Impact of Financial Development on Trade Balance: An ARDL Cointegration and Causality Approach for Pakistan.

Ahad, Muhammad and Muzammil, Muhammad (2015): Impact of Financial Development on Trade Balance: An ARDL Cointegration and Causality Approach for Pakistan. Published in: Global Business Review , Vol. 19, No. 1 (February 2018)

Abstract

This paper aim to examine the relationship between financial development, trade balance, exchange rate and inflation by using time series data from 1972 to 2014 for Pakistan. We have tested the unit root properties of variables by using Augmented Dickey-Fuller, Phillips-Perron and Breakpoint unit root tests. The ARDL approach is applied to examine the cointegration between variables due to mixed orders of integration between series I(0)/I(1). The ARDL findings suggested that long run relationship exists between financial development, trade balance, exchange rate and inflation. Error Correction Mechanism (ECM) is applied to analyze short run relationship. The lagged value of the Error Correction Term (ECMt-1) is negative and significant at 1% level of significance. The value of ECMt-1 is -0.91 which states that digression from the short run towards long run is corrected by almost 91 percent by every year. Financial development, exchange rate and inflation have significant impact on trade balance in the long run. But in the short run, only exchange rate and inflation have statistically significant impact on trade balance. Diagnostic statistics have confirmed the characteristics of model in the short run as well as in the long run. The causal relationship between variables are examined by VECM Granger causality and robustness of causal analysis is tested by Variance Decomposition Approach (VDA). The results of VECM have predicted that unidirectional causality from financial development to trade balance exist in the long run. The results of Variance Decomposition Approach explained that 19 percent of trade balance is explained by shocks stimulating in financial development. Government should enhance financial development by managing lending interest rates to improve trade balance.

• Item Type: MPRA Paper
• Language: English
• Keywords: Financial Development, Trade Balance, ARDL Cointegration, Causality, Pakistan
• Subjects: F - International Economics > F1 - Trade > F13 - Trade Policy ; International Trade Organizations; G - Financial Economics > G2 - Financial Institutions and Services > G23 - Non-bank Financial Institutions ; Financial Instruments ; Institutional Investors

References

Akbostanci, E. (2004). Dynamics of the trade balance: the Turkish J-curve.Emerging Markets Finance and Trade, 40(5), 57-73.

Aurangzeb, D., & Asif, K. (2012). Determinants of current account deficit: A comparison between Asia and Europe. Universal Journal of Management and Social Sciences, 2(12).

Beck, T. (2002). Financial development and international trade: is there a link?.Journal of international Economics, 57(1), 107-131.

Beck, T. (2003). Financial dependence and international trade. Review of International Economics, 11(2), 296-316.

Boswijk, P. H. (1994). Testing for Unstable Root in Conditional and Structural Error Correction Models. Journal of Econometrics, 63(1), 37-60

Banerjee, A., Dolado, J. and Mestre, R. (1998). Error-Correction Mechanism Tests for Cointegration in A single-Equation Framework. Journal of Time Series Analysis, 19(3), 267-283

Bayer, C., and Hanck, C., (2013). Combining Non-CointegrationTests. Journal of Time Series Analysis, 34(1), 83-95

Duasa, J. (2007). Determinants of Malaysian trade balance: An ARDL bound testing approach. Global Economic Review, 36(1), 89-102.

Dickey, D. A. and W. A. Fuller, (1981). Likelihood ratio statistics for autoregressive time series with a unit root. Econometrica, 49, 1057-1079

Elliott, G. R., Thomas, J. and J. H. Stock, (1996). Efficient tests for an autoregressive unit root. Econometrica,64, 813-836

Engle, R. F. and Granger, C. W. (1987). Co-integration and error correction: representation, estimation and testing. Econometrica: Journal of the Econometric Society, 251-276

Engle, R. F. and Granger, C. W. (1987). Co-integration and error correction: representation, estimation and testing. Econometrica: Journal of the Econometric Society, 251-276

Frankel, J., & Rose, A. (2002). An estimate of the effect of common currencies on trade and income. Quarterly Journal of Economics, 437-466.

Hur, J., Raj, M., & Riyanto, Y. E. (2006). Finance and trade: A cross-country empirical analysis on the impact of financial development and asset tangibility on international trade. World Development, 34(10), 1728-1741.

17

Haug, A. (2002). Temporal aggregation and the power of cointegration tests: a monte carlo study. Oxford Bulletin of Economics and Statistics, 64, 399-412.

