The Impact of Trade on Economic Growth in Case of Pakistan

Term Paper

By

Shehnaz Ali

MS(DS) 2268108

Submitted

To

Dr. Aziz Rasool

Department of Social Sciences

SZABIST University, Islamabad

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 Contents
Abstract............................................................................................................................................3

1. Introduction..............................................................................................................................4

1.1 Significance.......................................................................................................................6

1.2 Objective...........................................................................................................................6

1.3 Research Question.............................................................................................................6

2. Literature Review.....................................................................................................................6

3. Methodology............................................................................................................................9

3.1 Data Collection and Source...............................................................................................9

3.2 Description of Variables...................................................................................................9

3.3 Econometric Technique..................................................................................................10

3.4 Specification of Model....................................................................................................10

4. Results and Interpretation.......................................................................................................11

5. Discussion..............................................................................................................................13

6. Conclusion and Policy Implication........................................................................................15

References......................................................................................................................................16

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 Abstract
This research study highlights the relationship of trade with economic growth. We take the time
series data from 1980 to 2016 and make it stationary first by applying the Augmented Dickey-
Fuller test and then apply ARDL to estimate it. Results show the positive relationship between
Government Expenditure, Total Trade, and Exchange Rate with GDP but there is an inverse
relationship of FDI with GDP. Different tests are applied to check the health of the model.

Key Word: ARDL; Economic Growth; Trade; GDP

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1. Introduction
Trade of a country is considered to be vital for its growth. Trade plays a significant role in the
economic growth of the country. Growth can be achieved through foreign trade with other
countries. High growth rates have been achieved by the developed countries through trade. When
the trade sector is sustainable then the economy of a country with all other sectors grows
significantly. Trade impacts positively on the development of the country. Through trade, many
other sectors have been improved in most of the countries like China, India, Hong Kong, Japan,
America, Germany, France, etc. Most of the developed countries import raw material and export
finished goods. By doing this foreign reserves are increased in developed countries and the per
capita income increases. Therefore a high growth rate is achieved through foreign trade. Thus,
the trade sector has evolved.

Trade is the main sector that influences country’s economic growth and if the trade of a country
is low then a high growth rate cannot be achieved. If the foreign trade of a country is more, then
the reserves of the country are increased through it, and the growth rate is increased also. Free
trade increases productivity, increases the wage rate, and creates more jobs. In this way per
capita income increases and there is growth in the country.

The trade sector can be determined through FDI, Total Trade (Imports plus Exports), Exchange
Rate(ER), and Government Expenditures (GExp). As FDI increases then there is an increase in
GDP as well, because Foreign Direct Investment plays a positive role in the development of a
country. If Total Trade increases then GDP may increase or decrease because if Exports are more
than GDP will increase but when Imports are more than Exports then GDP will decrease.
Similarly when the Government expenditure is increased on non-developmental projects then
GDP will decrease otherwise GDP will increase.

Pakistan faces high borders of international exchange in its eastern and western and north-
western fringes. However, Pakistan passed generally important East-West trade courses linking
India with Focal Asia and China. Nevertheless, stressed relations with India, war and political
precariousness in Afghanistan, the lack of improved transportation bases to China for land
routes, and difficulties in inborn areas and Baluchistan have hampered Pakistan's east and west
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trade. The advancement of East-West trade provides Pakistan with an exceptional open door to
increase its economic growth (Nabi, 2013). There has been a great deal of excitement for
exploring the effect of trade development with India. In addition, the ongoing China-Pakistan
Economic Corridor (CPEC) venture has fuelled excitement for the potential to improve trade
with China. Generally, trade deficits are not a natural threat. The persistence, scale, and
development of the deficit and the causes of the deficit decide whether the trade deficit should be
a matter of concern and to what degree. A significant policy variable affecting trade flows,
capital flows, inflation, foreign reserves, and remittances is the exchange rate. Many empirical
findings indicate how shifts in exchange rates influence developed countries' trade balance.
There is a significant disagreement that the efficacy of the currency deficit as a means of
growing foreign trade is still being discussed.

