Research Report

Trade Openness vs. Growth in Pakistan

MBA (Ex.) I.D. # 6922 Institute of Business Management September 2010

By Imran Mustafa

Trade Openness vs. Growth

ABSTRACT

The most controversial topic over the past two eras is Trade Openness and its impact on gross domestic growth GDP. Mainly in last decade, Trade Openness (FDI, Volume in Export and Import, Tariff Rate, Government Policy and Tax rate) increased stridently. It Impact has been discussed in this research report on various components of GDP such as Agriculture, industrialization and Service sectors. The expected results of the study are found positive and significant relationship between variables. Policy recommendations have also been suggested in the view of results obtained, with respect to trade openness in Pakistan.

Introduction
Trade Openness has gained meaning in the last two decades primarily in developing countries and consequently in developed countries. Economists have given numerous statements about the impact and affects of FDI and Free Market on countrys growth. When we argue about closed economy, where no admittance of foreign savings, investment is exclusively financed by domestic savings. However, if we are discussing about open economy we must keep it in mind that in open economy investment is financed via various sources such as domestic saving as well as foreign capital flows which primarily includes foreign direct investment.

1.1. FDI Policy in Pakistan

Preference of foreign investor always inclines towards those countries / economies who actually provide them infrastructure and constructive policies for investments. Attractive policies form the economies also support foreign investors in providing precise direction for investments. In the previous decades especially in 60s and 70s, foreign investment was not allowed in the service sectors such as banking, insurance & commerce as well, however at present we have come across the fact that service industry plays integral part in circulations of economic engine particularly in developing countries. Initially joint ventures in collaboration with local investors were allowed in only those sectors where advanced technology, technical skills, and promotion techniques were required. In 80s establishment of Export Promotion Zone (EPZ) proved that government was giving more significance to this and also encouraged overseas Pakistanis in sending their investment in EPZ Earlier than 1991 FDI inflows in Pakistan were insignificant due to regularity polices towards FDIs. However, post 1991, under the revised policy frame work; it was assumed that the large function would be participated in development of country with respect to FDI. Conversely, Flow of FDI towards Pakistan was slower than other developing countries in Asian region.

1.2. Trade Liberalization

Post 1988 Pakistan gradually started focusing on trade liberalization, from 1988 to 1995, the momentum was very slow, however WTO provoked Pakistan to reduce duties on import and abolish a range of subsidies. Pakistan also focused on export orientation policy and condensed import substitution in order to increase countrys growth. In this paper, I analyzed the impact of Trade Openness on growth (GDP of Pakistan) for the period ranging from 1970-1971 to 2009-10. Paper consists of five segments. Next segment consist of literature review. Segment- 3 depicts the model and data sources. Segment 4 reports the estimation results while using diverse statistical tools. Eventually in segment 5, conclusion is given based on results proved by using statistical tools.

2. Literature Review
(Ahmad & Butt 2003) they estimated the fundamental relationship between FDI, export and output while using Granger non-causality period ranging 1972 to 2001. They also found positive effect from FDI to GDP growth. (Blomstrom 1994) examined relationship between FDI and GDP growth he took sample of seventy eight developing and twenty three developed countries he splited developing countries into two groups based on per capita income level. The impact of FDI on growth was found insignificant on the group which had low capita income. He also concluded that developing countries find compleity in using new technologies of developed countries. (De Mello Jr Luiz R. 1999) perfomed time series and panel data estiamtion. He took sample of fifteen developed and seventeen developing countries period ranging 1970-1990. His study found strong relationship bwtween FDI and output growth. The time series estimations concluded that impat of FDI on GDP or on capital accumulation and Total Factor Productivity TFP contrasts across the countries. The effect of FDI on capital accumulatin and TFP were found inconsistent across developed and developing countries. FDI has a positive impact on TFP growth in developed countries, however a negative impact in developing countries but he found reversed impact on capital accumulation. He conclued that growth depends on the degree of complementarity between FDI and domestic investment, as developing countries may find complexity in using up-coming techlologies of developed countries. Edwards (1992) In order to analyze relationships between trade openesss and GDP grwoth edward used cross country data. In the model two basic elements i.e. meassures of trade policy (tariff & non Tariff Barriers NTB) & Trade intervention and confined the degree to which trade policy distorted trade. While using OLS he found signficant relations between trade openess and GDP, however the indicator of trade invervention index was found nagatively connected with GDP growth. (Siddiqui, Amir Hussain and Iqbal, Javed 2005) they used model of sinha (2002) which indicates that GDP growth has three components, trade grwoth, population growht and investment growth. They found long run negative