Hanousek, J., & Kočenda, E. (2014). Factors of trade in Europe. Economic Systems, 38(4), 518-535.

Ibrahim, M. H. (2005). Sectoral effects of monetary policy: evidence from Malaysia. Asian Economics Journal, 19(1), 83-102

Johansen, S. (1991). Estimation and Hypothesis Testing of Cointegration Vectors in Gaussian Vector Autoregressive Model. Econometrica: Journal of the Econometric Society, 1551-1580

Khan, S. R., & Aftab, S. (1995). Devaluation and the Balance of Trade in Pakistan: A Policy Analysis. Sustainable Development Policy Institute.

Kiendrebeogo, Y. (2012). The effects of financial development on trade performance and the role of institutions. Economics Bulletin, 32(3), 2546-2559.

Laurenceson, J. and Chai, J. C. H. (2003). Financial reform and economic development in China. Cheltenham, UK, Edward Elgar

Muhammad, S. D. (2010). Determinant of balance of trade: Case study of Pakistan. European Journal of Scientific Research, 41(1), 13-20.

Nazeer, A., Shafi, K., Idrees, Z., & Hua, L. (2015). Exchange rate and determinants of balance of trade, its impact on balance of payment. American Journal of Business, Economics and Management, 3(1), 14-18.

Ng, S. and P. Perron, (2001), ‘Lag length selection and the construction of unit root test with good size and power’, Econometrica,69, 1519-1554

Narayan, P. K., (2005). The saving and investment nexus for China: evidence from cointegration tests. Applied Economics 37, 1979-1990.

Ogbonna, B. (2009). Long Run Exchange Rate Effects on Trade Balance. Evidence from Nigeria. Journal of Research in National Development,7(1), 127–136.

Onafowora, O. (2003). Exchange rate and trade balance in East Asia: is there a J-curve. Economics bulletin, 5(18), 1-13.

Phillips, P. C. and Ouliaris. S. (1990). Asymptotic Properties of Residual Based Tests for Cintegration. Economatrica: Journal of Econometric Society, 165-193

Pesaran, M.H., Shin, Y., and Smith, R.J., (2001). Bounds testing approaches to the analysis of level relationships. Journal of Applied Econometrics, 16, 289-326

Phillips, P. C. and Ouliaris. S. (1990). Asymptotic Properties of Residual Based Tests for Cintegration. Economatrica: Journal of Econometric Society, 165-193

Phillips, P. C. B. and Perron, P. (1988), ‘Testing for a unit root in time series regressions’.

Biometrika, 75, 335-346

Perron. P., (1989). The great crash, the oil price shock, and the unit root hypothesis. Econometrica, 57(6), 1361-1401.

Pesaran, M. H. and Pesaran, B. (1997). Working with Microfit 4.0: Interactive Econometric Analysis. Oxford: Oxford University Press.

Pesaran, M. H. and Shin, Y. (1999). An autoregressive distributed lag modeling approach to Cointegration analysis. Chapter 11 in Econometrics and Economic Theory in the 20 century: The Ragnar Frisch Centennial Symposium, Strom S. (ed). Cambridge University Press: Cambridge

18

Samba, M. C., & Yan, Y. (2009). Financial development and international trade in manufactures: An evaluation of the relation in some selected Asian countries. International Journal of Business and Management, 4(12), p52.

Shawa, M., & Shen, Y. (2013). Analysis of the determinants of trade balance: Case study of Tanzania. International Journal of Business and Economics Research, 2(6), 134-141.

Shah, A. Q. (2015). Trade Balance of Pakistan and its Determinants. Business and Management, 7(4).

Shahbaz, M., & Rahman, M. M. (2012). The dynamic of financial development, imports, foreign direct investment and economic growth: cointegration and causality analysis in Pakistan. Global Business Review,13(2), 201-219.

Stucka, T. (2004). The effects of exchange rate change on the trade balance in Croatia (No. 4-65). International Monetary Fund.

Vergil, H. (2002). Exchange rate volatility in Turkey and its effect on trade flows. Journal of Economic and Social Research, 4(1), 83-99.

Waliullah, M. K. K., Kakar, R., and Khan, W., (2010). The Determinants of Pakistan’s

Trade Balance: An ARDL Cointegration Approach. Lahore Journal of Economics, 15(1), 1-26.

Wilamoski, P., & Tinkler, S. (1999). The trade balance effects of US foreign direct investment in Mexico. Atlantic Economic Journal, 27(1), 24-37.