South Asian Journal of Business Studies

Trade openness, financial liberalization and economic growth: The case of

Pakistan and India
Rana Muhammad Adeel-Farooq, Nor Aznin Abu Bakar, Jimoh Olajide Raji,
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Rana Muhammad Adeel-Farooq, Nor Aznin Abu Bakar, Jimoh Olajide Raji, (2017) "Trade openness,
financial liberalization and economic growth: The case of Pakistan and India", South Asian Journal of
Business Studies, Vol. 6 Issue: 3, pp.229-246, https://doi.org/10.1108/SAJBS-06-2016-0054
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Financial
Trade openness, financial liberalization
liberalization and economic growth and economic
growth
The case of Pakistan and India
Rana Muhammad Adeel-Farooq 229
School of Economics, Finance and Banking,
Received 20 June 2016
Universiti Utara Malaysia, Sintok, Malaysia Revised 19 December 2016
Nor Aznin Abu Bakar 9 June 2017
25 July 2017
Department of Economics, Universiti Utara Malaysia, Sintok, Malaysia, and Accepted 30 July 2017

Jimoh Olajide Raji

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Department of Finance, Universiti Utara Malaysia, Sintok, Malaysia and

Department of Economics, Al-Hikmah University, Ilorin, Nigeria

Abstract
Purpose – The purpose of this paper is to empirically examine the effects of financial liberalization and trade
openness on the economic growth of two countries, namely, Pakistan and India for the period 1985-2014.
Design/methodology/approach – This study uses the autoregressive distributed lag technique, which
allows mixed order of integration. In addition, it uses the principal component method to create an index for
financial liberalization to examine how it affects the economic growth of the selected countries.
Findings – The findings reveal that in the short and long run, trade openness has positive effect on the
Pakistan’s economic growth while the financial liberalization has positive impact only in the long run.
In the case of India, both financial liberalization and trade openness positively and significantly influence
the economic growth in the short and long run.
Practical implications – By comparing the results of both countries, trade openness and financial
liberalization increase the economic growth of India more than that of Pakistan. These results suggest that
Pakistan should consider appropriate positive policies regarding financial liberalization and trade openness
to achieve high and stable economic growth in the future.
Originality/value – This study creates financial liberalization index by using the principal component
analysis method to explain the role of financial liberalization in the economic growth of Pakistan and India.
In addition, it makes comparison of the results based on which country benefits most from the liberalization of
trade and financial sectors. Only very few studies have examined these countries, yet their results have
remained inconclusive as well.
Keywords ARDL model, Economic growth, Trade openness, Financial liberalization
Paper type Research paper

1. Introduction
Trade openness and financial liberalization are enormously important to achieve economic
growth in recent times. Developed and developing countries have taken measures to liberalize
their trade and financial sectors. Financial liberalization is the practice of eliminating credit
control, no restriction on interest rate, free entry of banks in the banking sector, bank autonomy
and openness of the international capital (Williamson and Mahar, 1998). A liberalized financial
sector is indispensable for better economic conditions while a suppressed financial sector
hinders a country to achieve economic growth (McKinnon, 1973). In the end, financial
suppression such as control over interest rate may debar economy from been stable. In a
well-developed and liberalized financial system, financial intermediaries have an essential role
South Asian Journal of Business
in realizing economic development. According to Schumpeter (1934), liberalization of the Studies
financial system has positive effect on interest rate (deposit rate) and hence increases saving. Vol. 6 No. 3, 2017
pp. 229-246
A well-liberalized financial sector improves the efficiency and management of the overall © Emerald Publishing Limited
2398-628X
banking sector. Consequently, liberalization enhances economic growth (Schumpeter, 1934). DOI 10.1108/SAJBS-06-2016-0054
 SAJBS A well-developed financial sector utilizes savings efficiently for capital formation and
6,3 increases industrial productivity (Levine, 2005). It, through pooling of funds from small
savers and offering of many investment instruments to utilize savings, increases
production (Ansari, 2002). A liberalized financial sector spurs economic growth and makes
the financial inflows more productive. Moreover, an internationally liberalized financial
system proves to be more efficient, productive and transparent as compared to the
230 restricted one (Obstfeld, 2009).
In terms of trade liberalization, Lewis and Urata (1984) note that economic growth tends
to improve and stabilize with trade openness. Trade through technological spillovers
provides various opportunities to exploit resources and consequently creates employment
(Gervais, 2015). According to the new growth theories, there is potential for economic
growth to improve if trade is liberalized (Romer, 1990). Therefore, an open trade sector
affects economic growth positively as explained by export led and import led growth
hypothesis (Shahbaz, 2012).
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Conversely, trade restrictions such as hike in import and export tariffs, import
substitution, licensing rules and quota have proved to hinder improvement in industrial
productivity and economic growth. In view of these consequences, trade barriers have been
declining rapidly in the developed and developing countries and trade liberalization by
division of labor is increasingly pushing the world production toward the universal
production frontier. In this case, countries can enhance their production level through
import of modern technologies, raw materials at competitive price and efficient labor.
Moreover, in an open economy, international trade can have positive influence on
macroeconomic performance (Khan and Zahler, 1983; Semančíková, 2016).
The new growth theories provide the theoretical foundations for the relationship
between trade openness and economic growth (see Romer, 1990), whereas neoclassical
theories are of the opinion that there is no relationship between the trade openness and
economic growth. According to the neoclassical theories, government policies have no
impact on the steady state rate of growth. Results of some studies (Bashar and Khan, 2007;
Ahmed, 2010) have indicated that financial liberalization has no impact on economic
growth in support of neoclassical theories. However, some other studies (McKinnon, 1973;
Shaw, 1973; Levine, 2001; Bonfiglioli, 2005; Bekaert et al., 2005; Rancière and Tornell, 2016)
have shown that liberalization of the financial sector promotes economic growth.
Concerning the influence of trade openness on economic growth, many empirical
studies (Dollar and Kraay, 2004; Freund and Bolaky, 2008; Chang et al., 2009;
Huchet-Bourdon et al., 2011) have found a positive relationship between the two variables.
On the other hand, some studies (Haddad et al., 2010; Uslu et al., 2015) have found that
there is no relationship between trade openness and economic growth. These contrasting
results from the previous studies indicate that the debate about whether the trade
openness and financial liberalization improve economic growth is still ongoing.
Particularly in the developing countries, the previous empirical findings on this issue
have been mixed and inconclusive. Therefore, the present study attempts to investigate
the contributions of trade and financial liberalization to the economic growth of Pakistan
and India. In addition, it compares the results of both countries to know which of the two
countries has benefited more, given the policies of liberalization of the economy.
The two countries have some similarities in the sense that they got independence at the
same time. They also initiated liberalization of trade and financial sector together in 1980s after
accepting the liberalization policy introduced by the international financial institution such as
the World Bank and International Monetary Fund (IMF). Therefore, examination of these two
neighboring and developing countries (Pakistan and India) is very important in that having the
knowledge about the contributions of the trade openness and financial liberalization to
economic growth of both countries can provide clue to give necessary policy recommendation.
 Section 2 provides a brief overview of trade openness and financial liberalization in Financial
Pakistan and India, while Section 3 reviews the relevant literature. In Section 4, the study liberalization
discusses the theoretical framework, while in Section 5 it discusses the data and and economic
methodology. The results of the study are discussed in Section 6, and the last section gives
conclusion and policy implications. growth