relationship between trade growth and GDP growth. While taking seprate figures of the total trade volume in export and import they found insignificant positive relation. However, positive & significant relation was found between Investment and GDP. (Shabbir & Mahmood 1992) they analyzed relationship between foreign private investment and GDP in pakistan period ranging 1959-60 to 1987-88 and found postive impact/relationship on GDP (Sinha 2000) examined effects of trade openness and investment on GDP for fifteen Asian countries period ranging 1950-1992. Three components were taken into account in the model i.e. import + export, domestic investment and population and Auto Regressive Model (ARMA) results showed positive and significant relation between the factors however, weak relationship was found between GDP growth and population growth. (Yanikkaya Halit 2003) eximined the impact of trade openess on per capita for 120 countries period ranging 1970-1997. Two types of measures were used in the model. The first one was trade voulems (import + export). Another measure was based on trade restrictiveness by calculating restrictions on payments and existing trasactions. Generalize method of movement estimations showed positive relation with per capita GDP and research counclued that trade restriction can impact on GDP growth positively as well as negatively

3.

Empirical Analysis
Model & Data

I have used Multiple Regression and Granger causality Analysis, which state that GDP growth has two growth components i.e. Foreign Direct Investment FDI and trade growth (total volume). However, I have eliminated volume of import in order to avoid multicollinearity in the independent variables. Assumptions of Regression Model Statistical tests rely upon certain assumptions about the variables used in the analysis. Such as: Llinearity of the relationship between dependent and independent variables No multicollinearity exist in the data i.e. Independent variables have no correlation with each other No heteroscadicity heteroscedasticity exist in the data i.e. Error term have equal variance. Normality of the error distribution R2: In Regression Analysis, the coefficient of determinations measures the proportion of the total variation in the dependent variable that is explained by the variation in the independent or explanatory variables in the regression. Durbin-Watson (DW) stat: DW test is used to identify the existence of autocorrelation in the residuals (statistical errors) from a regression analysis. Adjustment involves avoiding autocorrelation includes: inclusion of time, additional explanatory variable to take in to consideration, inclusion of important missing variable into the regression, or the re-estimation of the regression in nonlinear form. In the below model there exists a evidence of positive serial correlation since the DW value was 0.2 with the actual data to overcome this issue I have taken Log of all variables Multicollinearity: refers to the situation in which two or more explanatory variables in the regression are highly correlated. In order to avoid multicollinearity I have removed the data of import (volume), as there is a strong relationship between FDI and import. (Telecommunication industry is one the best example in this context). Heteroscedasticity: It arises when the assumption that variance of the error term is constant for all values of the independent variables is violated. To overcome this issue I have taken log of explanatory variables. Prob (F-Statistics): The null hypothesis of F-Statistics is: the overall model is not significant and we always aim to reject this hypothesis by getting P-value of F-

Statistics less the (level of significance i:e 0.05) Shows the significance of overall model

Equations for Regression Model: Y = b0 + b1FDI + b2EXP (a) AGRI = b0 + b1FDI + b2EXP (b) IND = b0 + b1FDI + b2EXP (c) SER = b0 + b1FDI + b2EXP (d) Where Y refer to total GDP growth, AGRI to Agriculture, IND to Industries, SER to Services, FDI to Foreign Direct Investment and EXP to Export. The research mentioned above estimated the impact of trade openness on GDP for Pakistans data ranging 1970 2010 post separation of East Pakistan.
Data for Y, AGRI, IND, SER, FDI and EXP is in log form. Data collected from official web site of state bank of Pakistan SBP www.sbp.org.pk GDP data is in real growth term (constant factor - PKR) base year 1999-2000; however, for other variables such as FDI & Total Export, I have taken exchange rate of the corresponding year in order to convert USD (fig.) into PKR.

Estimation Results (from equation a to equation d) Impact of FDI & Export (volume) on GDP (a)

Y = b0 + b1FDI + b2EXP GDP = 10.96 + 0.0235*FDI + 0.2976*EXP Statistics value (170.26) (4.71) (34.57) P Value (0.0000) (0.0000) (0.0000)

(a)

Equation (a) shows that all the independent variables are significant at 95% level of significance. Coefficients define that 1% increase in FDI will increase the GDP by 0.0235% and 1% increase in Export volume will increase GDP by 0.2976% remaining all other factor constant. While conducting test it is found that coefficient of determination, or R2 is 0.99 this shows that variation in the FDI & Export explain 99 percent of the variation in the GDP growth and this is greater than the R2 0.84 that was obtained from the previous model in which import volume was also included.

While performing DW test it is proved that, there is an existence of autocorrelation i.e. 0.89, in the residuals, which can be overcome if the assumptions, related to DW test are catered. Prob (F-statistics) shows the significance of overall model. While performing regression analysis I have also found the significance of the overall model as the Pvalue of F-Statistics is 0.0000.

