European Journal of Scientific Research

ISSN 1450-216X Vol.41 No.1 (2010), pp.13-21

© EuroJournals Publishing, Inc. 2010
http://www.eurojournals.com/ejsr.htm

Determinant of Trade Deficit: Case Study of Pakistan

Sulaiman D. Muhammad
Associate professor, Federal Urdu University of Arts, Science and Technology
E-mail: Sulaiman1959@gmail.com

Abstract

This paper investigates the long run and short run relationship among trade deficit
and its determinants through Johansen Co integration and Error Correction Model. This
research project finds out that variables causes’ trade deficits to Pakistan’s economy
significantly are foreign income, household consumption, foreign direct investment and
real exchange rate. These variables do have a long run relationship. In Short run they are in
disequilibrium.

I. Introduction
In case of Pakistan’s economy, facing persistent trade deficit during an era of globalization is
completely ambiguous. It is first study conducted for Pakistani economy. It is to found reasons that
“Why Pakistan is facing persistent trade deficit”. It is very dangerous for economy and some policy
implications must be taken up to resolve this problem. We have only two fiscal years in the history of
Pakistani economy in which trade surplus was experienced. In 1951/52 earned foreign exchange
earnings through export of raw jute during Korean War. Secondly, in 1972/73 when Bhutto banned
import of luxury items and devalued rupee to increase exports.
Macroeconomic reforms & various policies/strategies were adopted: but Trade Balance still not
is improving. So what to do? This study focuses on policy recommendation to solve this problem.
This study will emphasize on the impact of trading partners on the trade deficit of Pakistan.
How change in their GDP’s impact our trade deficit.
External trade environment and domestic policies have a great impact on trade and economic
growth of an economy. The aim of these trade policy instruments were: Stimulate domestic production,
Promote exports, Safeguard domestic industries against dumping (Protectionism?) and Consumer
protection.
Pakistan has pursued diverse economic policies aimed at improving trade and enhances
economic development. Domestic policies involved included as exchange rates, tariff structure, export
taxation, import control, foreign exchange allocation systems and adjustment policies to external
policies but issue is all these policies doesn’t makes the difference to persistent trade deficit. So the
biggest question for today’s researcher is “What to do?”

Review of Pakistan’s Balance of Trade

For decades, Pakistan’s balance of trade remained negative, though not as high as now. Imports have
exceeded exports in almost every year since 1950, and Pakistan had a deficit on its balance of trade
each year from FY 1973 through FY 2008.2 Resultantly, Pakistan with negative current account was
obliged to remain dependent on the foreign donors, and creditors to pay for the short fall of its balance
of payment. Piling up of external financial liabilities and debt service payments had put on constant
constraint to appropriate resources from the national developmental goals. The debt burden and social
Determinant of Trade Deficit: Case Study of Pakistan 14

development deteriorated to such an extent that today our foreign debts are standing at $44.5 billion
and would reach to the tune of over $52 billion US with the addition of $7.6 billions of IMF loan.
Substantial chunk of foreign reserves are siphoned off at alarming rate in debt servicing.3 Inflation is
running at nearly 25 percent on average4 and about 25 percent of the population of 169 million is
living below the poverty line of $1 a day.5 Following the policy of liberalization, deregulation and
privatization instead of containing imports, Pakistan went for ‘cheap’ imports not realizing that this
addiction could lead to lethal after-effects even on economies like the US. In 1996-97 it touched $ 3.52
billion; then it doubled to $6.183 billion in 2004-05, In 2005-06 the trade deficit doubled again to
$12.011 billion, and in 2006-07 it rose further and in FY 2007-2008 it was a staggering figure of
$20.75 billion6. The deficit widened to $20.746 billion in 2007-08 from $13.563 billion in fiscal 2006-
07 sets very alarming indicators for economic policy makers of Pakistan.
From diagram given below represents the increasing trade deficit. Data in this diagram belongs
to last five years from 2003 to 2008. So it is most current scenario of Pakistani economy.

