Relationship Between Trade Deficit and Growth

Chapter 1 - Introduction

In today’s world, no one can deny the importance of Globalization. International trade is that kind of trade that gives rise to the economy of the world and for the country growth plays a backbone role. International trading has become very important for every country of the world – be it big or small, developing nation or developed nation. There is a common perception in the media and also in the general public that Trade Deficits are a bad news to a country’s economy. The conventional wisdom is that these deficits are a drag on Gross Domestic Product. Surely, it is not considered positive for a country’s economy to import more than it exports. Favorable Trade balance is a major determinant of growth in any country, as surplus increases GDP and deficit reduces it. Unfortunately in Pakistan, Trade Balance has never seen a surplus over the period of time.

If a country is subjected to free trade, it means that the country is having many benefits from this trade openness. By doing trade with countries or to be a part of any trade agreement like South African Development Authority. Trade openness has positive impact on economic growth. Through trade openness, the ratio of domestic investment to GDP increases and this has been proven by many theorists. Sometimes your country may lack in many goods and services, so by trading you can get those products. Free trade means no barriers to trade like no protectionist policies which can be very favorable for the developing countries like Pakistan that is heavily dependent on some imports from outside countries. The main sources of revenues in Pakistan mainly comprises of four components. First source is revenues from taxes, direct and indirect. Second the capital receipts include external borrowings and internal borrowings. External borrowings include the debts which have been taken from abroad and internal non-bank borrowing includes unfunded debt, public debt, treasury and public receipts, revenue account surplus and the surplus generated by Public Sector Corporation. There is another source of revenue which is called aid from developed countries. Aid divided into project and non project aids.

After revenues the main expenditures of government includes debt servicing, defense and public administration, social service, law and order, provision of subsidies, grants to Azad Jammu and Kashmir, grants to railways, community services and economic services. Public sector development plan has been built which is termed as development budget. Its major coins are reserved for infrastructure plans such as water, power, transport and communication. For economic development and achievement of government’s main objectives like employment, this kind of investment is necessary. Pakistan is also offering itself to be used as a medium to trade with Middle East and Eastern countries. China has already offered Pakistan to be engaged in its railway and communication so that it can pave ways to access Arabian Sea for its tradable goods.

In the world, Pakistan’s economy is on 27th position in terms of purchasing power and on 45th position in purchasing dollar. Pakistan is mainly based on semi-industrialized economies which are textiles, food processing, chemicals, agriculture and others. The growth of Pakistan’s economy is situated on the riverside of the Indus. The urban centre of modified economy of Karachi and Punjab exist together with pronominal developed areas on the other side of country. The economy has endured in past because of the decaying of internal political contend , the fast expanding population, foreign investment and a costly running challenge with Pakistan’s neighbor, India. The government policies were upgraded by IMF, support of foreign investment and reestablished access to global markets which have produced solid macro economy’s recovery in the last decade. Significant macro-economic reforms from 2000, most notably on privatizing the banking sector which developed the economy. Pakistan’s economy is mostly based on its agricultural products. Major exports of Pakistan are from primary sectors so agriculture is the most important sector of this economy. However with increasing industrialization and globalization, changes are being brought in the economy of Pakistan and now its contribution is less than 25% of its output but still it is highly due to the employment generation sector in the economy. More than 50% of total population works in this sector.

Over the stretch of the past 30 years, Pakistan’s trade deficit has only worsened instead of improving. The element of self-reliance lacking in the mechanism of Pakistan’s economy is one major reason as to why Pakistan has to import goods mainly on heavy prices from other countries. In comparison to the heavily priced imports that mostly comprise of manufactured goods, the exports of Pakistan in the international market constitute chiefly of raw materials or semi-manufactured goods that are at a great deal cheaper and lesser in demand as compared to the market of manufactured goods. Another factor that contributes towards exacerbating Pakistan’s trade deficit is the paucity of variety in the range of Pakistani exports. The textile sector constitutes a major part of Pakistan’s exports and although the exports have increased from before, still the contribution is very little to the overall Gross National Product of the country. 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, currency crises can erupt. Even before that this perspective materializes; the government can be induced to dampen GDP growth.

