Journal of Sustainable Finance & Investment

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The role of globalization in financial development,

trade openness and sustainable environmental -
economic growth: evidence from selected South
Asian economies

Ankasha Arif , Misbah Sadiq , Malik Shahzad Shabbir , Ghulam Yahya , Aysha
Zamir & Lydia Bares Lopez

To cite this article: Ankasha Arif , Misbah Sadiq , Malik Shahzad Shabbir , Ghulam Yahya ,
Aysha Zamir & Lydia Bares Lopez (2020): The role of globalization in financial development, trade
openness and sustainable environmental -economic growth: evidence from selected South Asian
economies, Journal of Sustainable Finance & Investment, DOI: 10.1080/20430795.2020.1861865

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JOURNAL OF SUSTAINABLE FINANCE & INVESTMENT
https://doi.org/10.1080/20430795.2020.1861865

METHODOLOGY AND POLICY

The role of globalization in financial development, trade

openness and sustainable environmental -economic growth:
evidence from selected South Asian economies
Ankasha Arifa, Misbah Sadiqb, Malik Shahzad Shabbirc, Ghulam Yahya d
,
Aysha Zamire and Lydia Bares Lopezf
a
Department of Economics, University of West London, RAK Branch campus, Dubai, United Arab Emirates;
b
Department of Economics, Al-Qasimia University, Sharjah, UAE; cDepartment of Management sciences,
University of Lahore, Lahore, Pakistan; dDepartment of Management sciences, The University of Azad
Jammu and Kashmir, Muzaffarabad, Pakistan; eDepartment of Economics, University of Karachi, Karachi,
Pakistan; fUniversity of Cadiz, Cadiz, Spain

ABSTRACT ARTICLE HISTORY

The aim of this study is to examine the association of financial Received 17 September 2020
development, trade openness and sustainable environmental- Accepted 7 December 2020
economic growth among the South Asian countries. This study
KEYWORDS
also identifies which particular country experience more Globalization; financial
sustainable economic growth in the region. This study collects development; trade
panel data set range from 1980 to 2018 from World Development openness; sustainable
Indicators and uses autoregressive distributive lag method for environmental growth;
data analysis. The results reveal with these remarks that financial south Asian countries
development has a positive and significant impact both in long-
and short-run dynamic on environment economic growth of JEL Classifications
South Asian economies. However, trade openness results E10; E12
regarding pooled mean group, Mean group and common
correlated effect mean group are also a positive effect on
economic growth. This study is the first-ever attempted for
globalization effects to investigate a combined impact on
financial development and trade openness on sustainable
environmental economic growth regarding South Asian
economies.

1. Introduction
The sustainable development goals (SDGs) of United Nations also has a multi-dimen-
sional agenda requiring a strong integration among all stakeholders in the development
process to ensure sustainability.1 The sustainable economic growth needs to be ensured
in such a manner that environmental safety is not compromised as per the Kyoto Proto-
col (1997). There is a need for high pace of transformation of economies and financial
institutions and less reliance on the fossil fuel and non-renewable energy resources.
The need of better practices of production of commodities that ensures environmental
safety, trade of the commodities which incorporate healthy production and environ-
mental safety standards, less pollution of air, soil and water created by the industries

CONTACT Malik Shahzad Shabbir mshahzad786.pk11@gmail.com

This article has been republished with minor changes. These changes do not impact the academic content of the article.
© 2020 Informa UK Limited, trading as Taylor & Francis Group
2 A. ARIF ET AL.