Impact of FDI & Export (volume) on Agriculture Sector (b)

Y= b0 + b1FDI + b2EXP GDP = 10.5030 + 0.0130*FDI + 0.2321*EXP Statistics value (143.75) (2.298) (23.75) P Value (0.0000) (0.0273) (0.0000) (b)

Equation (b) shows that all the independent variables are significant at 95% level of significance. Coefficients define that 1% increase in FDI will increase the GDP by 0.0130% and 1% increase in Export volume will increase GDP by 0.2321%. Equation (b) gives following indicators: R2 0.99 i.e. 99%, DW 0.81, & F-statistics 0.00000 there is only difference in DW test else the assumption of the equation b as same as equation a.

Impact of FDI & Export (Volume) on Industrial Sector: (c)

Y= b0 + b1FDI + b2EXP (c) GDP = 9.4903 + 0.02879*FDI + 0.2998*EXP Statistics value (86.5126) (3.3891) (20.4511) P Value (0.0000) (0.0017) (0.0000) Equation (c) shows that all the independent variables are significant at 95% level of significance. Coefficients define that 1% increase in FDI will increase the GDP by 0.02879% and 1% increase in Export volume will increase GDP by 0.2998%. Equation (c) gives following indicators: R2 0.98 i.e. 98%, DW 0.90, & F-statistics 0.00000 slight change in R2 and DW from the previous test however, overall model is significant.

Impact of FDI & Export on Service Sector (d)

Y= b0 + b1FDI + b2EXP GDP = 9.7586 + 0.0273*FDI + 0.3356*EXP Statistics value (103.1246) (3.7270) (26.5367) P Value (0.0000) (0.0006) (0.0000) (d)

Equation (d) shows that all the independent variables are significant at 95% level of significance. Coefficients define that 1% increase in FDI will increase the GDP by 0.0273% and 1% increase in Export volume will increase GDP by 0.3356%. Equation (d) gives following indicators: R2 0.99 i.e. 98%, DW 0.54, & F-statistics 0.00000 slight change in R2 but signification change in DW. The basic aim to conduct regression analysis on all of the equations is to identify the impact of independent variable on all the components of GDP i.e. Agriculture, Industries & Service. All equations prove the significance in relationship between independent and dependent variables, post considering key factors for the regression analysis.

Granger Causality It is a technique for concluding whether one time series is

valuable in forecasting another one. While performing granger causality I have found contradiction in results from regression analysis. Granger causality test shows the contradictory relation between FDI, Export and GDP i.e. FDI & export does not cause GDP conversely, GDP does cause FDI & Export. While performing Granger causality test it has observed that GDP does not significantly depends on FDI and Export but these two variable depends on GDP so in the regration analysis the selection of dependent and independent variable might be reversed to get actual picture, in both analysis regression and Granger causality it has proved that there is a relationship between GDP, FDI and export

Conclusion
Whether FDI & Export cause GDP or GDP cause FDI & Export, I have found positive relationship between these variables. I recommend government must focus on its internal factors and try to improve them gradually such as infrastructure, reduction in corruption, stability in political environment, safety and security, health issues and provide fundamentals to their residences. It certainly increases confidence level of the investor and investor will attract towards country in order to invest in different projects, eventually that help in boosting growth of an economy.

References
Ahmad & Butt 2003,"Foreign Direct Investment, Export, and Domestic Output in Pakistan",The Pakistan Development Review, 715-723. Blomstrom, Magnus, Robert E. Lipsey, and Mrio Zejan 1994, What Explains the Growth of Developing Countries? Oxford University Press, New York; 243-256. De Mello Jr Luiz R.1999,"Foreign Direct Investment in Developing Countries and Growth: A Selective Survey",evelopment Studies, 34(1), 1-34. Edwards, 1992,Trade orientation, distortions and growth in developing countries. Journal of development Economics 39, 31-57. Siddiqui, Amir Hussain and Iqbal, Javed Karachi University, 2005 "Impact of trade openness on output growth for Pakistan: an empirical investigation" Market Forces April 2005. Shabbir & Mahmood 1998 "The Multinational's Economic Penetration, Growth, Industrial Output and Domestic Savings in Developing Countries: Another Look", Development Studies, 55-82. Sinha2000,"Openness, Investment and Economic Growth Asia",Indian Economic Journal 49, 110-117. State Bank of Pakistan, Annual Report (various Issues) Yanikkaya 2003,"Trade Openness and Economic Growth: a cross country empirical investigation",Development Economics 72, 57-89. World Bank, Various issues, World Development Indicators