Investment Dynamics and Capital Formation in Pakistan: Financial Intermediation, Industrial Transformation and Macroeconomic Stability: A VECM Analysis

Abstract

Pakistan continues to experience persistently low levels of capital formation, constraining long-term economic growth and productive capacity. This study examines the macroeconomic determinants of Gross Fixed Capital Formation (GFCF) in Pakistan within the framework of financial intermediation, industrial performance, and macroeconomic stability over the period 1991–2024. Annual time-series data are analysed using the Augmented Dickey–Fuller (ADF) unit root test, the Johansen cointegration approach, and the Vector Error Correction Model (VECM). The results indicate that all variables are integrated of order one, I(1), and the Johansen tests confirm the existence of a long-run equilibrium relationship among the variables. The long-run estimates reveal that national savings positively influence capital formation, whereas the exchange rate has a significant effect on investment. Industrial performance demonstrates a statistically significant long-run association with capital formation, while inflation and bank credit to the private sector do not exhibit statistically significant long-run effects. The error correction term is negative and statistically significant, indicating that approximately 70.4% of short-run disequilibrium is corrected annually. Impulse response analysis suggests that shocks to national savings and industrial performance support capital accumulation over time. The findings underscore the importance of strengthening financial intermediation, mobilising domestic savings, promoting industrial development, and maintaining macroeconomic stability to achieve sustainable capital formation and long-term economic growth in Pakistan.