Currently, Pakistan is facing major economic challenges as similar to above. Particularly in this research, main objective is to examine the correlation between Trade Deficit and GDP and to investigate, if Trade Balance has a favorable impact on growth while deficits decrease the Growth, considering the case of Pakistan. The relationship between growth and trade deficit has been a subject of research.

Problem Statement

To study and investigate the relationship between Trade Deficit and Growth, considering the case of Pakistan, showing that increasing trade deficits are the cause of dampening growth.

Research Hypothesis

Trade Deficits and Growth are negatively related.

Chapter 2 - Literature Review

The relationship between growth and trade balance has been a subject of research, theoretical as well as empirical. Many Studies have been carried out over this topic but most of the work is focused on theoretical perspective, while only few economists analyzed the two variables empirically.

Baldwin (2005) concluded on the basis of statistical finding that increase in exports and increased growth are generally positively related. The export increase may be result of trade policy changes, other non-trade policy actions, or forces unrelated to a government’s policy actions. But at the same time it is noteworthy as pointed by the author that the export increase also may be the consequence of economic growth rather than the cause. Furthermore, the use of exports as an openness measure has the drawback of being a component of GDP, the usual measure of economic growth.

Amjad and Khan (2001) discussed the prospects of extended economic cooperation of Pakistan with the member countries of the SAARC (South Asian Association for Regional Cooperation). Amjad and Khan (2001) presented through statistical estimates, the major determinants of the region’s economic growth, where trade among the regional countries remains the major component of the growth. Finally, the study also consisted of the estimated relationship of major directions of Pakistan’s exports with economic growth of the country and presented the growth projections by increasing and diverting the exports to the SAARC and ASEAN region countries.

The result of this estimation shows that one percent increase in export earnings increases the growth rate of GDP by .04 percent, meaning that a doubling of the current export earnings in the countries of the region increases, on average, the GDP growth rate of the countries by 4 percent. Moreover, the results also showed that one percent decrease in trade imbalance increases the GDP by 4.85 percent. But still all countries in the SAARC region have been experiencing persistent trade balance deficits and the result provided sufficient ground to work on reducing the gap between export receipts and import payments.

Considering the case of emerging economies like Brazil, India, and China, Jayme (2003) basically attempted to test the model of Balance-of-Payments (BOP)-constrained economic growth used by Thirlwall. According to Jayme (2003), the model by Thirlwall was tested on the Brazilian economy after the take-off of the industrial sector in 1955 until 1998 by using the technique of Cointegration and a representation of VEC (Vector Error Correction) for the evaluation of the dynamic responses of exports to growth. The hypothesis was that Brazil is a fine example of a place where external aspects constrain economic growth. As based on statistical inference of the model, the outcome holds Thirlwall’s law in a way that exports, income elasticity of imports and growth have a long-run association with each other.

Basically, Thirlwall’s model stressed that demand factors induce economic growth. In an open economy, the dominant constraint upon demand is BOP. The basic idea of Thirlwall’s approach highlighted how BOP affects the growth performance of countries. The author also discussed and concluded that Keynesian models, such as Thirlwall’s BOP-constrained growth model, link trade to growth because exports pull demand. Indeed, trade represents a crucial constraint to economic growth when there are BOP problems. Static trade models suggested that movements toward openness can temporarily increase the rate of growth due to short-run gains from the reallocation of resources, which implies a positive relationship between changes in openness and GDP growth. The new growth literature also identified a number of avenues through which openness might affect long-run growth.

Sarkar (2006) examined the association between trade openness (Trade-GDP ratio) and economic growth. The study comprised a cross-country panel data evaluation of sample 51 countries of the South for the period of 1981-2002 showing that for only 11 wealthy and highly trade-dependent countries, a higher real growth is related with a higher trade share. Time-series study of single country experiences show that most of the countries covered in the sample together with the East Asian countries felt no positive long-term association between openness and growth during 1961-2002. Study of many other regions and groups showed that only the Middle Income group showed a positive long-term association.

Gould and Ruffin (1996) argued theoretically that “trade balances should not be related to long-run economic growth”. For empirical evidence, Gould and Ruffin (1996) used the Benchmark Model and presented the correlation analysis.