Along these lines, Pakistan is one of the nations that have been heading towards lack of trade for
the past few years. Pakistan was moving towards an exchange deficiency in the 1957-58 fiscal
year. Outside trade divisions were sensibly phenomenal in the money-related years 1953, 1954
and 1956. Its common tolls were 161 million dollars more than its imports. In the money related
year 1956-57 and in the budgetary year 2003-4 Pakistan has a surplus exchange rate change. This
was the financial year in which Pakistan had a positive exchange adjustment. These years,
however, Pakistan is facing the problem of trade and current record deficiency (Abbas, 2013).
Javaid et al. (2018) made a later study of human development factors in Pakistan. In addition,
Pakistan needs different financial arrangements to boost exchange adjustments and increase
monetary action and growth, including: levy structures, conversion scale, remote trade
designation System, and regulation of imports and calculation of taxes on tariffs. Pakistan should
make and change its external trade policies, but little is being done in this regard and the distance
between the exchanges that is going to take place is gradually widening. Critical success factors
empirically analysis the effect of the exchange rate on the trade balance using the annual per
capita gross domestic product (GDPPC) statistics, foreign direct investment, and exchange rate,
urbanization and money supply data for the period 1972 to 2012.

Throughout the 1990s, Pakistan underwent continuous trade and investment liberalization, and
the reform process is still going on. These reforms include the reduction of government
interference, the abolition of the import limit, import surcharges and regulatory duties, the

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rationalization of the structure of tariffs, the abolition of SROs, the enhancement of export
promotion and market knowledge programmers, the introduction of export promotion zones
(EPZs), the liberalization of exchange rates and investment regimes among others. Despite these
measures, Pakistan's export growth rates remained sluggish by international standards (GOP,
2011).

1.1 Significance
This study will be successful in boosting economic growth in Pakistan by building strong foreign
trade that reduces poverty, as well as in identifying those areas where more work needs to be
done to address poverty reduction and strong infrastructure.

This investigation would therefore add to the publicity of investigators; money related masters,
economists, plan developers and national financial specialists, i.e. how GDP shifts due to
improvement in swelling so that they can take on extraordinary approaches to holding the
expansion rate relevant for generation in the economy (non-unsafe expansion rate).

1.2 Objective
 To check the effect of foreign trade on economic growth and their factors; extraneous
direct investment net inflows, GDP per capita, Money supply and urbanization on the
trade balance of Pakistan.

1.3 Research Question

1. What are the main determinants of foreign trade for economic growth in Pakistan?
2. What are the factors that impede economic growth?
3. How current foreign trade has had an impact on Pakistan's economic growth

This is the brief introduction of trade and economic growth discussed above. In the second part,
review of literature is explained thoroughly. In third section, variable and methodology is
explained. Then the estimation technique is discussed. Results, conclusion, and policy
implication are discussed after.

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2. Literature Review
A number of studies shows that impact of export on economic growth. For example, Heshmati,
A. and Sun, P. (2010) told the effect of international trade on China's economic growth. Its
purpose was to explain the trade revolution in China has made a significant impact on China's
economic development. China went through revolution stages such as dependency on the Soviet
Union, completely isolating itself and opening itself to the whole world. China underwent
evolution through WTO which allowed it to contribute in the world trade by improving in the
trading system. Before 1978 China was following an inward-oriented trade policy which
consisted of China’s less trade with the world. Through trade liberalization since 1978 China has
gained lots of benefits from international trade. In the 1980's China imposed tariffs to minimize
the imports. The preliminary tariff was set very high at 56% in 1982. Then China reduced the
tariff rate in the last two decades ten times, reducing the normal tariff by 15 percentage in 2001
and 9.8 percentage in 2008. The data of 31 provinces of China used in this research is panel data
and is based on 6 years from 2002 to 2007.