2. Trade openness and financial liberalization in Pakistan and India 231

International financial institutions such as the World Bank and IMF restricted financial
assistance to the developing countries in order to combat the debt and financial
crisis of 1970s. Developing countries were directed to eliminate the trade barriers, liberalize
and develop the financial sector through more outward oriented policies set by the
aforementioned financial institutions (Santos-Paulino, 2005).
Trade and financial policy reforms started in South Asia during the mid-1980s,
after the acceptance of Structural Adjustment Program (SAP) as suggested by the IMF.
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The region has implemented various trade openness-related policies that consequently
reduced the tariff and non-tariff barriers. These outward oriented policies enhance both
the capital inflow and outflow as well as the trade and economic activity in South Asia
through integration of the financial sectors (Perera and Wickramanayake, 2012;
Rana, 2012; Otsuki et al., 2013).

2.1 Trade openness and financial liberalization in Pakistan

From the beginning, Pakistan implemented protectionist policies to protect the infant
domestic industry. In the 1950s, government implemented import substitution policies with
less attention given to export. During 1960s, the state took several measures to promote
export. For example, it introduced export bonus scheme and other trade liberalization
measure such as the automatic renewal of import licensing. During the 1970s, devaluation of
the currency, end of export bonus scheme and licensing were the key measures for the
liberalization of the trade sector. The decades of 1980s saw more liberalized trade polices as
compared to the previous decades. Most of the tariff barriers were removed. Although 1980s
and 1990s saw many trade liberalization policies, the trade sector of Pakistan remained
under strict control by the state. At the beginning of the year 2000, the military regime took
various measures for economic liberalization program and the privatization of states’ owned
enterprises was initiated into the program. Consequently, this period experienced a higher
economic growth.
Before the SAP, the financial sector of Pakistan was under tight control such that money,
bond and equity markets were probably not in existence; interest rate was under control and
commercial banks were owned by the state (Khan and Qayyum, 2007). Moreover, before the
financial sector reforms commenced following the acceptance of SAP in 1989, most of the
subsidies had been eliminated and remittances had reached the record level in 1980s.
Government decided to privatize the insurance companies and state-owned banks;
it liberalized the interest rate and strengthened the state bank of Pakistan. The second phase
of financial liberalization commenced in 1997 when the national saving scheme was
restructured, banks were privatized completely and more power was given to the central
bank to regulate the money market effectively.