BALANCE OF TRADE

40,000.0

30,000.0

20,000.0

10,000.0

0.0

(10,000.0)

(20,000.0)

(30,000.0)
2003-04 2004-05 2005-06 2006-07 2007-08

Imports Exports Trade Balance

Historical account of our trade

Export Imports
Year Value (FOB $ Bn) Change (%age) Year Value (FOB $ Bn) Change (%age)
2000-01 9.2 - 2000-01 10.7 0
2001-02 9.1 -0.7 2001-02 10.3 -3.6
2002-03 11.2 22.2 2002-03 12.2 18.2
2003-04 12.3 10.3 2003-04 15.6 27.6
2004-05 14.4 16.9 2004-05 20.6 32.1
2005-06 16.5 14.3 2005-06 28.6 38.8
2006-07 17 3.2 2006-07 30.5 6.9
2007-08 19.2 13.2 2007-08 40 30.9
2008-09 17.8 -6.7 2008-09 34.8 -13

The paper is organized as follows. Section 2 reviews the theoratical literature on the
determinants of the trade deficit. Section 3 discusses theoretical framework. Section 4 relates with data
and methodology used for this study. Section 5 presents Empirical estimation for long-term & short-
term relationship among the variables. Section 6 gives Conclusion and Section 7 presents Policy
recommendations.
Significance is to add knowledge to the existing literature, Guide to policy makers and Give
insight of measures to be taken to improve Trade Balance.
15 Sulaiman D. Muhammad

II. Review of Literature

(Himarios, 1989; Bahmani-Oskooee, 2001), various studies have found weak statistical evidence
connecting exchange rate changes and the trade balance (see, for example, Greenwood, 1984; Mahdavi
& Sohrabian, 1993; Rahman & Mustafa, 1996; Rahman et al., 1997). Empirical evidence also shows
that changes in real exchange rate have affected trade balances in some countries but not for all
countries which implies that the direction of the impact of real exchange rate changes on trade balance
is still unclear.
TB = M/X (Bahmani –Oskooss -1994) & Mulenga (2002)
Firstly they defined the model of trade balance and it is the main reference of the study. They
found the theoretical verification of relationship between imports and exports.
TB = f (RER, HC, G, Yw, FDI) Brada et al. (1997)
This model firstly defined the determinants of trade balance and verified them empirically in
1997. They took real exchange rate, household consumption, government expenditure, income of rest
of the world and foreign direct investment. I have also considered globalization.
Lardy 1996, Zhang, et al. 1999, Liu et al. 2001 have shown that foreign-invested firms have
contributed significantly to China impressive export expansion and economic growth. Using panel data
at the provincial level in the period of 1986-97, Tse (1997) proved inward FDI positively affect
provincial manufacturing export performance. But Sun (2001) argued the role of FDI changes across
the regions in China. Although FDI shows a positive and significant impact on exports from coastal
region to the central region, its impact on the western region is found to be insignificant. Earlier
literature has mainly focused on the impact of inward investment on china's export, while the linkage
between inward FDI and exports is quite well understand, there is still a paucity of systematic study on
the impact of FDI on China's foreign trade.
A study on the Association of South East Asian Nations (ASEAN)-5 countries (including
Malaysia) by Liew et al. (2003) has shown that trade balance in these countries is affected by real
money rather than nominal exchange rate and therefore it concludes that the role of exchange rate
changes in the trade balances has been exaggerated. However, as of now, very few attempts have been
made to incorporate other views on balance of trade/balance of payments analysis or to test these other
views empirically.
Duasa (2007) examines the short- and long-run relationships between trade balance, real
exchange rates, income and money supply in the case of Malaysia. The inclusion of income and money
variables in the study is purposely to examine the monetary and absorption approaches to the balance
of payments beside the conventional approach of elasticity, using exchange rates. Using the bound
testing approach to cointegration and error correction models, developed within an autoregressive
distributed lag (ARDL) framework, we investigate whether a long-run equilibrium relationship exists
between trade balance and the determinants. Additionally, we adopt an innovation accounting by
simulating variance decompositions (VDC) and impulse response functions (IRF) for further
inferences. Using this approach, we find evidence of a long-run relationship between trade balance and
income and money supply variables but not between trade balance and real exchange rate. The findings
also suggest that Marshall-Lerner condition does not hold in the long-run for Malaysia and for policy
wise the Malaysian trade balance/balance of payments should be viewed from absorption and monetary
approaches.

