Modelling trade, investment, growth and liberalisation: case study of Pakistan.
Khan, Muhammad Arshad ; Ahmed, Ayaz
1. INTRODUCTION
The role of trade in economic development as an engine of economic
growth has been at the centre of hot policy debates over the past four
decades. History supports the success of import liberalisation policy in
the United States of America (USA) in the 1940s, Japan in 1960s and the
exports promotion achievements of Asian Tigers in the 1970s and 1980s
[Yen (2009)]. (1) There is no doubt that increased movement of goods and
services across international borders over the past few decades has
helped developing countries to achieve faster and sustainable growth.
Many researchers argued that free trade has a key ingredient in
facilitating transfer of technology from developed to developing
countries [Heokman and Javorcik (2006) and Harding and Javorcik (2012)].
Theoretical literature suggest that trade liberalisation enhances
economic growth and development through the specialisation and
technological developments. The theoretical link between international
trade and economic development can be traced back to the earlier
writings of Classical Economists (Adam Smith and David Ricardo) and
Neoclassical Economists (Heckscher and Ohlin) in the early part of
nineteenth century. The Classical Economists hypothesised that nations
gain from trade, and World production would grow when trading nations
specialise according to the principles of comparative advantage. On the
other hand, the Neo-classical Economists argued that countries will tend
to specialise in those products that use abundant resources intensively
in the production process. As a consequence, factors prices will tend to
equalise across trading nations if production technologies remain
identical throughout the world (StolperSamuelson approach). They further
claimed that trade stimulate economic growth through production,
consumption and saving linkages. The proponents of free trade believed
that trade liberalisation would improve exports and economic growth
[Sachs and Warner (1995); Khan, et al. (1995); Iqbal and Zahid (1998);
Edwards (1993; 1998), Frankel and Romer (1999); Ravallion (2001); Qadir,
et al. (2000); Dollar and Kray (2002); Greenaway, et al. (1997), Kemal,
et al. (2002); Berg and Krueger (2003); Yanikkaya (2003); Din, et al.
(2003); Mamoon and Murshed (2006); Khan and Qayyum (2006); Qayyum and
Khan (2008), Miller and Mukti (2000); and Sachs and Howard (1996), among
others]. (2)
The standard partial equilibrium trade theory emphasises that trade
liberalisation can play an important role in boosting exports and
economic growth through technology transfer and diffusion of knowledge
among countries [Golder and Kumari (2003); Husted and Melvin (2001),
Laird (1997), Grossman and Helpman (1991), among others]. The new trade
theories emphasise the role of economies of scale associated with
international trade which further gains in efficiency [Helpman and
Krugman (1985)]. The main conclusion emerges from the static theories of
trade is that liberal and free trade fosters economic growth, welfare
and reduces poverty. The main transmission channels leading to this
outcome are growth, productivity, investment and price stability.
Ben-David (1996) argued that elimination of trade barriers and increase
in the volume of trade leads to a reduction in the income gaps between
trading nations.
Free trade is critical ingredient for sustainable growth and
productivity, jobs creation and higher wage rate is associated to higher
private industrial investment [Balassa (1978), Keesing (1967, 1979),
Krueger (1988), Bhagwati and Srinivasan (1978) and Khalid and Teck-Cheng
(1997)]. Openness creates international competitive environment through
the elimination of government trading monopolies. It allows reaching new
markets through trade and investment treaties, easy access to
international financial markets and brings with other benefits such as,
knowledge, technology and managerial capacity, creates business
environment, etc. Trade become the paramount engine of growth,
industrialisation and development, and is considered to be the third
among the most important factors contributing to growth following
improvements in infrastructure quality, economic governance and promote
industrialisation [Pakistan (2011)]. (3)
Pakistan has experienced a continuous trade and investment
liberalisation throughout the 1990s and process of reforms is still
going on. These reforms include reduction in government intervention,
removal of import quota, import surcharges and regulatory duties,
rationalisation of tariffs structure, elimination of the SROs, improving
export promotion and market information programmes, establishment of
exports promotion zones (EPZs), liberalisation of exchange rates and
investment regimes and opening up investment regime, among others.