Gould and Ruffin (1996) concluded that although a negative correlation exists between trade imbalances and economic growth, but the relationship is weak and that imbalanced trade values have little impact on economic growth rates, once taken into account the fundamental determinants of economic growth. The authors also concluded that surpluses and trade deficits are component of the efficient allocation of international risk sharing and economic resources that is critical to the long-run strength of the world economy.

Bouoiyour (2003) in his econometric analysis for Morocco indicated that increased trade has had a positive impact on GDP. Import expansion was found to increase goods’ exports, which in turn triggered higher GDP growth. However, exports have not been strong enough to pull the economy towards the economic growth rates that many other emerging economies have enjoyed. Indeed, since 2002, merchandise exports have been increasingly falling short of imports, implying increasing trade balance deficits.

Bouoiyour (2003) in his study utilized Cointegration and Granger-causality tests to examine the relationship between trade and economic growth in Morocco over the period of 1960-2000. The Augmented Dickey – Fuller (ADF) and Phillips-Perron (PP) tests (1988) were used to check the time series proprieties of the variables before running Granger-causality tests. The VEC model was also estimated. The results suggested a lack of long-run causality from imports or exports to GDP; from GDP or imports to exports and from GDP or exports to imports. The results showed that imports and exports Granger caused GDP and imports Granger caused exports.

To manage with capital flows, Thirlwall and Hussain (1982) further presented the original framework of the year 1979 by Thirlwall, to permit trade deficits and explained how the growth rate of a small open-economy may as well be constrained by capital inflows together with the trade factors.

However, a particular attribute of the research’s extension is that “although it allowed for nonzero capital inflows, it imposed no restriction whatsoever on the trajectory except for the balance-of-payments accounting principle, which forces debit and credit items to cancel out.”

In other words, Thirlwall and Hussain (1982) acquired a dynamic accounting identity that showed how capital inflows may tense or relax the BP constraint on economic growth.

Fischer (1993) used a panel approach to investigate the effects of inflation. The recent development of interest in long-run growth and the presence of macroeconomic data for large panels of countries generated importance among macroeconomists in deducing dynamic models with panel data.

Using a regression analog of growth accounting, Fischer (1993) presented cross-sectional and panel regressions presenting that growth is negatively related with inflation, large budget deficits and distorted foreign markets precisely foreign exchange markets.

Chen and Gupta (2006) examined the government expenditure in health and education and other structural factors that may have an effect on economic growth. The authors applied the GMM estimation technique which is the set of explanatory variables included in the growth regression specification, are based on the endogenous growth theory and can all be considered as important determinants of economic growth. The results showed that the coefficient on government expenditure in health and education is negative but is small in absolute value.

Mateev and Videv (2008) empirically studied the role of different economy-wide factors or macroeconomic variables in explaining excess stock returns in the Bulgarian equity market. The technique applied by Mateev and Videv (2008) is very much similar to the one used in my research. Mateev and Videv (2008) made several contributions to the literature on stock market returns in emerging markets. A multifactor framework is used to test the capital asset pricing model. To develop the empirical implications of this framework, the authors investigated the explanatory power of a set of five macroeconomic variables that was probably believed as the proxy for relevant systematic risk factors. The authors reported three major findings out of which two of the findings are considered relevant for this research. First, the results of the time-series asset-by-asset regressions indicated that macroeconomic variables play no significant role in explaining the variation in excess stock returns. Second, grouping the sample stocks into portfolios and using a two-pass regression procedure enhanced the explanatory power of the tests. The evidence indicated that there was a (weak) linkage between macroeconomic environment and capital markets in transition economies.

The basic idea behind the selection of this Article was to understand the technique used in this research and then applying the same in the proposed research.

From the empirical analysis of Sohn and Lee (2010), it was concluded that the economic growth can be well explained by trade structure variables that are free from definition and separation problems. In the empirics, the estimating equations had the goodness of fitness of about 0.4, showing a relatively significant relationship between trade structure and growth. In addition, the dynamic panel estimation for the data of 66 countries during 1991-2001 verified strong validity and robustness of the relationship.