and financial investments have become important areas of concern and major challenges
in the current era of globalization.
The South Asian economies are thriving hard to improve it economic growth and to
ensure that the SDG is achieved by them. Almost all South Asian countries have launched
different short- and long-term economic plans such as nationalization to stabilize their
economies. Whereas some countries among south Asian have made liberalization of
their economies in order to make upsurge in their growth level. However, Pakistan is
also one of them, who introduced nationalization program after Bangladesh partition
in 1971. Furthermore, Pakistan and Bangladesh have made liberalization of their
economy in 1990 and India prepared it in 1991 to attain the certain economic objectives.
The liberalization restrained subsidized to reduce policy-induced anti-export bias at a
modest level Shabbir (2019). Shahbaz (2012) analyzes the long-run effect of international
trade on economic growth in the long run, using econometric estimations to empirically
investigate the effects in details by using the Cobb-Dauglas’ framework and the sup-
plementary determinant for economic growth is taken as financial development and
the study supports feedback hypothesis. Moreover, the study also provides support to
the growth-led-import hypothesis.
It is important to study the relationship between the financial development, trade open-
ness and sustainable environmental-economic growth in the context of globalization. The
governments cannot target the sustainable growth in future if they are not able to identify
the linkages between the key economic variables. Different researches have been published
in this field; for example, Tsai (1994) investigated the demand side regarding FDI determi-
nants and its consequences on growth level from 1975 to 1978 for 62 countries and from
1983 to 1986 for 51 countries. The study finds that market size hypothesis is more appli-
cable for the given samples than the growth hypothesis. Hence, this highlights the impor-
tance of the trade balance and its association with the FDI influx, where more deteriorated
trade balance create more favorable approach toward FDI in both time periods. The export
growth rates lead to the economic growth in the seventies but domestic saving acted as the
main contributor of growth in the eighties time period and the study does not support the
modernization and dependency hypothesis.
The South Asian region has a significant importance in the global map due to natural
resources, large population size and geo-strategic locations. The Indian economy has
been a new center of attraction over time because of its growth potential and impact
on the global economy. This region has a potential to improve productivity, financial per-
formance, sustainable environment and economic growth and to become the fast-
growing region in the world economy given the government policies are supportive.
Hence, the current study aims to identify the interlinkages among financial development,
trade openness and economic growth for the region of South Asia. As each country in
South Asia has its own growth potential, hence this study contributes by investigating
which particular country attain these benefits properly to adhere the economic growth
level toward rapid upsurge through financial development and trade circle. This will
provide important policy implications for governments to identify their growth trajec-
tory based on the empirical evidence. This study measures several panel causality tests
in order to give exact relative picture for growth level among these countries.
The study finds that market size hypothesis is more applicable for the given samples
than the growth hypothesis. Hence, this highlights the importance of the trade balance
 JOURNAL OF SUSTAINABLE FINANCE & INVESTMENT 3

and its association with the FDI influx, where more deteriorated trade balance create
more favorable approach toward FDI in both time periods. Moreover, cheap labor
cost hypothesis showed a discouraging trend in FDI, when there is as increase in
nominal wages in eighties time period. The export growth rates lead to the economic
growth in the seventies but domestic saving acted as the main contributor of growth
in the eighties time period and the study does not support the modernization and depen-
dency hypothesis. The current study aims to identify the interlinkages among financial
development, trade openness and economic growth for the region of South Asia.
However, this particular region has significant importance in global map due to
natural resources, geographical locations and certain hidden factors. This study investi-
gates which particular country attains these benefits properly to adhere the economic
growth level toward rapid upsurge through financial development and trade circle.
This study measures several panel causality tests in order to give exact relative picture
for growth level among these countries.

2. Analysis of the GDP per capita, financial development and trade of the
South Asian economies
In this section, we would briefly discuss about the financial development, trade and
income of the South Asian economies. Real GDP per capita is shown in Figure 1. Sri
Lanka has experienced high income after 1997.
The economy started as the rural one but transition to manufacturing and service
sector took place.2 The increase in the income has reduced the “National poverty head-
count ratio’ to 4.1% in 2016 from 15.3% in 2006/2007. The end of conflicts with the rebels
and peace has increased the chances of prosperity for the country. India has also experi-
enced an increase in the income after 2004 onwards. The development of the manufac-
turing and service sector along with the investment in information technology have
increased the chances of sustainable economic growth many folds. For other countries

Figure 1. Real GDP per Capita of South Asian Economies. Source: World Bank data.
4 A. ARIF ET AL.

of South Asia, improvisation is seen over the period of time but Maldives has experienced
low level of income in the South Asian region.
The financial development index is shown in Figure 2. This index is showing a com-
bined effect of depth measured by the liquidity and size of market, access related to the
accessibility of financial services for the individual and companies and lastly efficiency
incorporating the domains of improvisation of the financial institutions that can lead
to the better supply of financial services in a least costly way which can lead to sustain-
ability of revenues and management of the level of transactions in the capital markets.
The highest trend is shown by India where the financial markets are opening up more
to enhance the business-related activities. In 1980s, the financial markets were regulated
in India and more openness was experienced by India and could not improve much but
later liberalization and the deepening of the financial activities enhanced the financial
openness in India.
The improvisation of trend is followed by Pakistan. From 2001 to 2006, deepening of
primary and secondary markets took place and volatility of short-time interest rate
reduced (State Bank of Pakistan 2002). Pakistan Investment Bonds were introducing
which improved the position of the bond market then later supply could not be
managed that created issues in market and sustainability could not be achieved. Sri
Lanka has also improved the standing in the financial development index. The resolution
of the 30 years of conflict in the state in the mid of 2009 resulted in the boost of confi-
dence of the investors and the stability of the interest rate at a low level helped the
financial markets to grow (Central Bank of Sri Lanka, 2012). In Bangladesh, though
the financial development remains low by 1995, but it increased in the early later and
had a sharp decline from 2000. Financial markets in Maldives remain less open with
costly provision of credit.
Figure 3 shows the trade as a percentage of GDP of the South Asian Economies. The
highest level of trade is experienced by Maldives. The fishery sector, food industry and a
small proportion of export of iron, steel and cooper are adding up to the trade revenue for
the country. It is followed by the Bhutan having a reasonably high trade as a percentage of
GDP. The patterns of trade fluctuate for Bhutan with an increase in 1989 and a dip in

