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It is widely recognized that foreign aid may not be used effectively in recipient countries due to a problem of absorptive capacity. This study assesses the role of such capacity in the effective use of foreign aid in Pakistan. To accomplish this, we incorporate domestic financial sector development in our model. The empirical analysis estimates growth equations using time series data of Pakistan over the period 1972-2011. We construct the index of financial sector development using principal component analysis. The ARDL bound testing approach of co-integration was used for empirical analysis. The empirical evidence substantiates the fact that foreign aid is more effective and consequently enhances both long and short run growth process only in the presence of local financial sector development. For instance, our result revealed that absorptive capacity (i.e. interactive term of local financial sector development and foreign aid) is positive and statistically significant. The findings support the claim that ‘local financial sector development plays an important role in the effectiveness of foreign aid’. In addition, the results indicate that foreign aid makes a positive and statistically significant impact on economic growth after allowing nonlinearity between the variables; this, in turn, indicates a diminishing return to foreign aid in case of the Pakistan. Our control variables i.e., physical capital and human capital bear their expected positive signs and are also statistically significant. This indicates that physical capital and human capital also play an important role in the log-run economic growth process of Pakistan.
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