Although the endogenous growth model variable, FDI / Trade had a positive impact on growth by itself, once combined with other structural variables, its impacts are dispersed into other variables. This result implied that FDI / Trade is a relevant trade structure variable that effectively affect to growth. However, in order to assess its impact correctly, Sohn and Lee (2010) needed to introduce a new model, equation or theoretical rationale.

Finally, this research was an attempt to open up a new look for the relationship between trade and growth. There were, however, many problems that remained to make this study complete and consistent.

Iqbal and Zahid (1998) employed a multiple regression framework to investigate macroeconomic determinants of growth in Pakistan including openness. The empirical result also suggested that the openness of the economy promoted growth. However, the study adopted Ordinary Least Squares as the estimation methodology without investigating the stationarity properties of the time-series. The results, therefore, were prone to the problem of spurious regressions.

Iqbal and Zahid (1998) found that the budget deficit and external debt were negatively related to economic growth. The authors suggested that relying on domestic resources was the best alternative to finance growth.

Krueger (1990) suggested the possibility that openness is correlated with changes in other policies. Growth performances also vary, although it was generally argued that old and new Asian Tigers have achieved relatively rapid and equitable growth, on the back of growing openness. There was some disagreement over what type of policies, domestic or foreign, were responsible for achieving openness.

Moyer (1967) related the input of man-hours to output (margins or profit margins) that provides an efficiency measurement in marketing. It was quite likely that time-series analyses revealed better than cross-sectional analyses did, in this research, the true relationship between growth in trade and economic growth. The statistical analysis showed a close relationship between this variable and a variable representing income per capita.

Kemal, Din, Qadir, Fernando, and Colombage (2002) observed a positive relationship between exports and growth for India as well as for other economies of South Asia. Kemal et al. (2002) analyzed the export-led growth hypothesis for the South Asian economies using a bivariate econometric framework.

The study by Kemal, Din, Qadir, Fernando, and Colombage (2002) confirmed that export growth has been instrumental in accelerating economic growth in all the economies. The evidence of both short-run and long-run causality between export growth and economic growth pointed out that there are several ways in which exports can have a positive effect on economic growth. Kemal et al. (2002) carried out an empirical analysis of the export-led growth hypothesis for Bangladesh, India, Nepal, Pakistan, and Sri Lanka. Within a Vector-Auto Regressive (VAR) framework, the concept of Granger causality was employed to determine the direction of causation between exports and output, duly taking into account the stationarity properties of the time series data. Various tests for the existence of unit roots confirmed that both real exports and real GDP are non-stationary processes that are integrated of order 1 for all countries. Furthermore, cointegration tests indicated that there exists a long-run equilibrium relationship between real exports and real GDP in all countries. The presence of common stochastic trends in real exports and real GDP dictated the use of a restricted Vector Auto Regressive framework, i.e. an error-correction model (ECM), to address the question of Granger causality.

Kemal, Din, Qadir, Fernando, and Colombage (2002) further briefed that in a longer term perspective, exports can have a beneficial effect on economic growth through a variety of channels. First, export production allows economies with narrow domestic markets to overcome size limitations and to reap economies of scale. Second, by relaxing the foreign exchange constraint, higher exports can permit higher imports of capital goods thereby strengthening the productive capacity of the economy. Third, exports lead to an improvement in economic efficiency by enhancing the degree of competition. Fourth, exports contribute to productivity gains through diffusion of technical knowledge and learning by doing. Finally, export-oriented production and investment tend to take place in the most efficient sectors of the economy fostering a pattern of production that is consistent with a country’s comparative advantages. Specialization in these sectors improves productivity in the economy leading to higher output growth.

Chapter 3 - Research Methods

Method of Data Collection

This Research was carried out through Secondary Data. The secondary data which was used in this research was available on the website of Federal Bureau of Statistics and State Bank of Pakistan (SBP) from the year 1975 to 2008.

Sample Size

In this research, data from the year 1975 to 2008 has been taken as a sample size. Annual data comprising of 33 years of Real GDP volume and Trade Balance (Exports minus Imports) volume was taken to test the hypothesis.

