Munich Personal RePEc Archive Exports-Led Growth Hypothesis in Pakistan: Further Evidence Akmal, Muhammad Shahbaz and Ahmad, Khalil and Ali, Muhammad National College of Business Administration and Economics (NCBAE), Lahore 2009 Online at https://mpra.ub.uni-muenchen.de/16043/ MPRA Paper No. 16043, posted 14 Jan 2011 09:23 UTC Exports-Led Growth Hypothesis in Pakistan: Further Evidence Muhammad Shahbaz Khalil Ahmad** & Muhammad AliAsad*** Abstract: This paper examines the exports-led growth hypothesis using quarterly data from 1990up to 2008 for Pakistan. In doing so, ARDL bounds testing approach, Error Correction Method (ECM) and Ng-Perron test for integration have been employed. The empirical findings show that exports are positively correlated with economic growth. This confirms the validity of exports-led growth hypothesis in the case of Pakistan both for short run and long span of time. Exchange rate depreciation declines economic growth while running real capital stock improves it. Keywords:Exports, Economic Growth,ARDL Approach JEL Classifications: F10, E10, C22 Adjunct faculty at GIFT University at Gujranwala, Pakistan **Faculty at National College of Business Administration & Economics at Lahore, Pakistan ***PhD student at University of Education at Lahore, Pakistan 1 Introduction The purpose of this article is to reinvestigate exports-led growth hypothesis in Pakistan after trade reforms in the period 1990-2008. The issue how an economy can attain economic growth is widely debated and is one of the crucial economic questions. Exports are often considered as an important source of economic growth. The association between exports and economic growth has been investigated in developing economies. According to international trade theory, exports can contribute to economic performance through many channels. As said by Adams Smith (1775) “international trade improves productivity by enhancing market size and enjoying economies of scale”. Furthermore, David Recardo (1817) documented that international trade plays an important role in economic growth. A country can attain specialization in the production of a good through trade in which it is comparatively advantaged. This attained specialization may perk up the efficiency of resources exploitation by raising the capital formation that improves the total factor productivity(TFP). Movements of ideas and advanced technologies across borders have become possible due to international trade. It improves the effect of growing competition and stimulates technical progress through innovations that lead to efficiency gains through productivity improvement. Increased exports are a major source of foreign exchange that helps to purchase import items for domestic use of the country. It is said that intra-industry trade can be increased through exports that integrate the country with the whole economy and help to absorb external shocks on the domestic economy as well. In such a scenario, it is concluded that exports play their role as ‘an engine of economic growth’. It is free trade that enables domestic firms to have easy access to foreign inputs at cheaper cost. Increased exports also enable the firms to have access to foreign capital and advanced technology through earned foreign exchange in the country. It is a fact that nowadays Foreign Direct Investment (FDI) is concentrated to more open economies not only to expand export volume but also to lead to high economic growth and rapid economic development as well (Richard, 2001). Export-growth link is summarized by Ramos (2001) in three channels. First, growth in exports seems to lead by trade multiplier for expansion of domestic production and employment. Second, foreign exchange or foreign 2 reserves earned through exports growth allows the country to import the capital goods that further leads to increase production capacity of the country. Finally, increased competition and volume of exports in the international markets accelerate the technological advancement in production process that causes to obtain economies of scale. On the theoretical basis, said channels strongly support for Exports-Led Growth hypothesis in the country. Exports oriented policies increase output, employment opportunities and domestic consumption. This causes to enhance the demand of output produced by the country. Improved exports sector widens the market share of firms that enables the firms to attain economies of scale and in resulting lower unit costs (Olorunfemi and Olowofeso, 2006). It is an exports sector that enables a country to trade with rest of the world along its lines of comparative advantage and specialization. Generally, it causes to lead the efficient allocation of domestic resources. Similarly, this efficiency can be improved by the exposure to international competition. This encourages the firms to utilize modern technology and produce quality products meeting the demand of international customers (Olorunfemi and Olowofeso, 2006). Positive externalities of exports are also pointed by Kessing (1967), Balassa (1978) and