III. Theoretical Frame Work and Modeling

Features characterizing Pakistan’s foreign trade are trade deficit, domination of primary goods in the
export basket and Domination industrial goods in the import basket.
Determinant of Trade Deficit: Case Study of Pakistan 16

Significance
Net trade with foreigners: exports less imports. A trade deficit means that exports are insufficient to
pay for imports. Sometimes called "net exports", the trade balance is a component of GDP, to the effect
that a perfectly equilibrated trade balance makes the GDP dependent only on domestic values
(consumption, public expenditure, investments). A simultaneous increase of both imports and exports
by the same amount leaves unaltered the trade balance. Any difference in dynamics between exports
and imports has a multiplied effect on trade balance.

Composition
Trade balance is usually decomposed by product and by country (bilateral trade balances). Relevant is
the degree of concentration of the imbalance in trade caused by one or few commodities. If
concentration is high, a targeted industrial policy could improve the balance (e.g. reduce the
imbalance). On the other hand, if a deficit is due only to few partners, proactive and consensus-based
trade negotiations with them could fairly quickly set the problem. Although less general than trade
balance, which includes both goods and services, the "merchandise balance", which includes only
goods and not services, is sometime used because of better data availability.

Determinants
Everything that impact asymmetrically on imports and exports can impact the trade balance. In
particular price and non-price competitiveness is relevant. If external pressure forces down the prices at
which a country sells its exports, than a trade deficit is more likely ("terms of trade" effect). In other
words, in a hierarchical world, trade balance can reflect political balance of power. A faster GDP
growth than trade partners' ones usually results in trade deficit, since imports are elastic to GDP (they
rise more than proportionally). Currency exchange rate can be very important: possibly due to a fixed
exchange rate and a higher inflation rate than commercial partners, an overvaluation of the domestic
currency can lead to deep trade deficits on most products and with most countries. A sharp devaluation
can dramatically improve all these relationships. If financial transactions are particularly intensive and
autonomous, an inflow of FDI can lead to higher imports (of production inputs for the new foreign-
owned plants), also because of revaluation of currency. Hopefully, this short-run effect will be
balanced by more exports in the future. In these cases, trade balance is adjusting to financial
movements.

Impact on Other Variables

Trade balance is a component of GDP: other things equal, a surplus increases GDP and deficit reduces
it. If this impact is strong enough, it gives rise to the traditional Keynesian multiplier effect with
consumption moving in the same direction. In financial terms, trade balance influence the total size and
the composition of the current-account balance and, more broadly, it influences the balance of
payments (which comprehends not only the trade balance but also income payments, loans and aid
from abroad, etc). In particular, long-lasting trade deficit can lead to foreign debt, on which a country
has to pay interests. If this debt is judged by market agents as unsustainable, a currency crises can
erupt. Even before that this perspective materialises, the government can be induced to dampen GDP
growth.

Long-term Trends
In order to reduce the gap with rich countries, poor countries have to rise much faster than them, which
are usually their main commercial partners. But this leads to trade deficit, which risks jeopardizing
growth with alternate phases of "stop-and-go".
17 Sulaiman D. Muhammad

Business Cycle Behavior

Trade balance tend to be strongly anti-cyclical: in boom periods it usually exhibits deficits, whereas in
recessions a trade surplus can help inverting the business cycle. The reasons are explained in depth
here and here.

IV. Data & Methodology

In data analysis, I will use E-Views to Check the Long-run & Short Run relationship; I will use
Johnsan Co-integration & ECM respectively. Time period is twenty eight years from 1980-2008.

Data Types (Secondary) and Source

1. TD (Exports-Imports) Economic Survey Of Pakistan,
2. Household consumption expenditure (IFS-IMF),
3. Foreign Direct Investment (IFS-IMF),
4. Real exchange rate (IFS-IMF)
5. Foreign Income or income from the rest of the world (IFS-IMF)
6. GDP (gross domestic product) IFS-IMF

Selection of Variables
This study is very distinct on segment of selection of variables. Because variables select, do not only
identified by theoretical framework or review of literature. As this is a first study in case of Pakistan
and in model specification two main variables GDP and G (government expenditures) are not taken
because some major reasons. As our government expenditure figure is not transparent or funds are not
allocated properly. As GDP is also ignored due to unreliable or politically manipulated information.