Figure 2. Financial Development of South Asian Economies. Source: World Bank data.
 JOURNAL OF SUSTAINABLE FINANCE & INVESTMENT 5

Figure 3. Trade as a Percentage of GDP in South Asian Economies. Source: World Bank data.

early 1990 but Bhutan recovered and started to show a stable growth rate which again
increased in 2005 and gradually decreased over the period of time. Sri Lanka showed
comparatively stable growth rate by 2000 and then trade starts to reduce. With the
passage of time, Nepal also experienced a reduction in trade after 2004 though the
trade patterns were high in 1990s. Bangladesh has shown an increase in the trade after
2004 onwards with a booming textile sector. The trade patterns of Pakistan showed
that in the current times, trade has declined amid the energy crises and less export of
the high-value finished goods. India has shown an upward trend in 2002 onwards and
experiencing a moderate level of trade.

3. Literature review
The several studies such as Arellano and Bover (1995) and Blundell and Bond (1998)
Generalized Method of Moments panel estimates, Habibullah and Eng (2006) and
Shabbir (2017) test the causality between financial development and economic growth
for 13 Asian developing economies using pooled cross-sectional and time series data cov-
ering from 1990 to 1998. The causality was measured through the indicators such as ratio
of domestic credit to GDP and real GDP. The same results are obtained by few more
researches (i.e. Fase and Abma (2003); Shabbir (2020) and Christopoulos and Tsionas
2004). A strong support exists for the King and Levine (1993a, 1993b) and Smarzynska
Javorcik (2004) contention stating ‘financial depth contributes more to the causal
relationships in developing countries’. The results highlight a strong association
between financial intermediation to endorse growth rate, specifically for nine economics
of the selected developing countries.
Anwar and Sun (2011) have developed a theory regarding financial institution-based
development and used simultaneous equation-based structural model to empirically
measure the association between economic growth, international investment stock and
domestic capital stock in Malaysia. The results reveal a significant impact regarding
financial development and domestic capital stock on growth rate. Moreover, these
results indicate that an increase in international investment stock upsurge the domestic
6 A. ARIF ET AL.

stock. However, there is a robust impact regarding exchange rate and degree of openness
on the stock of foreign investment. Furthermore, the human capital stock has a potential
to improve the growth rate, while expenditures of government have a negative impact on
growth level, which in-turn negatively affects the domestic capital stock. The study
suggests more improvements in the sector of finance and a reduction in government con-
sumption for economic growth in Malaysia.
Kim, Lin, and Suen (2010) study how the trade openness will influence financial devel-
opment by taking the panel data set of eighty-eight (88) countries for forty-five (45) years
period from 1960 to 2005. They measured the impact through three main indicators (i)
Private Credit, (ii) Liquidity Liabilities and (iii) Bank Assets and data were obtained from
WDI (2006), while the data related to financial development was taken from Financial
Structure Database. They divided the sample into two categories depending upon
income and inflation levels of the countries. For relatively lower-income countries,
findings highlight an encouraging long-term consequence regarding trade openness
along with some adverse short-run effects. Likewise, variations in inflation level yield
different results for both categories.
Ndikumana (2000) investigated the impact between local investment and financial
development for thirty (30) countries of sub-Saharan Africa from 1970 to 1995. The
study provides the support that financial development is significantly affected by the
private investment in Sub-Saharan countries. Results reveal negative effects of external
debt, black market premier, inflation and domestic borrowing of government on dom-
estic investment while international trade flows and per-capital GDP growth positively
contribute to domestic investment. The study highlight that more focuses on the
correct allocation of resources specifically for investment purposes would positively
affect the long-run economic growth. The study suggests a balanced expansion of
financial systems, policies with fewer costs of financial intermediation, supportive
environment for lending to investment purposes as significant contributors to domestic
investment and financial development.
Menyah, Nazlioglu, and Wolde-Rufael (2014) study whether the correlation exists
between the financial development and economic growth for twenty-one (21) Sub-
Saharan Africa (SSA) countries. The proxy used for the economic growth (RY) and
Trade openness (TO) are real GDP per capita and [(export + import)/GDP × 100%],
respectively. The findings of the study provided support only in one country regarding
the demand following hypotheses while results provide support for three countries
regarding supply leading hypothesis. The finance-led growth and trade-led growth
hypothesis are not supported by the results for these 21 SSA countries despite adopting
some advance policies for financial development and international trade. Sahoo and
Dash (2013) also empirically examined the role regarding development of financial
sector on ratios of national saving for five South Asian economies from the time
period start 1975–2010. They also divided the time period into two categories; the pre-
reforms period (1975–1991) and the post-reforms period (1992–2010). The finding of
this study highlights the leading development of financial sector for higher savings
mobilization in these South Asian countries.
Perera and Wickramanayake (2012) examined the financial market integration (stock
returns and bond return) in Bangladesh, India, Pakistan and Sri Lanka. The results show
positive evidence of long-term integration for these South Asian countries in comparison
 JOURNAL OF SUSTAINABLE FINANCE & INVESTMENT 7