Krueger (1980) such as greater capacity utilization, economies of scale, incentives for technological improvement and well-organized management due to foreign market competition. II. Literature Review Kaldor (1967) analyses the causal relationship between productivity growth and output growth, including some factors like economies of scale, learning curve effects, division of labour and new industrialization process. Further, he documents that the industrial development is worked as main determinant of output growth, in the context of productivity growth. He also investigates the causal relationship between output growth, via productivity growth to export growth. Kunst and Marin (1989) also find bidirectional causality, when productivity increases due to promotion of scale economies that causes to enhance exports. A contributory work has been done by Sharma and Dhakal (1994); Bhagwati (1988) on the relationship between exports growth and economic growth. They 3 argue that there is a possibility of existence for two-way causation between economic growth and economic growth. They also discuss the causality between trade and output. They come to conclusion that trade promotes output and income level which facilitates more expansion in trade volume, causes a process of a virtuous circle of growth and trade. Balassa (1984); Lucas (1990) and Sparout and Weaver (1993) seem to check the exports and output growth regression analysis based on the neoclassical growth accounting techniques of production function. They also show that high significant positive relationship between export growth variable in the growth accounting. They conclude that export growth causes output growth and no possibility of bidirectional causality between the two variables. On the other hand, Jung and Marshal (1985), Bahmani-Oskooee et al (1991) and Holman and Graves (1995) strongly support for causality between exportsgrowth and economic growth. The pervious work done before the eighties had not paid a serious attention on the time series characteristics of the variables such as different stationarity levels. It is commonly accepted that non stationary data set produces misleading information among the concerned variables. While, previous work on exports-led growth hypotheses (ELG) based on the cross-country comparison (Michaely 1997; Balassa 1978). These studies strongly support the exports-led growth hypotheses. In the development of causality test (Granger, 1969; Engel and Granger, 1987), correlation techniques failed to measure direction of causality. After the development of unit root tests (Dickey and Fuller, 1979) and cointegration techniques, (Phillips and Durlauf, 1986; Phillips1987; Phillips and Perron, 1988) checking for the stationarity properties of time series have become common routine to show said relationship. Thus, starting in the eighties, most of the studies seem to base on the cointegration techniques to find out the relationship between exports and economic growth. Finally, the relationship between exports and economic growth has been checked through traditional cointegration techniques and error- correction method. These types of model includes Bahamani-Oskooee and Alse (1993), Sengupta and Expana (1994), Ghatak et al (1997), Ekanayake (1999), Richards (2001) 4 and Ngoc et al (2003) to examine short run and long run relationship or association between exports growth and output growth1. In recent wave of country case studies, most empirical evidences seem support for exports-led growth hypothesis [Doyle, (1998) and Fountas, (2000) for Ireland; Ghali, (2000) for Tunisia; Hatemi-J and Irandoust (2000a) for Nordic countries; Balaguer and Cantavella-Jorda (2001) for Spain; Thungsuwan and Thompson, (2003, 2006)2 for Thailand; Ramos, (2001) for Portugal; Howard, (2002) for Trinland and Tobago; Abdulai and Jaquet (2002) for Cote d'Ivorre; Panas and Vamvoukas (2002) for Greece; Federici and Marconi, (2002) for Italy; Ngoc, Anh and Nga, (2003) for Vietnam; Chandra (2003) for India; Abual-Foul, (2004) for Jordan; Keong, Zulkorain, and Venus, (2003, 2005); Leow, (2004)3; Furuoka (2007) for Malaysia; Love and Chandra, (2004) for Pakistan and India but not for Sri Lanka; Bahmani-Oskooee and Domac, (1995); Ozmen and Furten, (1998); Sharma and Panagiotidis, (2005); Siliverstovs and Herzer, (2005); Karagoz, and Sen (2005) & Ferda, (2007); Taban and Akhtar, (2008); for Turkey; Begum, and Shamsuddin, (1998); Mamun and Nath, (2005) for Bangladesh4; Clarke and Ralhan, (2005) for Bangladesh and Sri Lanka; Pahlavani, (2005) for Iran; Alsuwaidi and Shamsi, 1997 and Abu-Stait, (2005) for Egypt; Awokuse, (2005a) for Korea; Awokuse, (2005b) for Japan; Love and Chandra, (2005) for South Asia; Shan and Sun (1998); Mah, (2005) for China; Siliverstovs, (2005); Siliverstovs and Herzer (2006) for Chile; Jardaan and Eita, (2006) for Nambia; Amrinto, (2006) and Agbola, (2007) for Philippines; Olorunfemi and Olowofeso, (2006) for Ecowas countries5; Merza, (2007) for Kuwait; Darrat et al. (2000);Chen, (2007) for Taiwan and Ramesh and Boaz, (2007) for Kenya]. In the case of Pakistan, Hameed et al. (2005) investigate that output growth has a positive effect on export growth in the case of Pakistan. Higher-exports-growth countries would be able to accelerate their economies through large exporting manufactured goods. 