2.2 Trade openness and financial liberalization in India

India had inward looking trade policies, focusing on import substitution. Protectionist’s
policies for the trade sector were in existence to protect the domestic industries from
external shocks in India. The trade policy of India was for intervention; it was inward
looking, and major big industries were controlled by the state (Cerra and Saxena, 2002).
 SAJBS The policy was import substitution oriented and special licensing requirements were
6,3 introduced for industries (Cerra and Saxena, 2002). India’s trade sector was under state
control with non-tariff tradable items and tariff barriers on others. During the mid-1980s,
India shifted its strategy from import substitution toward export promotion and the trade
liberalization program started. The complex industrial licensing requirement ended and
tariff was reduced to a greater extent. Between 1990 and 1996, average tariff decreased to
232 35 percent. Although the Indian financial sector was highly restricted, its financial
deepening was still better than that of many other developing countries. It should be noted
that the process of liberalization of the financial sector started after accepting the SAP
introduced by the IMF in the early 1990s. In 1991, India faced the balance of payment crisis,
which forced it to go for more liberalization of its financial sector. To settle the
macroeconomic imbalances, India moved toward accepting the IMF recommendations.
It liberalized interest rate, reduced the cash reserve requirements, let capital account move
freely, and allowed for competitive environment. Due to the banking sector reforms,
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the private sector’s credit to gross domestic product in 2007 rose to 55 percent from
30 percent in 1993.
Figure 1 shows that the pace and pattern of economic growth in both countries are quite
different from each other. For example, GDP growth rate of Pakistan fluctuated from 1985
until 2003 after which it started to increase until 2006. Again, it declined until 2008 and
thereafter, it started to increase again. In the case of India, the pattern of fluctuation is
ambiguous. However, the fluctuations appeared to be upward trend.
In addition, Figure 2 indicates the historical trend of trade openness[1] for the two
countries. For example, both plots for trade openness (TOP) in the two countries exhibit
increasing trends from 1985 until 2014. In Figure 3, the plot of financial liberalization[2] for
Pakistan indicates fluctuating trend from 1985 until 2006. Then, it started to increase until
2010 after which it started declining. In the case of India, the figure indicates that trade
openness increased continuously from 1985 until 2014.

8
12
7
10
GDP Growth Rate (Pakistan)

6
GDP Growth Rate (India)

5 8

4 6

3
4
Figure 1. 2

GDP growth rate 1

2

(Pakistan and 0 0
India, 1985-2014) 1984 1988 1992 1996 2000 2004 2008 2012 2016 1984 1988 1992 1996 2000 2004 2008 2012 2016
Years Years

10.4 11.8

10.3 11.6
Trade to GDP ratio (Pakistan)

Trade to GDP ratio (India)

10.2 11.4

10.1 11.2

10.0 11.0

9.9 10.8

Figure 2. 9.8 10.6

Trade openness 9.7 10.4
(Pakistan and 9.6 10.2
India, 1985-2014) 1984 1988 1992 1996 2000 2004 2008 2012 2016 1984 1988 1992 1996 2000 2004 2008 2012 2016
Years Years
 3. Literature review Financial
3.1 Trade openness and economic growth liberalization
The literature on the relationship between trade openness and economic growth is and economic
extensive. For instance, in Bangladesh, Ahmed (2003) uses endogenous growth model to
analyze the association between trade liberalization and economic growth over the period growth
1974-1996. The long-run results show that investment, export and secondary school
enrollment have significant contributions to economic growth. In addition, Iqbal and 233
Zahid (1998) examine the determinants of GDP in Pakistan for the period 1960-1997.
They find that openness of the economy as well as other key variables such as physical
capital significantly and positively influence the Pakistan’s economic growth.
In the context of India, Topalova (2004) examines the relationship between trade
liberalization and poverty. The study finds that trade liberalization through
industrialization enhances the economic growth and as a result, poverty decreases and
the people’s welfare increases. Similarly, a study by Khan and Qayyum (2007) investigates
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the relationship among trade liberalization, GDP, and financial liberalization in Pakistan for
the time interval of 1961-2005. The long-run results reveal that the effects of trade and
financial liberalization on the Pakistan’s GDP are positively significant. However, the impact
is low in the short run. Likewise, Ellahi et al. (2011) analyze the relationship among trade
liberalization, industrial value added and Pakistan’s economic growth during the period
1980-2009. Their results reveal that the influence of imports and exports on the economic
growth is positive until the industrial value added is considered.
Atif et al. (2010) investigates the relations among financial development, trade
liberalization and Pakistan’s economic growth. By using the autoregressive distributed
lag (ARDL) technique, the author concludes that financial development and trade
liberalization have positive influence on the GDP of Pakistan. Almasi and Gharehbaba
(2011) examines the role of financial liberalization and trade openness in the Iran’s
economic growth by employing the new classical production function such as Cobb-
Douglas production function. They find that foreign direct investment negatively affects
the economic growth of Iran.
Recently, Fetahi-Vehapi et al. (2015) examine the impact of trade openness on economic
growth of 16 South Eastern European countries for the period of 1996-2012. The generalized
method of moments (GMM) technique is used for the estimation. The study reveals that no
robust relationship is found between the trade openness and economic growth. However,
they observe that trade openness spurs economic growth in the economies with higher level
of initial income per capita, grossed fixed capital formation and FDI inflows. In Sub Saharan
African countries, Brueckner and Lederman (2015) employ instrument variable (IV )
approach to investigate the impact of trade openness on economic growth. Their empirical
findings indicate that in the short and long run, trade openness positively and significantly
affects the economic growth in the selected countries. In the short run, a 1 percent increase in