to the under-developed economies. Sekkat and Veganzones-Varoudakis (2007) analyzed

the improved economic and political conditions with respect to FDI in developing econ-
omies. The finding of this study indicates the significance of openness and sound invest-
ment climate to attract FDI specifically for Africa, South Asia and Middle East countries.
The study also highlighted the stronger impact of these two determinants of FDI. Shabbir
(2018) suggests developing countries to initiate and enlarge their efforts for openness and
more creating more sound investment climate to attract more foreign investors.
Baloch et al. (2020) study the causal relationship between the environmental degra-
dation as ecological footprints and poverty for 46 Sub-Saharan economies for the
period of 2010–2016. The study finds a causal relationship exists between the variables.
A reduction in poverty is occurs when the economic growth and availability of the elec-
tricity increases but it leads to the degradation of the ecological footprints. Baloch et al.
(2019) examines the relationship between carbon dioxide emissions (CO2), poverty and
income inequality over the time period, i.e. 2010–2016 for forty Sub-Saharan countries.
The results suggest that CO2 emission increases when income inequality is more and the
environmental degradation increases with the increase in poverty.
The study is done for Saudi Arabia by Baloch et al. (2018) for the period of 1971–2016
to analyze the relationship between CO2 emission and the financial instability. The
findings suggest an insignificant impact of financial stability exist on the CO2 emission
and the consumption of electricity degrades the environment. The increase in income
from the oil and non-oil sources also leads to more environmental degradation.
Baloch et al. (2020) study the relationship between energy innovation, financial develop-
ment, economic growth and environmental pollution for Organization for Economic
Cooperation and Development (OECD) countries from 1990 to 2017. The findings
show that more financial development and globalization leads to better environmental
quality and more energy innovation and environmental Kuznet curve is applicable for
OECD countries.
Baloch et al. (2019) has studied the relationship between ecological footprints and
financial development for the panel of the 59 countries that are part of the Belt and
Road project from 1990 to 2016. The findings show that the ecological footprints increase
with the increase in the financial development. The ecological footprints increases with
more foreign direct investment, economic growth, energy consumption and urbaniz-
ation and these countries need to develop policies to reduce the environmental degra-
dation. Xu et al. (2018) explored the relationship between environmental degradation
and financial development by controlling the consumption of electricity and globaliza-
tion process for Saudi Arabia for the time period of 1971 till 2016. The study finds an
insignificant relationship between the environmental degradation and financial develop-
ment but pointed out electricity as a major source of degradation of environment and bi-
directional relationship between h = globalization and CO2 submission in the long run.

4. Theoretical framework
With the evolution of globalization, the financial development has paced up (Samimi and
Jenatabadi 2014) and many researchers are trying to explore the relationship between
financial development and economic growth. The ‘supply leading’ concept states that a
vital factor for the economic growth is the financial development so causal relationship
8 A. ARIF ET AL.

runs from financial development to economic growth. The size and the composition
financial development induce savings that increases the financial assets and leads to
capital formation which in turn ensures economic growth (King and Levine 1993). Alter-
natively ‘demand following’ concept emphasizes that financial development can be
enhanced by the economic growth. Solely the development in the financial sector does
not have the potential to lead an economy as it is merely a byproduct of the economic
growth (Robinson 1952). Financial sector will grow resulting in more institutions, pro-
ducts and services only when the real sector grows and risk diversification will take place.
The less developed financial market is an indication of less demand of financial products
in a country. Financial liberation in countries like China and Japan is not the leading
factor of growth and Asian economic crises create doubt about the strengths of
financial system to be a leading factor in economic growth (Shan 2005).
Yet another concept prevails that economic growth and financial development can
have casual effects and can reinforce each other i.e. ‘complementarity’ exists (Greenwood
and Smith 1997). However few researches found the non-existence of any relationship
between financial development and growth (De Gregorio and Guidotti 1995) hence sup-
porting the concept of ‘neutrality’. In research, the direction of the relationship varies
among studies and regions though long-run relationship exists between these factors.
According to the study of Agbetsiafia (2004), one-way causality exists running from
financial development to economic growth supporting supply leading concept.
Moreover, the relationship between trade and financial development is also examined
by the researchers. The interest groups having lesser incentive to welcome financial open-
ness will resist this openness but the country will grow in case of dual openness, i.e. trade
and capital flow. However, a mixed trend of the causal relationship exists in literature
(Wolde-Rufael 2009; Shabbir 2018; and Gries, Kraft, and Meierrieks 2009).
In the light of the above discussion relationship between economic growth (E), financial
development (F) and trade openness (T ) will be studied as shown in Equation (1).
Ei,t = bo + b1 Fi,t + b2 Ti,t + 1it (1)
The variables are taken in the natural log so the respective βs are the long-run elasticities,
whereas ε is the error term.