Omoju, O. and Adesanya, O. (2012) discussed the impact of trade on economic growth in
Nigeria. Theories explain the direct association of trade with economic growth. Several studies,
using different methodologies have brought the direct impact of trade openness on economic
development. Frankel and Romer (1999) found a direct connection of trade openness on income
per capita. Michealy (1977) used simple regression and estimated correlation between exports
and economic development. He found that there was a weak association and he concluded that if
you want some level of development a country has to achieve from trade. The source of data was
the Statistical Bulletin of the Central Bank of Nigeria ranges from 1980 to 2010. The variables
are GDP, the value of import plus export, FDI, exchange rate and government expenditure. The
econometric model is derived from the production function which depends on these variables.
The dependent variable is growth which is used by GDP. The OLS method is used to estimate
the regression in log form. This technique explains the correlation between the dependent and
independent variables. There is a direct connection between trade and economic progress shown
after the estimation in Eviews. From this study, we have concluded that trade and economic
development are directly related to each other.

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Frankel, J., Romer, D. and Cyrus, T.(August 1996), discussed the trade and growth of East Asian
Countries like Taiwan, Singapore, China, Hong Kong etc, Its cause and effect. In trade exports
and imports are taken together. Empirical studies found that the ratio of exports to GDP is a very
significant determinant of growth. There is a problem of simultaneity between trade and growth
which can be misleading explaining the export direction in the growth performance (Rodrik
1994b, p.2) It has a backward causal relationship of exports and investment & growth also.
Bradford and Chakwin (1993) discussed the causality runs from investment to growth and
exports instead of another way. We adopt restricted convergence that has become common
literature on growth. The dependent variable is per capita GDP at the end of the sample
1985.GDP per capita appears explanatory variable at the beginning of the sample period
(1960)Sample contains 100 to 123 countries depending on the availability of the variables. A
standard gravity equation is used for bilateral trade between two countries. The Geography
approach is also used to find the fitted trade share. Under both approaches, the coefficient is
statistically significant. The OLS method is used to estimate the equations. The point estimation
for the effect of trade openness is greater than that of the OLS estimate. We conclude from this
study that how much has been added to East Asian growth through exogenous or regional
component or policy component. By this study, we find that East Asian countries like Hong
Kong, China, Taiwan, etc. have rapid growth over the last 3 decades and it is found that trade has
a direct impact on economic growth.

3. Methodology

3.1 Data Collection and Source

The analysis is based on secondary data that has been collected for a period of 1980 to 2016
which consists of yearly observations for each variable. The data of dependent and independent
variables i.e. Gross Domestic Product (GDP), Real Effective Exchange Rate (REER), Total
Trade (TT), Foreign Direct Investment (FDI), and Government Expenditure (GEXP) has been
taken from World Development Indicators (WDI).

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3.2 Description of Variables
Gross Domestic Product

“The market value of final goods and services newly produced within a nation’s borders during a
fixed period”.

Government Expenditures

“The expenditures of Government in which the purchase of final goods and services is included
or gross domestic product. Government expenditures are used by the Government sector for the
main purposes such as defense and education etc. These expenditures are financed by taxes and
borrowings”.

Total Trade

“It is the sum of total imports and total exports of the country”.

Exchange Rate

“The price of domestic goods relative to foreign goods equivalently, the number of foreign goods
someone gets in exchange for one domestic good is called the real exchange rate”.

Foreign Direct Investment

“The purchase or construction of capital goods by a foreign business firm; for example, a
Japanese auto company builds a new plant in the United States”.