120 180

115
160
110
FLI (Pakistan)

105
140
FLI (India)

100

Figure 3.
95 120

90 Financial
100
85 Liberalization
80 80
(Pakistan and India,
1984 1988 1992 1996 2000 2004 2008 2012 2016 1984 1988 1992 1996 2000 2004 2008 2012 2016 1985-2014)
Years Years
 SAJBS trade openness (trade over GDP) is associated with 0.5 percent increase in economic growth,
6,3 whereas in the long run, a 1 percent increase in trade openness leads to 2 percent increase in
GDP growth (Table I).

3.2 Financial liberalization and economic growth

In light of the significant role of financial liberalization in economic growth, many studies
234 have attempted to investigate their relationship. For example, McLean and Shrestha
(2002) examine the influence of international financial liberalization on economic growth
over the period 1975-1990 for 20 developed and developing countries. They conclude that
financial liberalization positively influences economic growth of those countries.
Tswamuno et al. (2007) provide explanation on how financial liberalization has affected
the GDP of South Africa. The results suggest that liberalization of bond and equity
markets does not affect economic growth and the post liberalization foreign portfolio
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investment. However, the stock market has significant negative effect on economic growth
after financial liberalization.
A study by Tash and Sheidaei (2012) on the influence of financial liberalization and trade
openness on the Iran’s economic growth for the time span 1966-2010 indicates significant
effects of both variables on the GDP of Iran. The study concludes that the impact is because of
the process followed for the liberalization of trade and financial sectors. Sulaiman et al. (2012)
explain how financial liberalization affects the economic growth of Nigeria for the time
interval 1987-2009. They conclude that financial liberalization positively affects the economic
growth of Nigeria. Bilel and Mouldi (2011) examine the influence of foreign direct investment
and financial liberalization on GDP of the six MEENA countries for the period 1986-2010.
The results reveal that financial liberalization has negative effect on the gross domestic
product while FDI has positive impact.
A study by Akingunola et al. (2013) examines the influence of financial liberalization on
Nigeria’s economic growth from the period 1976-2006. Different explanatory variables are
used as proxy for financial liberalization but only the ratio of M2 to GDP has significant and
positive influence on the economic growth of Nigeria. They conclude that Nigeria has not
liberalized the financial sector completely. Hye and Wizarat (2013) investigate the influence
of financial liberalization on the Pakistan’s economic growth by developing an index of
financial liberalization. The results show that, in the short run, financial liberalization
positively influences the economic growth of Pakistan, while the long-run estimate is
insignificant. The rate of interest effect is negative on the economic growth in the short run.

Sl no. Study Country/time period Method/model Outcomes

1 Ahmed (2003) Bangladesh (1974-1996) Co-integration technique Positive

endogenous growth model
2 Iqbal and Zahid Pakistan (1960-1997) Multiple regression Positive
(1998)
3 Topalova (2004) India (1994-2000) Gordon Hanson Model Positive
4 Khan and Qayyum Pakistan (1995-2005) Autoregressive Distributed Lag Positive
(2007) Technique (ARDL)
5 Ellahi et al. (2011) Pakistan (1980-2009) OLS Technique Granger Causality Test Positive
6 Atif et al. (2010) Pakistan (1990-2010) Autoregressive Distributed Lag Insignificant
Table I. Technique (ARDL)
Summary of the 7 Fetahi-Vehapi et South Eastern European Generalized method of moments (GMM) Positive
literature review – al. (2015) (1996-2012) technique
trade openness and 8 Brueckner and Sub Saharan African Instrument Variable (IV ) Approach Positive
economic growth Lederman (2015) countries (1980-2009)
 Dhungana (2016) investigates the impact of financial liberalization (using two indicators Financial
of financial liberalization, namely, Broad Money (M2) and credit to private sector) on liberalization
economic growth of Nepal. By employing the vector error correction (VECM) model, and economic
the study provides evidence of long-run association between financial liberalization (M2 and
credit to private sector) and economic growth. It is suggested that government should growth
strengthen and develop financial institutions to accelerate economic growth.
In conclusion, it is observed that the results of the relationship between trade openness 235
and economic growth on the one hand, and financial liberalization and economic growth on
the other hand, are still mixed and inconclusive, and there is need for more empirical studies
for further evidence (Table II).