5. Methodology
This study has collected data for South Asian economies over the years 1980–2018 from
World Bank Indicators (World Bank) for the Panel data analysis. The countries under
this study are Bangladesh, Bhutan, India, Maldives, Pakistan, and Sri Lanka. The econ-
omic growth (E) is taken as real GDP per capita and trade openness (T ) is taken as
trade (import and export) as a percentage of GDP. The financial development index
(F ) is created as a proxy of financial development. Many variables can be considered
at a time to capture the essence of financial development and inter-linkages between
the financial products can create multicollinearity. Hence the formation of an index
appears to be viable step here so as to avoid the loss of information in the model. The
variables used in the construction of index by using principle component analysis are
log of M3 (as % of GDP), log of M2 (as % of GDP), log of total domestic credit to the
private sector and log of domestic credit to private sector by the banks. (Menyah,
 JOURNAL OF SUSTAINABLE FINANCE & INVESTMENT 9

Nazlioglu, and Wolde-Rufael 2014). The banking sector is a major player in the financial
dealings in South Asia hence these variables have a potential to capture the financial
aspects.
In order to analyze Equation (1), panel data methodology dealing with cross-country
differences is employed instead of taking traditional homogenous slope for countries. We
would use autoregressive distributive lag (ARDL) method to estimate Equation (1) under
the framework given by Pesaran, Shin, and Smith (1999). The slope heterogeneity is
tested followed by the test of unit root and integration. The methodology of pooled
mean group (PMG), Mean group (MG), and common correlated effect mean group
(CMEMG) is used to calculate short-run, long-run and error correction coefficients.
The data sets of large time period (T ) are available now so the countries can be estimated
separately (Blackburne and Frank 2007) and in case of large cross-sectional units (N),
slope homogeneity may not be the viable assumption (Pesaran and Smith 1995;
Pesaran, Shin, and Smith 1999; Shabbir and Wisdom 2020; Phillips and Moon 2000;
Im, Pesaran, and Shin 2003) hence panel data is categorized as heterogeneous due to
slope heterogeneity (Blackburne and Frank 2007).
The PMG and MG estimation methodologies are proposed by Pesaran and Smith
(1995) for the estimation of heterogeneous panel data. In MG model, all slope parameters
are estimated separately for each cross-section and mean is taken. This model allows vari-
ation across group in intercept, slope and error terms yielding estimates that are consist-
ent and reliable in case of large time series and cross-sections. However, the model is
reliable with small sample also (Jalil 2014) as setting of MG in ARDL framework
makes it more consistent compared to other autoregressive models (Pesaran, Shin, and
Smith 1999). The issue of endogeniety can also be tackled in this way if direction of caus-
ality is from economic growth to financial development.
ARDL model in our study is as under:

p

q
Ei,t = hi + li,j Ei,t−j + gi,j Zi,t−j + 1it (2)
j=1 j=0

whereas E is the level of GDP in ith group at t time. The fixed effect in data is captured by
hi and vector of explanatory variables i.e. financial index and trade openness is shown by
Zi,t−j . The first difference of Equation (2) can be rewritten as:

p−1

q−1
DEi,t = hi + ti Ei,t−i + si Zi,t + l∗i,j DEi,t−j + g∗i,j Zi,t−j + 1it (3)
j=1 j=0
p q p 
q−1
whereas ti = −(1 − li,j ), si = − gi,j l∗i,j = − li,m and g∗i,j = gi,j with
j = 1, 2, … ., p-1. j=1 j=0 m=j+1 m−j+1

Now grouping the variables in level would yield Equation (4):

p−1

q−1
DEi,t = hii + ti [Ei,t−i − ui Zi,t ] + l∗i,j DEi,t−j + g∗i,j Zi,t−j + 1it (4)
j=1 j=0

While long-run elasticities are shown by pi = si /ti and speed of adjustment to

approach long-run equilibrium is shown by ti .
10 A. ARIF ET AL.

In order to have consistent estimates of MG and PMG, it is important to test the slope
homogeneity assumption (Catao and Terrones 2005) to capture the cross-country
characteristics. Swamy (1970) proposes slope homogeneity test of panel data estimators
with T smaller than N. The modified version is proposed by Pesaran and Yamagata
(2008) which does not have restriction on T or N and is given below in Equation (5):

