Financial Deepening, Foreign Capital Inflows, and Economic Expansion in Pakistan: An ARDL Bounds Testing Approach

Abstract

This study investigates the dynamic interplay between financial deepening, foreign capital inflows, and economic growth in Pakistan from 2004 to 2021. Utilizing macroeconomic data from the World Development Indicators, we apply the Autoregressive Distributed Lag (ARDL) bounds testing approach alongside an Error Correction Model (ECM) to capture both short- and long-term macroeconomic dynamics. While the bounds test reveals the absence of a long-run cointegrating relationship among the variables within this finite sample, static long-run estimates highlight the pivotal role of financial deepening: domestic credit to the private sector significantly stimulates economic expansion, whereas inflation acts as a severe macroeconomic drag. Furthermore, short-run ECM estimates demonstrate a rapid mean reversion to equilibrium, alongside evidence that inflationary shocks and broad money contraction decisively hinder near-term economic performance. Diagnostic evaluations confirm robust structural and parameter stability across the study period. These findings offer critical policy insights, underscoring the necessity for the State Bank of Pakistan (SBP) and fiscal authorities to prioritize efficient credit allocation, rigorous inflation targeting, and the optimized structural absorption of foreign capital to foster sustainable economic growth.

Keywords:

Financial deepening, ARDL bounds test, economic growth, Pakistan, FDI, remittances, error correction model