Despite these measures, Pakistan's export growth rates were still
modest by international standards [Pakistan (2011)].
Although researchers gradually agreed that trade is good for
economic growth, but quantitive analysis have shown different picture
with respect to the trade-growth relationship. There are three big
reasons of mixed empirical results [Yen (2009)]. First, disagreement
over the choice of trade liberalisation indicators, whether it is actual
trade [Learner (1980)] or tariffs and non-tariff berries [Sachs and
Warner (1995)]. Second, choices of explanatory variables for economic
growth are different in countries carry out trade liberalisation
measures. Third, more sophisticated methodology is needed to investigate
the linkages between trade and growth, rather than single-equation
methodology. Salvator (1983), Rashid (1995) and Wacziarg (2001)
identified various channels through which trade liberalisation affects
economic growth.
Given the paramount importance of trade liberalisation in economic
growth process, it is necessary to understand the transmission channels
through which liberalisation affects industrial productivity, private
industrial investment, exports, imports and hence economic growth in
Pakistan. Previous studies in Pakistan inter alia Khan, et al. (1995),
Iqbal and Zahid (1998), Din, et al. (2003), Mamoon and Murshed (2006),
Khan and Qayyum (2007), Qayyum and Khan (2008), among other, either
estimated export function or tested Granger/Toda-Yamamoto causality
between trade and real GDP and fail to incorporate imports as
explanatory variable along with exports in the production function.
Omission of import variable from the production function would result in
spurious conclusions regarding the export-led growth hypothesis because
imports of capital goods are used as inputs for exports and domestic
productivity [Riezman, et al. (1996)]. Furthermore, liberalisation of
trade also affects industrial productivity through investment, exports
and imports channels. To the best of our knowledge no study is available
that focused on the transmission channels through which trade
liberalisation affects economic growth, industrial productivity, private
industrial investment, exports and imports in Pakistan.
The present study tries to fill up this gap by developing a
simultaneous equations model to determine how trade liberalisation
affect industrial productivity, domestic investment, exports and hence
economic growth in Pakistan over the period 1972-2011. Besides, the
present study develops a composite trade liberalisation index following
Wacziarg (2001) and then estimates simultaneous equations model using
ordinary least squares methodology. It is worth mentioning here that
application of Wacziarg (2001) approach for time series data is more
superior to other approaches because it separately analyses partial
channels to evaluate the impact of economic reforms initiated in 1990s
to Pakistan's economy, of which liberalisation of trade and
investment regimes is the most fundamental innovation in external
sector. The Wacziarg (2001) approach allows us to decompose the total
effect of liberalisation policy into industrial productivity into its
different components.
The rest of the paper is organised as follows: Section 2 briefly
overviews the trade liberalisation policy so far carried out in
Pakistan. Transmission channels model of trade and development is
specified in Section 3. Section 4 presents data sources. Construction of
liberalisation policy index is also discussed in this section. Empirical
results are interpreted in Section 5, while concluding remarks are given
in the final section. 2
2. OVERVIEW OF TRADE POLICY IN PAKISTAN
Pakistan has pursued a mixture of inward-and-outward-looking trade
policy for nearly four decades. High tariff rates, non-tariff barriers,
exchange controls and other administrative controls are the main
features of Pakistan's policy. The objective of this policy regime
was to promote import-substitution industrialisation and to protect
infant industries from external competition. This policy has generated
anti-export bias, inefficiencies and promoted rent seeking attitudes
[Qayyum and Khan (2009)]. However, learning lessons from successful
trade strategies by developed countries inspired many developing
countries including Pakistan to adopt outward-oriented trade policies
[Balassa (1989) and Michaely, et al. (1991)]. Benefits of
outward-orientation policies inspired Pakistan and other Asian countries
to open up their economies for trade and investment in the early 1990s.