3.3 Econometric Technique

In carrying out the ARDL methodology; we use GDP, FDI, TT, REER, and GEXP. For all the
variables, we use actual values obtained from World Development Indicators. Before the
application of any statistical and econometric model, the data set of each variable was checked
for stationarity i.e. if the mean and variance are constant overtime. The stationarity of the
variables was checked by using the Augmented Dickey Fuller Unit Root test. Any data set that is
non stationary is differenced using the following formula∆ Y t=Y t −Y t −1. Every non stationary
data set was differenced until it became stationary. After checking the stationarity of each data
set, we applied Auto Regressive Distributive Lag (ARDL) Model to evaluate the long run

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relationship between variables with different order of integration. “ARDL models are least
square regressions using lags of the dependent and independent variables as regressors”. To see
how speedily adjustment occurs form short run to long run equilibrium i.e. to show the speed at
which inflation comes back to its equilibrium position, long run form and bound test and Error
Correction model was applied.

3.4 Specification of Model

In order to check how monetary policy can influence inflation rate in Pakistan, the following
econometric model is formulated. This model explores the long run impact of independent
variables i.e. REER, GEXP, TT, and FDI on GDP.

GDPt =β 1+ β2 (REER )+ β3 ( FDI ) + β 4 ( TT ) + β 5 (GEXP ) ε t … … ..(3)

Where ε t is the residual term, β 1is the intercept term, whereas the coefficients are represented by
β 2, β 3, and β 4 ; measure the relative change in response. Gross Domestic Product is represented
by GDPt , whereas Foreign Direct Investment is denoted by , FDI .TT ,GEXP and REER are total
trade, government expenditure, and real effective exchange rate respectively. To evaluate how
these dependent and independent variables relate in long run, the following equation was
formulated:

c1 c2 c3 c4
GDPt =β 0 + ∑ β 1 i ( FDI ) t−i+ ∑ β2 i ( REER ) t−i+ ∑ β3 i ( TT ) t−i+ ∑ β 4 i (GEXP ) t−i+ ε … ..(4)
i=1 i=0 i =0 i=0

4. Results and Interpretation

Since the data used in the analysis was secondary and time series and for the purpose of
investigating the stationarity among the variables, the ADF unit root test was run. The result
showed that the p-values for GDP, REER, TT, FDI, and GEXP are less than 5% significance
level. The null hypothesis has been rejected and concluded that the series does not contain unit
root and that the variables are stationary. GDP is stationary at second difference while REER,
TT, FDI, and GEXP are stationary at first difference. The table 1 summarize the results of unit
root test.

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Table 1: Unit Root Test

Augmented Dickey-Fuller test statistic

Variables Order Prob.

GDP Second Difference 0.0000

REER First Difference 0.0000

TT First Difference 0.0000

FDI First Difference 0.0054

GEXP First Difference 0.0021

Source: Author’s own calculations

The probability of F-statistic is 0.000540645 which is less than 1%, 5% and 10% significance
levels and it was concluded that variables were jointly insignificant. The value of R-squared is
0.963135764 which indicates that that 96.3 percent of the variations in GDP is shown by the
REER, TT, FDI, and GEXP. The value of adjusted R-squared is 86.8% and adjusted R-squared is
high only when there are relevant variables present in the model. Hence our model is good fit as
table 2 shows.

Table 2: F-Statistic and R-square

F-statistic Prob. (F- statistic) R- squared Adjusted R- squared

10.22343750 0.000540645 0.963135764 0.868927161

Source: Author’s own calculations

Now to test for the presence of cointegration and long run relationship we have performed long
run form and bound test. The F-statistic value 5.006251965 is above critical value bound at 1%,

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2.5%, 5%, and 10% and it was concluded that there exists co-integration and long run
relationship between GDP, REER, TT, FDI and GEXP. Table 3 shows the results

Table 3: ARDL Bounds Test

Test statistic Value Sig. I(0) I(1)

F-stats 5.006251965 10% 2.45 3.52
K 4 5% 2.86 4.01
2.50% 3.25 4.49

1% 3.74 5.05

Source: Author’s own calculations

The estimated coefficients of long run relationship are positive for foreign direct investment and
government expenditure. This shows that foreign direct investment and government expenditure
has positive impact on gross domestic product. An increase in these variable will result in rise in
GDP of the country. The estimated coefficients are however negative for real effective exchange
rate and total trade. This shows that total trade and real effective exchange rate have a negative
impact on GDP. An increase in these variables will cause a negative effect on GDP, whereas
decline in these variables will result in rise in GDP of the country as table 4 summarize the
results.