4. Theoretical framework
The economic theory linking economic growth has generated contentious debate after the
inception of endogenous growth models in the 1980s. The endogenous growth theory puts
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forward the most effective channel to enhance economic growth. The theory assumes
increasing return to scale from human and physical capital as compared to the neo-classical
theory of growth that assumes decreasing return to scale.
The endogenous growth theory considers technological change as the endogenous
factor. This technological change outgrows endogenously from investment in human capital
(HC) and knowledge-based industries. The endogenous growth theory elucidates in detail
that complementary investments (investment in HC and infrastructure as well as
expenditure on research and development) are vital factors responsible for long-run growth.
That is, governments should spend more on HC, and research and development to accelerate
the pace of growth (Todaro and Smith, 2012). On the other hand, exogenous growth theory
considers an exogenous factor responsible for growth. However, the theory has failed to
explain the reason there was no substantial growth in the developing countries even after
heavy investment.
Therefore, endogenous growth theory provides the theoretical basis for the current
study. According to endogenous or new growth theory, liberalization of the economy
encourages economic growth through boosting the scale of spillover effects produced
by technological advancement, HC and investment in knowledge-based industries
(Romer, 1990). Through capital account liberalization, banking sector reforms and
elimination of the trade restriction, an economy receives capital and import advance
technology that consequently encourages export and economic growth (Ahmed, 2010).
In endogenous growth model, HC, physical capital and total factor productivity are the
main drivers of economic growth. This study employs the endogenous growth model as
used in the recent study of Manwa and Wijeweera (2016) in order to examine the influence of

No. Study Country/time period Method/model Outcomes

1 Tswamuno et al. (2007) South Africa (1975-2005) OLS technique Positive

2 Tash and Sheidaei (2012) Iran (1966-2010) VAR Model Principal Component Positive (very
Analysis (PCA) minimal)
3 Sulaiman et al. (2012) Nigeria (1987-2009) Johansen Co-integration Test and the Positive
Error Correction Mechanism (ECM)
4 Bilel and Mouldi (2011) MENA countries Traditional Panel Data Methods Negative
(1986-2010) Table II.
5 Akingunola et al. (2013) Nigeria (1976-2006) Johansen Co-integration Test Positive Summary of the
6 Hye and Wizarat (2013) Pakistan (1971-2007) Auto Distributive Lag Model (ARDL) Insignificant literature review –
7 Dhungana (2016) Nepal (190-2014) Vector Error Correction Model Positive financial liberalization
(VECM) and economic growth
 SAJBS trade and financial liberalization. We have added trade and financial liberalization to the
6,3 equation and employed the following augmented production function:


y ¼ f AH C b1 PC b2 TOP b3 FLI b4 eet (1)

In Equation (1), y is economic growth, A is technological change, HC is human capital, PC is

236 physical capital, TOP is trade openness and FLI is financial liberalization index.

5. Data and methodology

5.1 Data discussion
This study examines the influence of trade openness, financial liberalization and two control
variables, namely, HC and physical capital on the economic growth of India and Pakistan
over the period 1985-2014. The data for all the variables including trade openness, financial
liberalization index, human and physical capital are obtained from the World development
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Indicators, World Bank.

The literature categorizes the measurement of financial liberalization into two broad forms,
namely, the de jure measures and the de facto measures. The de jure measures of financial
liberalization include the control over transboundary transactions. These scoring-based
measures involve the IMF’s “Annual Reports on Exchange Arrangements and Exchange
Restrictions (AREAER)”. For instance, Brune and Guisinger, and Chinn and Ito (2008)
developed financial openness index and KAOPEN index using de jure measures of financial
liberalization. However, the pioneering attempt to analyze cross-country financial
liberalization through de jure measures was by Alesina et al. (1994). The de facto measures
take into account the stock of capital and actual capital flow across the borders such as FDI
flows and portfolios flows. For developing countries in particular, the de facto measures are
the most appropriate proxy variables to be employed for the measurement of the financial
sector liberalization (Bumann et al., 2012; Edison et al., 2002; Kose et al., 2006).
Apart from the de facto and de jure measures, there is another measurement for financial
liberalization in which composite indices of financial liberalization are constructed through
merging various de facto measures into one composite index. For instance, Abiad and Mody
(2005) constructed an index by amalgamating six de facto measures such as control over
current account and interest rates, removal of entry barriers and denationalization of
financial institutions into one composite index to measure financial liberalization.
The present study constructs a comprehensive financial liberalization index using the
principal component analysis (PCA) method by merging five de facto variables such as net
FDI inflows, domestic credit to private sector as percentage of GDP, Broad Money (M2)
to GDP, credit disbursed by the banking sector as share of GDP and Gross domestic
savings to GDP. Liberalization of the financial sector is a broader phenomenon. In the
literature, various studies have employed different measures for financial liberalization.
According to Levine (1997), higher credit to private sector by banks indicates more
liberalization and more share of the banking sector for financing. Moreover, higher credit to
private sector not merely shows the development of the financial system but also specifies
the higher investment at domestic level (Levine, 2005). Net FDI inflows show the actual flow
of capital across borders and M2 to GDP characterizes deepening of the financial system.
The last variable employed for financial liberalization is gross domestic savings as
percentage of GDP. Domestic saving is one of the most effective channels to spur economic
growth through the developed financial system (Pagano, 1993). All the above-mentioned
explanatory variables employed for the construction of financial liberalization index
represent the combination of capital account liberalization and banking sector development.
These are the two out of three main dimensions of financial liberalization other than the
equity market liberalization.
 Furthermore, the study measures trade openness (TOP) as trade to GDP ratio, HC as Financial
gross primary enrollment rate and physical capital by gross fixed capital formation as liberalization
percentage of GDP. and economic
growth
5.2 Model specification
5.2.1 Unit roots. We check the order of integration of the variables by employing
Augmented Dickey Fuller (ADF) test. ADF test examines the order of integration among the 237
variables (Dickey and Fuller, 1979). ADF test uses the following mathematical expression
for computation:

