 2 * 0.503636 34.15284 24.27596 0.0021

At most 3 * 0.330185 13.13949 12.32090 0.0364

At most 4 0.036545 1.116873 4.129906 0.3383

Trace test indicates 4 co-integrating eqn(s) at the 0.05 level

* denotes rejection of the hypothesis at the 0.05 level


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5.4.2 Unrestricted Co-integration Rank Test (Maximum Eigenvalue)

Hypothesized Max-Eigen 0.05

No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

None * 0.697390 35.85936 30.43961 0.0096

At most 1 * 0.630491 29.86743 24.15921 0.0075

At most 2 * 0.503636 21.01335 17.79730 0.0158

At most 3 * 0.330185 12.02261 11.22480 0.0361

At most 4 0.036545 1.116873 4.129906 0.3383

Max-eigenvalue test indicates 4 co-integrating eqn(s) at the 0.05 level

* denotes rejection of the hypothesis at the 0.05 level

The trace statistic shows that there is four co-integration equations at the level 0.05%. The trace

test also shows that the trace statistic values are greater than the critical values which shows the

rejection of null hypothesis at the 0.05% level.

While in the maximum eigenvalue test shows that there is also four co-integration equations at

the 0.05% level. In the max-eigenvalue test the critical value is lower than the max-eigen statistic

values that show the rejection of null hypothesis. And probability values also shows the

significance of the variables in both trace and max-Eigen test. In the comparison of trace

statistics and Max-Eigen statistics with critical values. The value of trace statistics and Max-

Eigen statistics exceeds 95% critical value respectively. The null hypothesis is rejected clearly as

shown in this table by both the max test statistic and trace test statistics. Hence, it is concluded

that there exist a co-integration relationships between financial crisis and economic growth.


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5.5 Vector Error Correction Model (VECM)

In order to check the stability of long run relationship between Growth rate and its independent

variables, we implied vector error correction model (ECM). In an vector error correction model,

the short-run dynamics of the variables in the system are influenced by the deviation from

equilibrium. Without a full dynamic specification of the model, it is impossible to find which of

the possibilities will occur. Nevertheless, the short-run dynamics must be influenced by the

deviation from the long-run relationship (Enders, 2010) (see, table 5.5).

Table 5.5.1: Vector Error Correction Model in Short run

R-squared 0.698585 Log likelihood 16.25920Adj. R-squared 0.594387 Akaike AIC -0.283947

Sum sq. resids 0.594148 Schwarz SC 0.276532

S.E. equation 0.181682 Mean dependent -0.007054

F-statistic 3.792577 S.D. dependent 0.260715

Variables Coefficient Standard Error t-statistic

D(GDP)-0.290819 (0.11930) [-2.2700]

D(INFL)0.174006 (0.16860) [1.0320]

D(FDI)-0.311869 (0.12324) [-2.5305]

D(EXR)0.009992 (0.01137) [0.87857]

D(FD)-0.000179 (0.00341) [-0.0524]


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In the above table, short run coefficients are discussed with their t-value and probability value. In

short run, all independent variables like EXR AND INFL are having positively influencing Real

GDP. However, FDI and FD is negatively influencing on Real GDP. And FDI shows the

significant relationship in short run.

Table 5.5.2: Long Run Elasticitys

Source: E-views

In the above table, long run coefficients standard error are discussed with their t-value. In long

run, the independent variables like EXR AND FDI are having positively influencing Real GDP.

While the FDI shows the significant relationship with growth rate of Pakistan. However, FD and

INFL is negatively influencing on Real GDP and also shows the significant relationship with

growth rate in long run.

Variables Coefficient Standard Error t-statistic

FDI(-1) 1.555207 (0.43095) [3.60879]

FD(-1) -19.30495 (7.58802) [-2.54414]

EXR(-1) 2.010026 (1.05049) [1.91314]

INFL(-1) -1.839185 (0.49465) [-3.71818]


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5.6 Granger Causality Model:

There exist long run relationship between financial crisis and economic growth. But to check

causality among the variables we apply Granger causality. The results of Granger causality are

given below, by considering probability value to accept or reject null hypothesis. Table 4.4

shows hypothesis and probability of all variables.

Table 5.6 Pair wise Granger Causality analysis

Pairwise Granger Causality Tests

Sample: 1980 2012

Lags: 2

Null Hypothesis: Obs F-Statistic Prob.