n ′
xi M − Xi2
S′ = (bi − b̃w ) (bi − b̃w ) (5)
i=1
p2

While Pooled Ordinary Least Square estimates are given by bi , weighted fixed effect esti-
mators are given by b̃w , identity matrix is defined as M and asymptotic normal distri-
bution is followed by the test.
The long-run estimators are same across countries whereas short-run slope estimates
may differ (Pesaran and Smith 1995) which is more relevant assumption our analysis
where the economic growth is explained through financial development and trade open-
ness. Mostly countries experiences the long-run growth path at a constant rate due to
technological transfer as explained by Hall and Jones (1999) (also see Parente and Pre-
scott 1994; Shabbir et al. (2020) and Eaton and Kortum 1996) hence the use of MG
and PMG and can be justified in this study and it would enable us to find the varying
intercept, slopes and error correction terms across the cross-sections. We would test
the stationarity, i.e. unit root test and integration. Cross-sectional independence is not
a suitable assumption in here as dependence can exist in the macroeconomic indicators
as explained by Urbain and Westerlund (2006).
This study uses the cross-sectional dependence (CD) test that is proposed by Pesaran
(2004). The null hypothesis states that no cross-sectional dependence exists between the
cross-section of panel where the test is given in Equation (6).

2T

N −1

N
CD = (( r̂ij) N(0, 1) (6)
N(N − 1) i=1 j=i+1

whereas estimate of the correlation coefficient of residuals is give as r̂ij which can be
further expanded as follows:
T
t m̂it m̂ij
r̂ij = r̂ij =  0.5  0.5 (7)
t=1 m̂it t=1 m̂ jt
T T

The stationarity has to be tested in the data set having more T than N as a check of spur-
ious correlation. The unit roots tests for first and second generation are available in the
literature. The first generation model assume cross-sectional independence, i.e. Maddala
and Wu (1999), Arif and Shabbir (2019), and Im, Pesaran, and Shin (2003). Whereas
second-generation models assume cross-sectional dependence, e.g. Bai and Ng (2004);
Saleem et al. (2019); Shabbir (2016); Nguyen et al. (2020); and Pesaran (2007). The inte-
gration among countries based on economic growth, finance and trade may be a cause of
this dependence in our model hence this study would focus on Pesaran (2007) panel unit
root test.
 JOURNAL OF SUSTAINABLE FINANCE & INVESTMENT 11

Table 1. Results of panel unit root test H0 = series is I(1).

Lag 0 Lag 1 Lag 2
(1) Maddala and Wu panel unit test
Y 0.946 0.96 0.41
F 0.465 0.767 0.683
T 0.258 0.107 0.003
(B) Pesaran Panel Unit Root test (CIPS)
Y 0.714 0.33 0.089
F 0.002 0.321 0.857
T 0.094 0.169 0.104

Next we will run the test for cointegration to identify the existence of the long-run
relationship between the concerned variables. The test proposed by Westerlund (2007)
is applied in this study which has four measures, i.e. Pt and Pa are panel test working
under alternative hypothesis of cointegration as a whole. The Ga and Gt are tests of
group mean working under alternative hypothesis which states that minimum of one
element of the panel will have a pattern of cointegration. Afterwards, the short- and
long-term coefficients are estimated by using PMG, MG and CCEMG frameworks.

6. Results and discussions

The panel unit root tests are presented in Table 1. The results of Maddala and Wu (1999)
and Saleem et al. (2019) are also presented alongside the Pesaran (2007) panel unit root
test. Maddala and Wu (1999) test assumes cross-sectional independence but as the
process of globalization became more pronounced, countries started to engage them-
selves in trade and financial exchanges leading to evidence in support of cross-sectional
dependence (Jalil 2014). Therefore, Pesaran (2004) and Muhammad et al. (2020) test
would be more reliable in case this case. As shown in Table 1, the order of integration
is sensitive to lag length and overall variables are I(1) but the mixed level of cointegration
leads this study to opt for ARDL framework which works well in case of different order of
integration.
In order to test for cross-sectional dependence; LM test of Breusch and Pagan (1980)
and Pesaran (2004) shows that rejection of the null hypothesis of no cross-sectional
dependence (p < .01) in Table 2. The p-value of adjusted Swamy’s test of slope hetero-
geneity (Pesaran and Yamagata 2008) shows that slope homogeneity hypothesis is
rejected. The importance of this result lies in the theoretical consideration that if meth-
odology of pooled lease square or generalized method of moment is used to generate
long-run coefficients through panel autoregressive or error correction model then
results would not be reliable as heterogeneity exists in our model Saleem et al. (2020).
The model specification is also important to be tested in case of slope heterogeneity as
the results can be altered by it. Therefore, functional form is tested (see Table 6) under the

Table 2. Test for cross-sectional dependence and Slope heterogeneity.

χ2 p-value
(A) Test for cross-sectional dependence LM Breush Pagan test 129.45 <.001
Pesaran test 18.46 <.001
(B) Test for slope heterogeneity
Adjusted Swamy statistics 56.33 <.001
12 A. ARIF ET AL.

Table 3. Westerlund EC panel cointegration tests.