1It is also pointed out by Sharma and Panagiotidis (2005) that econometric methods used in most of the empirical investigations are dominated by the work of Granger (1969, 1988) Sims (1972), Engle and Granger (1987), Johansen (1988) and Johansen and juselies (1990). 2Ukpolo (1998) fails to find out support for export led growth in South Africa 3exports-led growth hypothesis is met short span of time 4Love and Chandra, (2005) find causality running from income to exports in the case of Bangladesh 5For more informations see appendix 5 Dodaro (1993) do not able to find out the any significant relationship between said variables in the case of Pakistan. Bahamani-Oskooee and Alse (1993) strongly support the empirical evidence of two way causality between export growth and GDP growth. Anwer and Sampath (2000) do not find any indication of causation between export growth and GDP growth. Kemal et al. (2002) reveal bidirectional causality for long run between exports and economic growth. Muslehuddin (2004) finds long run equilibrium association among export, imports and output for Pakistan and Bangladesh but not for India, Sri Lanka and Nepal6. Causal relationship between performance of exports and economic growth has been investigated by Khan and Saqib (1993); Khan and Afia (1995); Khan et al., (1995) for Pakistan. They support for bidirectional causality between exports performance and economic growth in the country. On contrary, Multairi (1993) does not seem to find any support for exports-led growth hypothesis for Pakistan during 1959-91. Furthermore, Shirazi and Manap (2004) find latent equilibrium among exports, imports and economic growth. They document one-way causality running from exports to output growth in the country. Similarly, Quddus and Saeed (2005) seem to support exports-led growth hypothesis through one-way causality from exports to economic growth. Recently, Sidiqui et al., (2008) revisit exports-led growth hypothesis for Pakistan using annual data (1971-2005). They support exports-led growth hypothesis in the country for long run and short span of time as well. They have used terms of trade which is basically a ratio of real exports to real imports for external shocks. Also, they have used real exports and real imports in their model instead of terms of trade7. This has created a doubt of multi- colinearity in the model. That’s why results are not reliable. Finally, short run model is not well specified and insignificant8. 6Literature reveals that exports seem to cause economic performance in the case of Pakistan. The country has sufficient domestic resources to expand exports volume but Pakistan still is relying on import items that help to boost manufacturing and industrial sectors. These sectors play key role to enhance output. To increase exports share in international market, country has to import advance technology that will further help to compete with the other countries of region. It may conclude that export orientation policies not only increase openness of an economy but also helps in having access to foreign technology. This leads the country to grow more than the other countries through export growth. 7Rael effective exchange rate is better to check the impact of external shocks in the economy. 8They have also used dummy variable to capture the impact of trade liberalization. It is not appropriate indicator to investigate impact of trade liberalization on exports performance in the country. 6 Literature shows mixed results about exports-led growth hypothesis generally and specifically for Pakistan. Most studies regarding Pakistan have utilized annual data to examine exports-growth relationship. Traditional methods such as OLS, residual based Engle-Granger (1987) test9, and Maximum Likelihood based Johansen (1991, 1992) and Johansen-Juselius (1990) tests have been used to validate exports-led growth hypothesis. All these methods require that the variables in the system be integrated at equal order of integration. These methods do not include the information on structural break in time series data and suffer from low predicting power. New developed ARDL bounds testing is superior to other methods for analyzing the long-run relationships when the variables are having mixed order of integration, i.e., I(0) and I(1). ARDL bounds technique is also having information about structural break in the time series data. Structural break in an economy is having significant importance to analyze the macroeconomic time series. It occurs in any time series due to many reasons such as economic crises, changes in institutional arrangements, policy changes regime shift war. The structural break in the economy may provide biased results towards the erroneous non-rejection stationary hypothesis (Leybourne and Newbold 2003; Perron, 1989, 