Globalisation and World Trade Organisation (WTO) regime has enabled
developing countries to reap benefits of specialisation, obviate the
constraints of small size of markets and enhance the capacity of
absorbing spillovers of knowledge creation in different parts of the
world [RIS (2004) and Qayyum and Khan (2009)]. Due to
outward-orientation policies the growth performance of Pakistan has
improved steadily (Table 1).
Pakistan has introduced a series of measures including
rationalisation of tariff structure and removal of quantitive
restrictions to liberalise trade and investment regime. To this end,
maximum tariff rate on imports which was 225 percent in 1986-87 has come
down to 25 percent in 2005 [Hussain (2005) and Khan and Qayyum (2006)].
The average tariff rate which was 66 percent in 1990 was reduced to 14.7
percent in 2009. Similarly the number of custom duty slabs was reduced
from 13 in 1996-97 to 4, quantitive restrictions were lifted except for
those relating to security, health, and public morals, religious and
cultural related. All para-tariffs have been merged in to the statutory
tariff regime and import duties on 4000 items were reduced.
These measures have brought down effective rate of protection,
eliminate the antiexport bias and promote competitive and efficient
industry environment [Khan and Qayyum (2006)]. A number of laws were
promulgated to bring the trade regime in line with WTO regulations. (5)
However, despite the substantial reduction of tariffs and nontariffs
barriers, the growth in exports in 1990s was only 5.6 percent as
compared to 14.97 percent in 1970s and 8.5 percent in the 1980s. Table 1
depicts the outcomes of the liberalisation policy.
It can be seen from the Table 1 that since 2008 Pakistan's
economy followed a very low growth trend. This could be due to the
energy shortages, rising global commodity prices, adverse effects of
unprecedented floods of 2010 and low productivity of manufacturing
sector [Amjad, et al. (2011)]. Despite the liberalisation measures,
trade to GDP ratio in 2010 was approximately the same as a decade
earlier. Quality of poor governance and poor management structures,
dispersal of responsibilities among implementing agencies and absence of
mechanism for monitoring and resolving policy issues could be the
reasons of this trade policy ineffectiveness [Pakistan (2011)]. Import
dependence ratio which was 15.71 percent in 2001 increased to 23.28
percent in 2008, and then followed declining trends and reached to 16
percent in 2011. The simple tariff rate which was 20.2 percent in 2001,
decreased to 14.71 percent in 2009. Similarly, tariff revenue over total
imports was decreased after the enforcement of WTO agreement in 2001.
This sad picture of external sector performance calls to revisit the
trade liberalisation programme, further rationalise tariff structures
and eliminate regulatory duties.
3. TRANSMISSION CHANNEL MODEL OF TRADE AND DEVELOPMENT
Taking lead from Wacziarg (2001) we formulate macroeconometric
model of trade and development and identify various potential channels
such as, industrial sector private investment, exports and imports that
could affect industrial productivity in Pakistan. These channels can be
grouped into three broad categories viz. private industrial investment
channel that measure size and quality effects on industrial productivity
(i.e. by increase in inflow of capital goods and by increasing return to
scale due to specialisation). Yen (2009) argued that size effect of
investment on growth can be directly measured by the capital variable
and the quality effect is measured by total factor productivity (TFP) in
growth equation in which economic growth rate is entered as dependent
variable. Technology transmission channels that includes export of
manufacturing goods and import capital goods and trade liberalisation
channel that enhance growth through the creation of incentives for
governments to increase economic efficiency and growth through the
removal of market distortions and trade impediments.
We start with the assumption that Pakistan's economy consists
of industrial and non-industrial sectors. Aggregate real output
([T.sub.t]) is decomposed into the industrial output ([Y.sub.t.sup IND])
and non-industrial output ([Y.sub.t.sup IND]):
[Y.sub.t] = [Y.sup.IND.sup.t] + [Y.sup.NIND.sub.NIND] ... ... ...