Research Model

The model used for analysis of data is Linear Regression Model where the dependent variable (GDP) is a function of independent variable (BOT). Balance of Trade is calculated as the difference of Exports and Imports. The model developed for research is as follows:

GDP = α + β (BOT) + Å«

Where GDP = Gross Domestic Product, BOT = Balance of Trade, the coefficients α and β are regression parameters for the independent variable and Å« = (1-R²) is denoted as the error term.

Statistical Technique

Simple linear regression technique was applied on the 33 years of Real GDP volume and Trade Balance volume to test the hypothesis that “Trade Deficits and Growth are negatively related”. Any sign (-ve or +ve) shows the correlation and the hypothesis was accepted at p<0.05.

Chapter 4 - Results

Findings and Interpretation of the Results

Firstly, the correlation technique is used to determine the correlation between independent variable i.e. Trade Balance (BOT) and dependent variable Gross Domestic Product (GDP). Then, further analysis is shown by using the simple linear regression technique to determine the relationship between the two variables keeping in view the linear regression model.

Table 4.1

From the above correlation table, it can be observed that a negative relationship exists between Trade Deficit and GDP growth. As the significant value is less than 0.05, it means that the Null hypothesis is not rejected. Correlation value for both the variables is -0.804 and it means that in Pakistan economy, there is a strong negative correlation that exists between GDP growth and Trade Deficit.

Table 4.2

Initially, when the simple linear regression test is run on the data set, the R Square 0.647 suggests that there is 64.7% variation in GDP due to its linear relationship with Trade Balance BOT, where GDP is 64.7% explained.

Table 4.3

The ANOVA table suggests that Trade Deficit explains a significant amount of variance in GDP. In the table above, F = 56.754, p< .05 and therefore it can concluded that the regression is statistically significant.

Table 4.4

The coefficient results show that there is a negative association between Trade Deficit and GDP in Pakistan. The results reflect that the beta of BOT variable has a negative value and the t-value of BOT is statistically significant at 0.05.

From the above regression model, it is concluded that the relationship exists between Trade Deficits and GDP.

However, here it is also observed that the Durbin Watson value is 0.172 and it is interpreted that there is an existence of autocorrelation in the data set. In order to resolve this issue of autocorrelation, the first level lag variable is generated in the data set by the name of LagGDP.

Table 4.5

The above table shows the method that was used to perform the multiple linear regression, the independent variables were LagGDP and Trade Balance (BOT) in Billion USD.

Table 4.6

The adjusted R Square of the above Linear Regression function is 0.988 which is interpreted as 1 unit change in the independent variable set brings out a 98.8% change in the variation of the dependent variable. As it can be observed that after the inclusion of Lag variable, the Durbin Watson value is 1.847, which is fine and indicates that the issue of autocorrelation in the data set has been resolved.

Table 4.7

The significant value of the above table is less than 0.05 and it means that the regression model is appropriate to be applied on the data set.

Table 4.8

The above table represents the beta values of the independent variables. As it can be seen that the significant value of the constant is 0.330 that is greater the 0.05 which means that the constant value for the data set is equal to zero. It means that if there are no independent variables, the GDP growth is equal to zero.

Coefficient output table gives the following regression equation:

GDP = -1.456 + (-0.658) BOT + 1.072 LagGDP

β = -0.658, t = -2.456 at p < .05

Results have shown that there is a negative relationship between Trade Deficit and GDP Growth. If Trade Deficit increases by 1 unit, the GDP Growth decreases by (0.658) billion USD due to its linear relationship.

The Beta value of BOT here is (0.658) which means that a negative relationship exists between GDP and Trade deficit. The significant value of BOT is 0.020 that is less than 0.05. It therefore, can be said that the Null hypothesis is not rejected, trade deficits do have a significant impact on GDP growth. If there is a one unit change in the Trade deficit, the change in GDP is equal to (0.658).

The beta value of the LagGDP (lagged dependent variable as an explanatory variable) is 1.072 which means that every year GDP growth is dependent on its last year GDP growth. For e.g. if in any year the GDP is Equal to 1, then the minimum GDP growth next year would be 1.072.