X
k
DZ t ¼ g þyyt1 þgT þ Wj DZ tj1 þet (2)
j¼1
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In Equation (2), Z is series at time t; γ is a constant term, k is number of lags and εt is white
noise error term. If the computed ADF value is less than the critical value, then the null
hypothesis of series having unit root cannot be rejected. It indicates that there is presence of
unit root in a series.
Conversely, if the ADF test value is more than critical value, then we reject the null
hypothesis of series having unit root. It shows that there is no unit root in the series.
In addition, if the data have unit root or is not stationary, then we do differencing once to
make it stationary.
5.2.2 ARDL model. The study applies the ARDL model (Pesaran et al., 2001). The ARDL
technique to co-integration has advantages in that it can be applied when series are
integrated of different orders. Moreover, in determining co-integration, it accommodates
different optimal lags to be assigned to variables (Raji et al., 2014, 2017). The ARDL
technique is an advance technique of regression having many features. It can be used
efficiently for small sample set. The ARDL model is as stated in the following equation:

X
k X
k X
k
D ln GDPt ¼ aþ b1 D ln GDPti þb1 D ln TOP ti þb2 D ln FLI ti
i¼1 i¼0 i¼0

X
k X
k
þb3 D ln H C ti þb4 D ln PC ti þg1 ln GDPti
i¼0 i¼0

þg2 ln TOP ti þg3 ln FLI ti þg4 ln H C ti þg5 ln PC ti þU t (3)

In Equation (3), Δ is the first difference operator, ln stands for the natural logarithm, K is the
optimum lag, GDP is the economic growth measured by GDP (annual percent), and TOP is
the trade to GDP ratio. HC is measured by gross primary enrollment rate. PC is the physical
capital and is measured by gross fixed capital formation as percentage of GDP, and FLI is
the financial development index created through PCA method.

6. Results and discussion

6.1 PCA
Many recent studies have used the PCA method to construct indices in economics and other
branches of social sciences. PCA is a statistical tool, which reduces a large sum of correlated
values into smaller uncorrelated values called components by employing their variances,
 SAJBS without losing the original information ( Jolliffe, 1986). PCA also addresses the issue of
6,3 multicollinearity in the data.
Table III indicates the component matrix or factor loadings of the components. These
factor loadings are obtained through the PCA method. Variables with different measuring
units should be standardized first. PCA measures eigenvalues that are called variance of the
factor and can be employed to measure the value of any of the component. If the explanatory
238 variables are the same, their mean and variance equal to 0 and 1, respectively (Tash and
Sheidaei, 2012). The one-dimensional estimate of the broader phenomenon, as financial
liberalization, is obtained as:

X
N
FLI t ¼ di X it (4)
i
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In Equation (4), FLIt indicates the one-dimensional measure of financial liberalization at time
t whereas Xth is the ith financial liberalization proxy at time t. Moreover, δi is the eigenvector
that indicates the corresponding measure of ith proxy variable. It is obvious from the
statistics in the table that the factor loadings are reasonably high. The higher values of
factor loadings explain FLI efficiently.

6.2 Unit root tests

We use the ADF test for checking the stationarity of the series. This is important to ensure
that the estimated results are not spurious.
From the results in Table IV, the ADF test results show that some variables are
stationary in level while others are stationary in first difference. Therefore, based on the
ADF tests results, we choose to use the ARDL method to conduct the long-run and short-run
analysis. The ARDL method is desirable when variables have mixture of orders of
integration, that is, I(0) and I(1). It is worth mentioning that among the variables tested, no
one is integrated of order 2, which may negate the use of the ARDL approach. Thus, our
study is free of spurious results.

Factor loadings
Factors Pakistan India

M2 0.872 0.883
CRDT D 0.703 0.784
CRDT B 0.919 0.851
Table III. FDI net inflow 0.956 0.906
Component matrix GDS 0.891 0.908

Pakistan India
Variables Level First diff. Order of integration Level First diff. Order of integration

GDP −3.436 −6.514 I(0) −4.361 −7.537 I(0)