... ... ... ... (1)
Industrial output includes small scale and large scale industries,
constructions, electricity and gas subsectors. Non-industrial output is
taken as exogenous and calculated by subtracting industrial sector
value-added from overall GDP. In industrial sector capital stock
([K.sup.IND.sub.t]) and labour ([L.sup.IND.sub.T]) are the key factors
of production. The production function for industrial sector is
specified as:
[Y.sup.IND.sub.t] = [Y.sup.IND]([K.sup.NIND.sub.t],
[K.sup.IND.sub.t]) ... ... ... ... ... ... (2)
The model expressed in Equation (2) is incapable to explain the
effects of structural changes on industrialisation and development
(Salvatore, 1983). Lewis (1954) argued that in the process of
industrialisation, labour ([L.sub.t]) and capital ([K.sub.t]) migrated
from low productivity sector (agriculture sector) to high productivity
sector (modem industrial sector). This mobility of factors depends on
the pace of industrialisation which can be taken as proxy for the rate
of past investment. Assume that increasing productivity of industries
may consider as preconditions for further growth of infrastructure and
skilled labour which are the key ingredients of industrial development
and hence economic growth [Salvatore (1983) and Rashid (1995)].
Besides labour and capital, it is assumed that total factor
productivity (TFP) can be affected by trade liberalisation. Theoretical
literature also recognised that exports contribute to greater economic
growth through generating favourable externalities, allowing economies
of scale to accrue, alleviating foreign exchange constraints and
fostering competitive pressures [Sprout and Weaver (1993)]. Production
of manufactured exports ([MX.sub.t]) and primary exports ([PX.sub.t])
introduces greater competition; equipped the economy with latest
technological advances and leads to higher rate of savings and
investments. Capital goods imports ([CM.sub.1]) and agriculture
productivity ([Y.sup.Agr.sub.t]) are another important determinants of
industrial growth. Capital goods imports are an important source of
technology transfer; enhance competition and reduce constraints in terms
of intermediate inputs. Agriculture value added is also included in the
specification because agriculture sector is backbone of developing
economies. Rapid agriculture growth has been associated with
industrialisation and leads to industrial productivity and economic
growth. Besides, shortages of energy, particularly natural gas shortages
to manufacturing sector ([INDGAS.sub.t]) and inflation rate
([INFL.sub.t]) are likely to influence manufacturing productivity
[Zerftt (2002) and Khan and Din (2011)].
It is assumed that technical efficiency of production depends
largely on the trade reforms and can have significant impact on
production function. To capture the effects of trade liberalisation we
have included trade liberalisation index ([LIB.sub.t]) in the
specification. Now the industrial production function takes the
following form:
[Y.sup.IND.sub.t] = [Y.sup.IND] ([K.sup.IND.sub.t],
[K.sup.IND.sub.t][L.sup.IND.sub.t][IX.sub.t], [PX.sub.t], [CM.sub.t]
>[Y.sup.Agr.sub.t], [INDGAS.sub.t], [INFL.sub.t], [LIB.sub.t]) ...
(3)
All right hand sides variables are expected to influence
manufacturing production positively except for inflation rate
([INFL.sub.t]).
3.1. Transmission Channel 1: Private Industrial Investment
The private industrial investment is one of the important channels
through which liberalisation affect industrial productivity and economic
growth. The standard literature points out that rate of investment
([I.sub.t]) is determined by domestic saving rate ([S.sub.t]) and
foreign capital inflows ([K.sup.f.sub.t]). Many developing countries
including Pakistan have been facing the problem of capital shortage. Low
levels of domestic saving and foreign exchange is the big constraint on
the level of domestic investment [Salvatore (1983)]. Although foreign
capital inflows often leads to a fall in domestic savings, however,
domestic savings can make a positive net addition to the rate of capital
formation because technological progress is embodied into new capital.