1990). This study is good contribution in literature with respect to Pakistan. The objective of such endeavour is to investigate exports-led growth hypothesis in the country using quarterly data starting from 1990Q1 up to 2008Q4 which is also known as area of trade liberalization10. For cointegration, ARDL bounds testing has been employed and error correction method (ECM) for shot run dynamics. III. Model and Data Source In this study log-linear modeling specification has been used. Bowers and Pierce (1975 suggest that Ehrlich’s (1975) findings with a log linear specification are sensitive to 9The residual-based co-integration tests are inefficient and can lead to contradictory results, especially when there are more than two I(1)variables under consideration 10In 1980s Pakistan adopted managed floating exchange rate policy in order to improve the trade balance, whereas the linkage between local currency and international market was created in 1990s which was considered to be an era of flexible exchange rate. 7 functional form. However, Ehrlich (1977 and Layson (1983) argue on theoretical and empirical grounds that not only log linear form is superior to the linear form but also makesour resultsmore favorable. Exports-led growth hypothesis is re-investigated as an insightful guide in choosing variables for present paper on the determinants of Pakistan’s economic growth. Present model is formulated on basis of theoretical framework of studies conducted by Riezwan et al. (1995), Al-Yousif (1999) and Keong et al. (2003). To re-visit exports-led growth hypothesis, following algebraicequation is being used: LRGDP  LREXPLK LREER (1) 1 2 3 4 Where, RGDP = Real GDP, REXP = Real exports, K = Capital stock proxies by gross fixed capital formation, REER = Real effective exchange rate According to international trade theory, there is positive correlation between exports and economic growth. Total factor productivity (TFP) can be improved through export expansion significantly. Various channels explain the positive link between exports and total factor productivity in developed economies and developing countries as well. It is explained by Balassa (1984) that “in general, the production of export good is focused on those economic sectors of the economy which are already more efficient”. It not only leads to focus investment in said sectors of the economy but also improves total factor productivity. Furthermore, higher growth rate of capital formation and growth of exports causethe total productivity to improve in the country(Kavoussi, 1984). Many models are developed in literature to study exports-led growth hypothesis. Neoclassical aggregate production function has been discussed for production growth link. As assumed by Hichs, neutral-technological-change-aggregate growth can be documented as growth of total factor productivity (TFP) and growth rates of factor inputs are sum of weights (Keong et al., 2003). These weights are called the elasticities of output to each input respectively having equal factor share. It is stated that increase in 8 input will move production function upward that leads to increase in output. It is concluded that labour and capital are two main determinants to improve production productivity (Keong et al., 2003). The link between exports and output is not direct and simple to understand. The relationship may be affected by price variability, international market and political intervention. Exchange rate has been included in the model to check the impact of price competitiveness in the internal market and its effect on economic growth through exports growth channel (Al-Yousif, 1999, Keong et al., 2003). Mostly, in developing economies, exports depend on world demand that depend on prices of exported goods and income of buyers in the international market. Thus, changes in exchange rate is important for an emerging economy like Pakistan. Exchange rate is also affected by changes in world prices. This shows that exchange rate is included in the model to check the impact of external shocks in the economy. It is expected that depreciation in Pak rupee will raise competitivenessofdomestic goods. This will raise exports in the country. Table-1 Correlation Matrix and Descriptive Statistics Variables LRGDP LREXP LRK LREER Mean 13.7795 7.4326 7.5530 4.62082 Median 13.7615 7.3092 7.4278 4.5986 Maximum 14.2065 8.1642 8.4894 4.7608 Minimum 13.2917 6.9624 7.0697 4.4951 Std. Dev. 0.2286 0.3805 0.3338 0.0784 Skewness 0.0848 0.8225 1.5492 0.1655 Kurtosis 2.0643 2.2548 4.3928 1.5855 Sum 1019.688 550.018 558.929 341.940 Sum Sq. Dev. 3.81671 10.5721 8.1376 0.4491 LRGDP 1.0000 LREXP 0.8636 1.0000 LRK 0.7821 0.8932 1.0000 LREER -0.8154 -0.6517 -0.4817 1.0000 Table-1 explains descriptive statistics and correlation matrix; there is positive correlation among real GDP, real exports and real domestic capital stock proxies by real gross fixed capital formation. Similarly, exports and real gross fixed capital formation are correlated positively. Real effective exchange rate and real GDP are inversely associated. In this 9