Table IV. TOP −0.422 −6.454 I(1) −1.272 −7.540 I(1)
ADF unit root HC −0.486 −5.700 I(1) −0.434 −4.572 I(1)
test results PC −1.243 −4.647 I(1) −1.006 −5.408 I(1)
 6.3 Bound test for co-integration Financial
We employ F-statistic to test the joint significance of the parameters. We then compare the liberalization
computed value of F-statistic with the critical values of the two bounds, that is, upper bound, and economic
I(1) and lower bound, I(0). We accept the existence of co-integration if the estimated
F-statistic is more than the critical value for upper bound and conversely, we reject the growth
existence of co-integration if F-statistic is below the critical value for lower bound.
The finding will remain inconclusive when F-statistic is between the critical values for lower 239
and upper bound. The null hypothesis of F-statistic test is that co-integration does not exist
among variables. Table III shows the results of bound test for co-integration (Table V ).
In the ARDL method, we have to check the bound test before conducting the
co-integration relationship among the dependent and independent variables. The bound test
shows the values of F-statistic for India and Pakistan are more than critical value for upper
bound at the 1 percent significant level. This suggests the existence of co-integration among
the variables for the two countries. That is, GDP has long-run relationship with
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the explanatory variables (FLI, TOP, HC and PC) for the two countries. On the basis of the
bound test results, we move forward to conduct the long-run estimates of the model.

6.4 Estimation of long-run relationship

Table VI shows the results of co-integration between economic growth and each of the
explanatory variables. In the case of Pakistan, financial liberalization index and trade
openness have significant and positive relations with the economic growth of Pakistan.
The results show that a 10 percent increase in financial liberalization causes economic
growth to increase by 7.6 percent while a 10 percent increase in the trade openness results in
15.4 percent increase in economic growth. HC and physical capital are also significant
in influencing economic growth. Results show that a 10 percent increase in HC leads to
about 10.2 percent increase in Pakistan economic growth. Similarly, a 10 percent increase in
physical capital causes economic growth of Pakistan to rise by 5.7 percent.
The long-run results for India show that the four variables are significant. All variables
have positive influence on the economic growth of India. The coefficient of financial
liberalization indicates that a 10 percent increase in financial liberalization leads the GDP to
increase by 14.1 percent. Our results are in line with those obtained in other countries as
pointed out in the literature (see McLean and Shrestha, 2002; Tash and Sheidaei, 2012;

Pakistan India
Bound Critical Value Bound Critical Value
99% 95% 99% 95%
F-statistic I(0) I(1) I(0) I(1) F-Statistic I(0) I(1) I(0) I(1) Table V.
Results of bound test
5.820 3.241 5.374 2.401 4.011 6.744 3.759 5.721 2.814 4.150 for co-integration

Pakistan India
Regressor Coefficient p-value Coefficient p-value

FLI 0.76 0.03** 1.41 0.01*

TOP 1.54 0.02** 2.01 0.01*
HC 1.02 0.01* 1.79 0.04** Table VI.
PC 0.57 0.04** 1.60 0.02** Estimated results of
Note: *,**Significant at 1 and 5 percent level, respectively long-run relationship
 SAJBS Sulaiman et al., 2012; Dhungana, 2016). Similarly, the findings for the financial liberalization
6,3 in the current study are in accordance with the previous results of studies in the context of
Pakistan and India (see e.g. Hye and Wizarat, 2013).
Trade openness also has high positive impact on the economic growth of India. It indicates
that a 10 percent increase in trade openness makes the GDP of India to increase by 20.1 percent.
The findings also support the endogenous growth theory in both countries that liberalization of
240 the economy accelerates the economic growth through influx of capital and technological
diffusion. Moreover, the results obtained for the impact of trade openness on economic growth
are in line with the findings of some studies (Fetahi-Vehapi et al., 2015; Brueckner and
Lederman, 2015) cited earlier in the literature review. Specifically, the present results support the
results obtained by the previous studies (Ahmed, 2003; Iqbal and Zahid, 1998; Topalova, 2004;
Ellahi et al., 2011; Atif et al., 2010) conducted in the context of Pakistan and India.
Similarly, HC is statistically significant, suggesting that a 10 percent increase in HC
makes GDP to increase by 17.9 percent. Lastly, the results indicate that physical capital has
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significant positive impact on GDP. This implies that a 10 percent increase in physical
capital contributes about 16 percent to GDP.
It should be noted that in the long run, the estimated coefficients of trade and financial
liberalization for the two countries indicate that India has gained much more than Pakistan
after liberalization.

6.5 Estimation of short-run dynamics

Table VII displays the results obtained for short-run dynamics. The coefficient of ECM
results for the two countries are negatively significant. This, in addition to bound test
results, confirms that GDP has long-run relationship with other explanatory variables.
The results reveal that trade openness has positive and significant influence on the economic
growth of Pakistan. The results show that a 10 percent rise in trade openness makes GDP to
increase by 16.5 percent in the short run. HC is positively significant in affecting the economic
growth of Pakistan in the short run. This implies that a 10 percent increase in HC makes the
Pakistan’s gross domestic product to increase by 9.3 percent. We also found that physical
capital (PC) has positive significant impact on economic growth. It shows that a 10 percent
increase in physical capital makes GDP to increase by 11.4 percent.
The short-run results for India show that all the variables significantly and positively
influence the economic growth of India. Financial liberalization is statistically significant and
it shows that a 10 percent increase in financial liberalization causes economic growth to
increase by 2.01 percent. Trade openness is significant and contributes positively to the
economic growth of India in the short run. Results indicate that a 10 percent increase in trade
openness makes economic growth to rise by 22.7 percent. Human and physical capital,
in short run, positively and significantly affects the economic growth of India. The result
shows that a 10 percent increase in HC affects economic growth to rise by 18.2 percent while a
10 percent increase in physical capital causes GDP to increase by 12.5 percent.