Hypothesis Assessment Summary

Table 4.9

Hypothesis

R

Square

F

Significance

Value

Regression

Coefficient β

t

Empirical

Conclusion

Trade Deficits and Growth are negatively related

0.647

56.754

p<0.05

-0.804

-7.534

Accepted

Chapter 5 - Conclusion, Discussions, Implications and Future Research

Conclusion

Pakistan has to explore the new markets for its exports as many countries are now quality conscious and increasing terrorism and corruption rates in Pakistan are leading Pakistan’s economy to the more miserable condition. The main exports of Pakistan are textile and cotton but due to lack of focus and concentration, Pakistan is losing its markets though these sectors have contributed 60% to all the exports. However the imports have been rising on an increasing speed. In fact, the rates of imports are also rising due to the increasing oil prices that in turn increases the cost of raw materials and stopping the growth rate of value addition in the industrial sector.

It is proven by the fact from this research that country is not facing trade surplus which means that current account balance is negative so it will have negative effects in the economy in terms of GDP growth and economic development as it has been clearly identified that Pakistan is suffering from the problem of deficit. It is clear that the country’s GDP rate is declining and decreasing living standards of people in the country.

From this research analysis, the value of the trade deficit indicated that there is a negative relationship existing between GDP and Trade Deficit. The significant value of Trade Deficit in this research shows that Null hypothesis is not rejected, which proves that trade deficits do have a significant impact on GDP growth and every year GDP growth is dependent on its last year GDP growth.

Discussions and Implications

Analyzing the research facts, there are different ways which the government can apply to make sure that the deficit can be converted into surplus. Government can use its tools of fiscal policy, public expenditure and taxes to reduce aggregate demand. If less money will be pumped around the circular flow of the income in the economy, people will be having less to spend on imports. Secondly, government can increase the cost of borrowing and interest rates which will attract the flow of hot money into the country. Investor’s confidence will increase and there will be inflow of the wealth into the country. Besides these, some of the protectionist policies can be used like tariffs, quotas, embargo and subsidies on exports so that it can be flourished. Reasons behind using trade barriers can be protection of employment, infant industries, to prevent dumping and due to the scare of retaliation.

In this case, the deficit country will be trying to find out the ways through which the imports can be financed. Firstly, the country will try to exceed the exports and will implement diversifications but in the case of no result, there can be many things on which the country has to rely like exports of services. Foreign aids can fill the gap for developing countries. Sometimes the surplus in capital account balance will offset the deficit in current account balance. Sometimes net property income from abroad can be put out to work as individuals working outside can transfer payments to pay for the imports.

References

Amjad, F., & Khan, N. Z. (2004). External Determinants of Growth and Growth Projections: SAARC and Pakistan. The Pakistan Development Review, 43, 737-755.

Baldwin, R. E. (2003). Openness and Growth: What’s the Empirical Relationship? JEL F13, F14, F32, 1-34.

Bouoiyour, J. (2003). Trade and GDP Growth in Morocco: Short-run or Long-run Causality? Brazilian Journal Business and Economics, 3, 14-21.

Chen, P., & Gupta, R. (2006). An Investigation of Openness and Economic Growth Using Panel Estimation. JEL F15, H51, H52, N17, O47, R11, 1-26.

Fischer, S. (1993). The Role of Macroeconomic Factors in Growth. Journal of Monetary Economics, 32, 485-512.

Gould, D. M., & Ruffin, R. J. (1996). Trade Deficits: Causes and Consequences. Federal Reserve Bank of Dallas Economic Review, 10-20 (fourth quarter).

Iqbal, Z., & Zahid, G. M. (1998). Macroeconomic Determinants of Economic Growth in Pakistan. The Pakistan Development Review, 37, 125-148.

Jayme, F. G. (2003). Balance-of-Payments-Constrained Economic Growth in Brazil. Brazilian Journal of Political Economy, 23, 62-84.

Kemal, A. R., Din, M., Qadir, U., Fernando, L., & Colombage, S. S. (2002). Exports and Economic Growth in South Asia. A Study Prepared for the South Asia Network of Economic Research Institutes.

Krueger, A. O. (1990). Asian Trade and Growth Lessons. The American Economic Review, 80, 108-112.

Matee