Model Specification
TD = β 1 + β 2 Yw + β 3 HC + β 4 FDI + β 5 RER
TD: Trade Deficit
Yw: Foreign Income
HC: Household consumption expenditure
FDI: Foreign Direct Investment
RER: Real Exchange Rate

Relationship Among Variables

TD
It is a trade deficit. It is multiplied by -1 to have positive values.
Yw:
It is a foreign income determined by taking average of GDP’s of USA, UK, Kuwait, UAE and
India. As Yw increases they will import more from Pakistan. Hence, have negative impact on
trade deficit.
HC
As Consumption increases, imports increases which results higher trade deficit. Hence, have
positive impact on trade deficit.
RER:
It is to eliminate the effect of nominal exchange rate and Inflation (PPP). As RER increases
(Devaluation), imports become expensive than exports. Encourage exports. Hence, have
negative impact on trade deficit
FDI:
Determinant of Trade Deficit: Case Study of Pakistan 18

Short run net effect is positive due to production lag, and LR effect is negative.

V. Result Analysis
Recent development in the field of econometrics showed that most of macroeconomics variables series
are non-stationary as says above. The influence drawn such regression is spurious and unreliable if the
variables are not stationary or other words we says integrated on different order. Thus it is important to
check stationary of the variables of time series data before examining the long run relationship between
these variables.

Table 2: Augmented Dickey-Fuller test Statistic

First Difference (with intercept and

Variables Level (with intercept and trend)
trernd)
TB (trade deficit) -3.2568 -4.63425*
Yw (Foreign Income) -2.2144 -4.27541*
HC (House Hold Consumption) -1.8897 -4.72084*
FDI (foreign direct investment) -0.2566 -3.24498*
RER (real exchange rate) -2.3336 -7.04578*
*significant level at 5%

The table no.1 shows the result of unit root test obtained from using of augmented dicky fuller
(ADF) test. The result shows the non stationary is presented in all variables. The null hypothesis that
the series are non stationary is accepted at the level of all variables at the 1% significant level at most.
We have used equation to check the stationary in the variables is with trend and intercept. After check
the stationary at level and our result shows that there is non stationary in the data we check stationary
now on second difference here our result shows that all the variables is stationary at second difference
here again we used equation of ADF with trend and intercept. In brackets values shows the lag length
of difference variables. All variables are integrated at order one i.e. is I(1)
After analyzing the stationary in the variables and result shows the data is integrated at order
two our next step to check the long run relationship between variables is exist or not in this purpose we
have used the Johansen co integration test. The result of Johansen co integration test shows below

Table 3: Shows Johnsen co integration test

Null Hypothesis Alternative Hypothesis Trace Statistics Critical value at 5%

r=0 r=1 120.886* 88.8038
r=1 r=2 67.99299* 63.8761
r=2 r=3 37.64353 42.91525
r=3 r=4 15.85919 25.87211
r=4 r=5 6.760108 12.51798

Table no 3 shows the result of co integration test. The johansen- Juselius co integration test
shows that on all these seven variables are co integrated of six vector as we saw above table no. 3 and
both maximum trace statistics and maximum eignen value says r=6 co integration equation. Optimal
lag of VAR structure model is 2 lag by using Shewariz criterion. So result shows six co integration
equation in the VAR model shows long run relationship between variables.
19 Sulaiman D. Muhammad
Normalized Coeffienct of First co Integration Vector

Variable YW HC FDI RER C

Coefficient -1.47092 3.82925 0.572093 13.6317 -2120.27
Std. Error 0.363649 0.839875 0.271015 3.995172 1058.401
t-Statistic 4.04488 4.55931 2.110928 3.412044 -2.00327
Prob. 0.0005 0.0001 0.0454 0.0023 0.0566

the coefficient of foreign income is negatively effect on trade deficit as foreign income increase it can
cause reduce trade deficit because it can positively influence our export which can reduce trade balance
deficit. Coefficient of House hold consumption is positive and significant shows that as house hold
consumption increase it can cause to increase trade deficit because increase in house hold consumption
cause less goods available for export and increase import which can increase trade deficit. Variable of
FDI is effect positively on trade deficit as FDI flow increase the goods which we import is now
produced domestically through multinational corporation it can reduce import and positive impact on
trade balance. Finally coefficient of real exchange rate is also impact positively as real exchange rate
deprecate it can increase trade balance to wards surplus.

Table 4: ECM(Short-rum Relationship)

Variable D(YW) D(RER) D(HC) D(FDI) C U(-1)

Coefficient 1.546756 2.365805 -3.95306 0.566236 -41.9586 -1.02459
Std. Error 0.357609 11.51858 1.166076 0.267988 187.0118 0.24278
t-Statistic 4.325267 0.20539 -3.39006 2.112913 -0.22436 -4.22025
Prob. 0.0003 0.8392 0.0026 0.0462 0.8245 0.0004

Results of ECM represents that, in shot-run there is disequilibrium. Equilibrium will be attained
at 102% speed of adjustment.