Pakistan India
Regressor Coefficient p-value Coefficient p-value

FLI 1.47 0.77 2.01 0.01*

TOP 1.65 0.01* 2.27 0.04**
HC 0.93 0.03** 1.82 0.02**
Table VII. PC 1.14 0.04** 1.25 0.01*
Estimated results of ECM(−1) −0.64 0.00* −0.59 0.00*
short run relationship Note: *,**Significant at 1 and 5 percent level, respectively
 6.6 Diagnostic tests Financial
The study conducts some diagnostic tests to ensure model fit and stability. Table VIII liberalization
indicates that the model passes all the diagnostic tests conducted. For example, the results and economic
of autocorrelation and heteroscedasticity tests are not significant at the 5 percent level.
It means problems of serial correlation and heteroscedasticity do not exist. In addition, the growth
results of Ramsey RESET stability tests are not significant at the 5 percent level for the two
countries, suggesting that the models are stable and fitted. 241
We further apply CUSUM and CUSUM of squares to test for the stability of our models
for the two countries. Figures 4 and 5 plot CUSUM and CUSUM of squares for Pakistan and
India, respectively. The two figures indicate that the models are stable for the two countries
since CUSUM and CUSUM of squares lines for the two countries do not go beyond the
5 percent critical lines for the two tests.

7. Conclusion and policy implications

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The study attempts to analyze the effects of trade openness and financial liberalization on
the Pakistan and India economic growth. Both countries share many common
characteristics. Pakistan and India after getting independence pursued restrictive trade

Test-statistic LM tests F-test p-value

Pakistan
Ramsey RESET test − 0.7413 0.397
Serial correlation CHSQ (4) 5.7968 – 0.215
Heteroscedasticity CHSQ (4) 6.7591 – 0.149
India
Ramsey RESET test − 0.7324 0.386
Serial correlation CHSQ (4) 4.6988 − 0.316 Table VIII.
Heteroscedasticity CHSQ (4) 5.4581 − 0.168 Diagnostic tests

15
10
5
0
–5
–10
–15
1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

CUSUM 5% Significance

1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
–0.2
–0.4 Figure 4.
Plots of CUSUM and
1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

CUSUM of Squares
for Pakistan
CUSUM of Squares 5% Significance
 SAJBS 15

6,3 10
5
0
–5
–10

242 –15

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014
CUSUM 5% Significance

1.4
1.2
1.0
0.8
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0.6
0.4
0.2
0.0
–0.2
Figure 5. –0.4
Plots of CUSUM
1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014
and CUSUM of
Squares for India
CUSUM of Squares 5% Significance

and financial measures for long time, and liberalized their financial and trade sector almost
the same time. Our results (short- and long-run estimates) suggest that trade openness and
financial liberalization significantly affect the economic growth of Pakistan. In addition,
the short- and long-run estimates show that physical capital and HC positively influence the
Pakistan’s economic growth.
For India, trade openness and financial liberalization positively and significantly
influence GDP. The results (short- and long-run estimates) also show the importance of
human and physical capital to the economic growth of India. Our findings indicate that
India has gained much more after liberalizing the trade and financial sector.
Both countries should also focus more on the development of physical and HC because
the results suggest that in the long and short run, physical and HC have contributed
positively to the economic growth.
By comparing the results of both countries, trade openness and financial liberalization
increase the economic growth of India more than that of Pakistan. These results
suggest that Pakistan should consider appropriate positive policies regarding
financial liberalization and trade openness to achieve high and stable economic growth
in the future.
In particular, Pakistan can boost up her economic growth by embracing more openness
in trade and financial sectors in order to integrate with the global market. For example,
Pakistan should promote its exports, which are declining in recent years. According to the
State Bank of Pakistan, exports declined by 12 percent between 2013 and 2015, and by
1.3 percent in 2017 (SBP, 2017). Hence, the Pakistan should encourage exports by improving
security conditions, infrastructure and the energy sector in the country.
In terms of HC development, the Institute of Social and Policy Sciences (I-SAPS) reported
that Pakistan has 24 million children out of school, the second highest in the world after
Nigeria. However, Pakistan spent 2 percent of its total budget on education, the lowest in the
region (I-SAPS, 2015). Therefore, Pakistan should invest more in HC through providing
education in order to enhance human skills.
 Similarly, India should also focus on HC development by spending more on educational Financial
sector because the country still has the highest number of children out of school in liberalization
South Asia (ACE, 2015). If this is done, then India will be able to reap the benefits from trade and economic
and financial liberalization.
growth
Notes
1. Trade openness is measured as Trade to GDP ratio. 243
2. Financial Liberalization Index (FLI) created by PCA method measures financial liberalization.

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Corresponding author
Rana Muhammad Adeel-Farooq can be contacted at: adeelr333@gmail.com

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