EXR does not Granger Cause GDP 31 1.33510 0.2806

GDP does not Granger Cause EXR 0.26504 0.7692

Lags: 2


FD does not Granger Cause GDP 31 2.94090 0.0706

GDP does not Granger Cause FD 2.49021 0.1025

Lags: 2


FDI does not Granger Cause GDP 31 3.54285 0.0436

GDP does not Granger Cause FDI 0.43935 0.6492

Lags: 2


INFL does not Granger Cause GDP 31 6.36218 0.0056

GDP does not Granger Cause INFL 0.11961 0.8877

Source: E-views 6


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The table 5.5 shows the results of granger causality test. And the table 5.5 provide the F-statistic

and probability to accept or reject the null hypothesis. The granger causality test categorized in

three types that mentioned above in 4.2.5. The results show that GDP has causal relationship

with three indicators of financial crises in Pakistan .The results of granger causality shows that

there exist unidirectional causal relationship between financial crisis and economic growth. The

results obtained from standard Granger Causality test shows that the alternative hypothesis is

accepted which means one variable is causing other variable while the null hypothesis is rejected

which means the dependent variable does not cause the independent variables. The table shows

Probability value for accepting or rejecting null hypothesis. As Probability values are significant

that null hypothesis is rejected. The probability values are considered up to 0.10 or 10% but

higher than this value is considered insignificant up to 1 or 100%.


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Chapter 6

CONCLUSION AND RECOMMENDATION

6.1 Conclusion

The study analyzes the causal relationship between determinants of financial crises (CPI,

FD, EXR, and FDI) and GDP in Pakistan. The determinants of financial crises were represented

by Inflation (CPI), Real Exchange rate, Foreign Direct Investment and foreign debt (FD) and

dependent variable is gross domestic product (GDP). On analysis of co-integration between

determinants of financial crises and GDP, it was found that foreign direct investment, inflation

rate and foreign debt are having co-integration with GDP. They have co integration with GDP at

5% significance level. This study also explains that GDP has relationship between all macro-

economic variables used in this study except real exchange rate in long run.

This research aims to identify the effect of changes in financial crisis on GDP. The impact of

financial crisis has not been felt in Pakistan as a separate crisis as the country is already facing

the same since 2007. The country may escape the immediate negative implications of the

financial crisis. But, there will be long-term direct and indirect consequences.

Therefore, at present, the Pakistan economy is under threat. Old problems are combining with

emerging new ones. There is a real danger that if the government does not respond to the

emerging financial crisis. Then there is no doubt that an adverse external economic environment


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in the shape of the current financial crisis has contributed to some extent to the crisis in Pakistan

today. Nevertheless, the genesis of the current crisis is internal. The key reasons for the current

meltdown of the economy are low reserves, depreciation of currency risen in the inflation rate,

low level of foreign investment and increase in the amount of foreign debt. In addition, this is the

right time to divert Pakistans trade and investment from the West to the region, particularly

China. As both the U.S. and Europe have been severely hit by the global financial crisis, Chi nas

reserves have increased and it is searching for investment across the globe. The country is

fortunate to have a friend like China in the neighborhood.

Pakistans deteriorating conditions after the Financial Crisis had resulted in sharp downfall in

GDP growth rate. Real GDP growth rate declined significantly in 2008 as it reached to 1.6 % and

in 2009 it rose slightly to 3.4 %. Unfortunately, Pakistan was already suffering from

macroeconomic instability before the Financial Crisis due to hike in depleting foreign exchange

reserves. Financial Crisis widened trade gap. Increase in budget and current account deficits and

soaring inflation brought further problems for Pakistans economy.

It can easily be concluded that GDP is one of the measures of macroeconomic stability and

regression results have made it clear that Real Exchange Rate, Foreign Direct Investment and

even Inflation had an impact on GDP. Financial Crisis had a severe impact on macroeconomic

stability of Pakistan. It has been established by research that GDP carries importance in

assessing macroeconomic stability. Regression results have shown that potential impendent

variables have an impact on GDP.


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6.2 Policy Recommendation

Financial Crisis in Pakistan has exposed loopholes in financial system of World. The crisis has

revealed that there is a dire need for reformation of currently existing financial system. The crisis

has further given a lesson to governments all across the World to improve regulatory authorities

especially Central Banks. The global recession has worsened macroeconomic conditions of all

countries. All countries need to develop collective action plan to deal with the Financial Crisis.

Pakistan should increase the foreign investments, and reduced the level of inflation by creating

new policies. Government of Pakistan needs to pay attention towards development policies.

There is an urgent need to increase tax to GDP ratio and expenditures of the government should

also be reduced.

Dealing with the financial crisis was difficult for Pakistan, especially due to pre-existing fiscal

constraints. Specific weaknesses in terms of balance of payments weaknesses have forced the

country to resort to an IMF stand-by arrangement, which imposed further conditionalitys related

to budget restrictions. Subsidies on wheat, electricity, fertilizer and oil had to be phased out,

which in turn increased the inflationary burden on the consumer.


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Financial Crisis and Economic Growth of Pakistan by Uzair Akhtar