What is the relationship between growth and trade balance

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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) concludes 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 nontrade policy actions, or forces unrelated to a government's policy actions. But at the same time it is noteworthy as pointed by 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 South Asian Association for Regional Cooperation (SAARC). In this study the authors presented through statistical estimates the major determinants of the region's economic growth, where Trade among the regional countries remains the major component of their Growth. Finally, the study also consists of the estimated relationship of major directions of Pakistan's exports with economic growth of the country and presents the growth projections by increasing and diverting the exports to the SAARC and ASEAN region countries.

"The result of this estimation show 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 will increase, on average, the GDP growth rate of the countries by 4 percent." Moreover, the results also show 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 provides 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 (2001) basically attempted to test the model of Balance-of-Payments (BOP)-constrained economic growth used by Thirlwall. According to him "This model is tested on the Brazilian economy after industrial take-off in 1955 until 1998 using the Cointegration technique and a Vector Error Correction (VEC) representation to find the dynamic responses of exports to GDP." The hypothesis is 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 of this paper support Thirlwall's law in the way of exports, income elasticity of imports and GDP have a long run association.

Basically Thirlwall's model stresses that demand factors induce economic growth. In an open economy, the dominant constraint upon demand is BOP. The basic idea of Thirlwall's approach highlights 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 suggest that movements toward openness can temporarily increase the rate of growth due to short-run gains from the reallocation of resources, which would imply a positive relationship between changes in openness and GDP growth. The new growth literature also identifies a number of avenues through which openness might affect long-run growth.

Sarkar (2006) examines 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 (2006) have argued theoretically that "trade balances should not be related to long-run economic growth". For empirical evidence, Gould and Ruffin (2006) have used the Benchmark Model and presented the correlation analysis.

In conclusion, Gould and Ruffin (2006) mentioned that although there is a negative correlation between trade imbalances and economic growth, but the relationship is weak and that trade imbalances have little effect on rates of economic growth once taken into account the fundamental determinants of economic growth.

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 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 Thirlwall's (1979) original framework 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 their extension is that "although it allowed for nonzero capital inflows, it imposed no restriction whatsoever on their trajectory except for the balance-of-payments accounting principle, which forces debit and credit items to cancel out." (Moreno-Brid 1998, p 283) In other words, Thirlwall and Hussain acquired a dynamic accounting identity that showed how capital inflows may tense or relax the BP constraint on economic growth.

Fischer (1993) used a similar approach to investigate the effects of inflation.The recent revitalization of interest in long-run growth and the availability of macroeconomic data for large panels of countries has generated interest among macroeconomists in estimating 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) examine the government expenditure in health and education and other structural factors that may have an effect on economic growth. They apply the GMM estimation technique which is the set explanatory variables included in the growth regression specification are based on the endogenous growth theory and can all be considered to be important determinants of economic growth. The results show that the coefficient on government expenditure in health and education is negative but is small in absolute value.

Mateev and Videv (2008) have 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 their capital asset pricing model. To develop the empirical implications of this framework, they investigated the explanatory power of a set of five macroeconomic variables that we believe might proxy for relevant systematic risk factors. They reported three major findings out of which two of the findings are considered relevant for my 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 picking this Article was to understand the technique used in this research and then applying the same in my 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 timeseries. 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. They 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 reveal better than do cross-sectional analyses 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. They analysed the export-led growth hypothesis for the South Asian economies using a bivariate econometric framework.

The study by Kemal et al. (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 et al. (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.