5. Discussion
Foreign direct investment, exchange rate, trade, and public spending play an important role in
stimulating growth of the economy. Foreign direct investment and Gross domestic product are
positively related to one another. This is due to the reason that FDI in an economy depicts that
the trend of investment is good which in turn cause the GDP of the economy to rise due to which
growth rate also rises. When the foreign direct investment rises in the economy, it automatically
puts a positive impact on the gross domestic product and hence, GDP rises as well. Moreover,
there is a two-way relationship between GDP and FDI. When the GDP of the country rises, it
offers high opportunities of profit by attracting domestic as well as foreign direct investment.
Similarly, there is a positive relationship between government expenditure and GDP as well.
When government increases its spending or expenditure, it in turn causes the GDP of the country

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to rise. On the other hand, if government reduces spending, it causes the GDP to fall. Increase or
decrease in public spending in turn increase or decrease aggregate demand which in turn
stimulates GDP, economic growth, and employment in the economy (Shirazi et al., (2004).
Furthermore, total trade and real effective exchange rate have negative relationship with GDP.
Total trade effects GDP in a way that if there is rise in demand for foreign products by the
consumers and lowers their demand for domestically produced goods, then it will cause GDP of
the country to decline as demand for foreign manufactured goods enhances relative to
domestically produced commodities. Similarly, if consumers rise their demand for domestic
goods and purchase less foreign goods, it will increase the GDP of the country. In addition to
this, real effective exchange rate negatively effects the GDP of the country. When the exchange
rate appreciates, it slows down the growth of GDP because falling exports and rising imports
results in unemployment in the economy. If a permanently higher share of the domestic market is
taken up by imports, the higher exchange rate will thus negatively affect growth in the economy
(Miankhel et al., 2009).

Furthermore, there exists a long run relationship between gross domestic product, foreign direct
investment, total trade, real effective exchange rate, and government expenditure. In addition to
this, the error correction coefficient is negative and significant which shows low momentum of
convergence towards equilibrium. If due to any external or internal shock, disequilibrium arises
in GDP, it will return back to its equilibrium position with a low speed of recovery (Yaqub et
al.,2016).

6. Conclusion and Policy Implication

By the empirical findings from the above study, it was conclude that trade causes economic
growth and Exchange Rate, Government Expenditure, and Total Trade have a positive impact on
the GDP. When ER, GExp, and TT increase then GDP also increases but on the other hand
Foreign Direct Investment is showing a negative impact on GDP. This is because FDI is not
contributing to the growth of the economy and also investment is not made in developmental
projects. So Pakistan should make good relations with other countries and promote trade through
free trade policies. By doing this ER will appreciate and GDP will increase. Pakistan should

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introduce free trade policy with neighboring and other countries. By such policies, exports of
Pakistan will increase and there will be a positive impact on GDP.

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Ahmad, D., Afzal, M., & Khan, U. G. (2017). Impact of exports on economic growth empirical
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Azam, Muhammad.‟ Exports and Economic Growth: An Empirical Analysis,” Journal of

Managerial Sciences, Vol. V, No.2

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Frankel, A. J., Romer, D., and Cyrus, T. (1996), ‟Trade and Growth in East Asian Countries:
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Omoju, O., and Adesanya, O. (2012), ‟Does trade promote growth in developing countries?
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Roe, T. (2004), ‟International Trade as a Source of Economic Growth: Trade Barriers and
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Seetanah, B., Matadeen, J. and Matadeen, J.(2012), ‟Trade Openness and Economic
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