H0: no cointegration
Value p-value
Gt −4.732 .0305
Ga −2.418 .9514
Pt −4.865 .0372
Pa −3.409 .0519

null hypothesis stating correct specification of functional form. The p-values show that
null hypothesis cannot be rejected and model is correctly specified (Table 3).
In order to check if long-run cointegration exists in our model, we have used Wester-
lund (2007) error correction (EC) panel cointegration test as it yields reliable results in
the presence of cross-sectional dependence and slope heterogeneity. The lag length is
selected by using the Schwarz information criterion. The results of Gt, Pt and Pa indicates
that relationship exist among the variables in the long run. Westerlund (2007) explains
that even if Ga may be insignificant for short time period but if Pt and Pa are significant
then there is an indication of long-term relationship. Hence, we can conclude that long-
run relationship exist in our model.
Next step is to find the casual relationship between the variables as cointegration test
tells us the existence of relationship only. The granger casuality is determined by using
estimates of PMG model (Jalil 2014) and Equation (4) is used to estimate the error cor-
rection model. In addition, two more equations are estimated by taking financial devel-
opment as a function of economic growth and trade and trade as a function of financial
development and economic growth. Then the null hypothesis is tested for no causality by
analyzing the significance of coefficient for each explanatory variable in equations as
given in Table 4. The panel causality test indicates the two-way causality among the
financial development and economic growth. When the economic activity is accelerated,
it also accelerates the demand for the financial instruments which provides a pathway for
the development of financial sector. Similarly, financial development leads to an increase
in economic growth by increasing both saving and investment for the region of South
Asia over the period of years. Unidirectional causality runs from financial development
to trade. More established financial markets provide a sound base for the trade flow in
favor of goods especially manufacturing good as explained by Beck Wolde-Rufael
(2009) and Gries, Kraft, and Meierrieks (2009).
The methodologies of PMG, MG and CCEMG are used for the estimation of cointe-
gration vector to determine short and long-run elasticities. The long-run elasticities are

Table 4. Panel causality test for economic growth, financial index and trade.
Regressors Sources of causation
SR LR
ΔY ΔF ΔT ECT
ΔY NA 0.04053** 0.04346 −0.0157*
NA (0.0145) (0.056) 0.004
ΔF 0.9266** NA 0.5216 −0.0887***
(0.423) NA (0.3234) 0.0493
ΔT 0.0782 0.0693*** NA −0.0662***
(0.2631) (0.0405) NA (0.0322)
Note: Level of significance: *1%, **5%, and ***10%.
 JOURNAL OF SUSTAINABLE FINANCE & INVESTMENT 13

Table 5. Long-term effect of financial development and trade on economic growth.

Regressors PMG MG CCEMG
F 0.19** 0.23 0.09**
(0.06) (0.17) (0.03)
T 0.27* 0.68** 0.15
(0.02) (0.2) (0.19)
Hausman test 0.3984
Standard error in parenthesis
Note: Level of significance: *1% and **5%.

mentioned in Table 5. Financial development affects the economic growth positively and
it is significant in case of PMG and CCEMG model. The financial services and products
increase the margin for the countries to explore more forum and development of econ-
omic activities. The growing financial markets encourage flow of the fund, attract more
foreign investors and buildup the confidence of the local investor in the country. Our
results differ from Shan (2005) that explains Asian economic crises create doubt about
the strengths of financial system to be leading factor in economic growth.
The trade also creates a positive influence on the economic growth and affect is sig-
nificant for PMG and MG estimates. The trade helps the domestic producers to focus
on the production methods that cost-effective and leads to a better quality of the
product. The spatial influence of the South Asian economies has increased with the
passage of time. India has experienced an increase in the export of the processed pet-
roleum, pharmaceutical and precious stones from 2002 onwards and Bangladesh and
Sri Lanka have improved the trade potential in textile and garments. Hence trade gener-
ates the stream of income for region. The signs of PMG and MG models are the same, but
in order to determine more reliable and batter fitted model, we would apply Hausman
test suggested by Pesaran, Shin, and Smith (1999). The null hypothesis to be tested is
PMG model has a better fit than MG model. The p-value of .39 shows that null hypothesis
cannot be rejected and PMG is a better model. PMG results shows the prevalence of slope
homogeneity in long run.
However, the shortfall of panel data is that differences in the slopes across countries
cannot be estimated but the advantage of PMG model lies on the fact that it allows for
slope heterogeneity in short run. The results are presented in Table 6. Moreover, the
time series data is estimated for each country also so analyze the short-term effects.
The results suggest that directly proportional and significant impact of financial devel-
opment exist on the economic growth in all South Asian countries except Nepal and

Table 6. Country’s dynamic: short run.