VI. Conclusion
From the findings of this study and under the guidance of the previous studies, I have found out that
the variables taken as determinants are in accordance with theoretical framework. Main contributing
factors for the persistent trade deficit of Pakistan are household consumption expenditures, real
exchange rate and foreign direct investment. Where as foreign income, which is the average of GDP’s
of Pakistan’s trading partners contributes to decrease the trade deficit of Pakistan.

VII. Policy Recommendations

According to Viqar Ahmed and Rashid Amjad in their book “Management of Pakistan Economy”
gives theoretical basis for trade policy. In which they have taken two scenarios. First is import and
local production, which refers that you import production equipment or machinery to support your
local production. Second is to export and domestic consumption it refers that you export primary good
in case of agrigarian economy and domestic consumption through imports and agri products. These
two scenarios will be foundation of our policy making. Instead of Import & Local Production, Export
& Domestic Consumption We must go for Import & Export (to Incash Gawadar port).
There is following step should be taken to rise our export to international market.
Pakistan exports are concentrated in the few items. More than 75 percent of the exports are
originating from the cotton, leather, rice and sport goods. There is need to diversify our exports by
moving gradually to the exports of steel, electronics, chemicals and other engineering goods. The
Asian economies like Japan, Taiwan, Hong Kong, Malaysia, India and Korea started with the sharp
Determinant of Trade Deficit: Case Study of Pakistan 20

increase in the exports of textile and then progressively shifted to the capital intensive production of
electronics and other light and heavy engineering goods.
• Foreign Direct Investment in the export sector plays key role in export promotion. The foreign
investors are integrated into the marketing, distribution and supply management networks of
their home countries thereby helping to capture the international market. China’s clothing
industry, through large inward FDI is heavily integrated into the global distribution systems and
has direct involvement of OECD retailers which give it a comparative edge over its
competitors. Today FDI in Pakistan is concentrated in the oil and gas sector,
telecommunication and financial sector. The attraction of FDI in the export sector can be
beneficial in terms of technology transfer, skill development of the local labor and marketing.
• The Government should provide the strong infrastructure to the exporters like transport and
communication, roads highways, powers and well functioning ports. The weaknesses in the
infrastructure like the transportation failures and frequent power break down interrupt the
production processes making it difficult for the exporters to meet their delivery time lines.
• The imposition of punitive antidumping duty on bed wear exports together with loss of GSP in
the EU market has affected our exports adversely. The Government has an important role to
play in this regard by providing the exporters a level playing field in the major countries and
regions through effective trade diplomacy.
• The countries across the world are engaging themselves in the different regional and bilateral
trading agreements to get the preferential or free market access. The Government should also
enter into such Preferential Trade Agreement (PTAs) and Free Trade Agreement (FTAs) along
with successful implementation of the agreements already entered.
• The increase in the per capita productivity has become necessary in the textile and clothing
sector to compete with China and India in the Post Multi fiber Arrangement (MFA) period. The
increased education facilities, on-the job training, skill up gradation and dissemination of new
knowledge and techniques go a long way in this regard.
• The reluctance of Pakistan’s exporter to ensure compliance with environmental standards and
labor standards agreed under international codes and agreements also hits their exports
adversely particularly in the areas of fish and fish preparation. They should become fully
compliant with the requirements of the advanced economies buyers and governments.
• The anecdotal evidence suggests that cost of doing business in Pakistan is relatively high as
compared to its major competitors mainly on account of the high utility charges. In particular
the high value added textile items have started showing signs of slow down in the international
market on account of tough competition from China and India. According to the market sources
Pakistan’s competitor countries are subsidizing their exports at the rate higher than that of
Pakistan. Pakistan should also simplify the tax and tariff regime for exporters and consider
other subsidizing measures to provide level playing field to its exporters.
• The Small and Medium enterprises (SMEs) in Pakistan are playing a key role in production of
exports. They performance can further be improved by integrating them into an organized
production network for exports. The formal sector, through strategic alliances, subcontracting,
and outsourcing can help the SMEs to materialize productivity gains.
21 Sulaiman D. Muhammad

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