Diagnostic tests
Country ΔF ΔT ECM SC FF NOR HET
Bangladesh 0.0250*** 0.0901** −0.0249** 0.17 0.12 0.84 0.23
Bhutan 0.0075 0.0887*** −0.0189*** 0.81 0.52 0.64 0.69
India 0.0874* 0.0736*** −0.0333* 0.51 0.49 0.76 0.35
Maldives 0.0572* 0.2006** −0.0223** 0.5 0.143 0.22 0.18
Nepal 0.0189 0.2321** −0.0037*** 0.15 0.69 0.96 0.24
Pakistan 0.0917* 0.0874 −0.0169*** 0.23 0.28 0.4 0.26
Sri Lanka 0.0250*** −0.1431** −0.007*** 0.29 0.42 0.57 0.47
Notes: Level of significance: *1%, **5% and ***10%. Diagnostic test: SC = serial correlation, FF = Functional form, NOR =
normality and Het = heterogeneity.
14 A. ARIF ET AL.

Bhutan. Whereas trade has a positive impact on economic development except for Paki-
stan. Pakistan has faced the energy shortages in the previous years, which has created the
hindrance in the production processes. It has lost its position as one of the major exporter
of the textile items over time as the competition has emerged within the region and Ban-
gladesh and Sri Lanka have experienced more demand of textile export in the recent
times. The error correction term is also mentioned in Table 6. The error correction,
i.e. speed of adjustment in the short run is taking system towards convergence in long
run in all countries and is significant the though difference in speed of adjustment
exists among the economies of South Asia. It is 0.033 for India and 0.007 for Sri
Lanka. This shows that previous year’s shock occurring in Indian economy would be
adjusted towards long-run equilibrium by 3.3% in current year whereas the previous
shock would be adjusted by 0.7% in Sri Lanka. It can also be inferred that if the
financial shock or trade shock hits the market than India would take almost 30 years
to recover form shock whereas Sri Lanka would take around 142 years for the adjustment.
Other countries can be interpreted in the same manner.
It is important that the model pass through multiple diagnostic tests in order to ensure
robustness of results. The model diagnosis for the serial correlation, functional form,
normality and heteroscadascity are presented in Table 6 (four columns on the right).
The test statistics show that our model is free from serial correlation, functional form
is correctly specified, normality prevails in the distribution of residuals and heteroscadas-
city does not exist. Hence, the impact on economic growth determined in the model can
provide important policy implication due to stable estimators found in this study.

Conclusion
The model aims to determine the relationship between economic growth and financial
development and trade. The second-generation panel unit root test is employed in
order to check cross-sectional dependence and slope homogeneity is also monitored.
These measures are taken to ensure that important information provided by the data
is not missed and estimation technique of heterogeneous panel data is opted by the
study. The analysis of country-specific results, i.e. short-run heterogeneous estimates
are presented for each country along with the homogenous estimates for the long run
are studied for the economies of South Asia.
This study finds that financial development and trade have significant impacts on
economic growth in South Asian economies in long run. The financial development
and economic growth reinforce each other hence our study supports the ‘complementar-
ity hypothesis’. If the financial market develops then it can enhance economic inte-
gration. Likewise, the economic growth will enhance the demand of the financial
products leading to more developed financial sector. Financial development also has a
casual effect on the trade. More financial flows will enhance the exchanges in trade
sector also. McKinnon (1973) proposes that financial liberalization should be based on
free-market forces to ensure more economic growth but our study makes us to learn
the proposition that development of the financial markets should not be left unchecked
from policy point of view. The rapid financial liberalization in the western parts of world
has created havoc in the recession of 2008. But the South Asian region was not affected
severely by the financial crises of 2008 because of less established channels of global
 JOURNAL OF SUSTAINABLE FINANCE & INVESTMENT 15

financial integration. So such kind of unchecked liberalization experiences may be con-

trolled in the region and policy should be drafted carefully to target the channels which
can lead towards promising and stable growth patterns.
We obtain some more substantial results that the routes of financial development
which improvise trade should be channeled carefully in case of financial reforms so
the real sector growth can be enhanced and further economic growth is ensured.
Trade openness also plays an important role in the development of countries in the
South Asia. It would create an income stream which will help the South Asian economies
to flourish hence the hypothesis of trade-led growth is supported in long run by our
study. The trade policies should be focused on improvement in exports in term of
nature and value of commodity. This study captures the cross-country effects based on
the heterogeneity across the region hence results can be used to draw important policy
implications. Alongside the country-specific factors, cross-sectional dependence in the
region should be considered by policy makers. We have learned from the study that
the economic growth of a country can be affected by growth of other countries so policies
should be aligned in that perspective and relationship among the countries should be
chalked out to promote more economic growth in the region. This study provides the
opportunity for further studies to explore the impact of development of different types
of financial markets in South Asia over time in the current study context. This study
can also be replicated for region-based analysis for other regions of the world.

Notes
1. https://sustainabledevelopment.un.org/sdgs.
2. https://www.worldbank.org/en/country/srilanka/overview.

Disclosure statement
No potential conflict of interest was reported by the author(s).

ORCID
Ghulam Yahya http://orcid.org/0000-0002-0346-026X

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