Following Chenery and Eckstein (1970) and Salvatore (1983) domestic
savings can be specified as a function of real income ([Y.sub.t]) and
real exports ([X.sub.t]):
[S.sub.t]=S([Y.sub.t], [X.sub.t])... ... ... ... ... ... ... (4)
In Equation (4) real income reflects a country's state of
development and expected to have a favourable impact on the saving rate
[Rashid (1995)]. Export performance is expected to affect the saving
rate positively. A higher ratio of exports relative to GDP can be
expected to lead to a higher level of private (public) savings because
trade taxes are the major sources of government revenue. Since imports
are generally restricted by government restrictive policies and act as
constraint on the domestic investment. Thus, import of investment goods
has been included in the private industrial investment function as proxy
for foreign capital. Based on the above arguments, private industrial
investment can be specified as:
[I.sup.IND.sub.t] = [I.sup.IND] ([Y.sup.IND.sub.t], [X.sub.t],
[CM.sub.t], [LIB.sub.t]) ... ... ... ... ... (5)
It can be argued that primary exports and manufactured exports also
play an important role in determining the private industrial investment.
Therefore, we extend Equation (5) by incorporating primary goods exports
and manufactured goods exports. Furthermore, inflation rate is also
treated as one of the important determinant of private industrial
investment. Increases in inflation rate generate macroeconomic
uncertainty which eventually produces adverse impact on private
industrial investment. Further, public investment in industrial sector
([GI.sup.IND.sub.t]) which concentrates mostly on infrastructure
development exerts significant influence on the private industrial
investment. By incorporating primary goods export (PX,), manufactured
goods export ([PX.sub.t]), inflation rate ([INFL.sub.t]) and government
investment in industrial sector, Equation (5) now can be rewritten as:
[I.sup.IND.sub.t] = [I.sup.IND] ([Y.sup.IND.sub.t], [PX.sub.t],
[MX.sub.t], [CM.sub.t], [GI.sup.IND.sub.t], [INFL.sub.t]) ... ... (6)
The impact of liberalisation policy ([LIB.sub.t]) on private
industrial investment is ambiguous. However, literature has identified
two factors that could contribute to the fall in private industrial
investment. First, some expenditure-switching policies accompany the
reform package could result in an increase in the relative price of
imported capital goods due to the devaluation in the real exchange rate.
Second, costly resource reallocation involved uncertainty. As a result,
private investors may keep capital either abroad or in existing
activities until the policy uncertainty will not be reversed. Evidence
suggests that private investment could fall due to the lack of
credibility of overambitious reforms in an unsettled macroeconomic
environment [Faini and de Melo (1990)].
3.2. Transmission Channel 2: Manufactured Exports Function
Manufactured exports can be treated as another important channel
through which trade liberalisation influences industrial productivity.
The learning effects of exports accumulate mostly in the manufacturing
sector. In Pakistan the share of primary exports in total exports and
the share of manufactured exports in total exports was 16 percent and 52
percent respectively in 1990-91, which was increased to 18 and 69
percent respectively in 2010-11. This implies that trade liberalisation
has increased technological capability in Pakistan's industrial
sector because the share of manufactured exports has increased since
1990-91.
To specify the exports function, it can be postulated that exports
are generally depends on relative competitive position of the nation and
the world market conditions [Salvatore (1983)]. The level of
industrialisation can be measured in terms of industrial productivity
([Y.sup.IND.sub.t]) which can be expected to affect the range and
quality of exports. Theoretical literature suggest that exports are
expected to increase with the world income ([Y.sup.W.sub.t]), industrial
productive capacity ([CAP.sub.t]) and trade liberalisation policies. On
the other hand, exports are expected to decrease with the increase in
price of exports relative to domestic price level ([RPX.sub.t]).
Following Goldar (1989), Paulino and Thirlwall (2004), Lopez (2004) and
Khan and Din (2011) exports function can be specified as:
[X.sup.J.sub.t] = X([RPX.sub.t], [Y.sup.W.sub.t], [CAP.sub.t],
[LIB.sub.t]) ... ... ... ... ... (7)
Where [X.sup.J.sub.t], represent exports of primary goods,
semi-manufactured goods and manufactured goods.
3.3. Transmission Channel 3: Imports of Capital Goods
Finally in trade and industrialisation model, imports should be
treated as endogenous and are generally determine by relative price of
imports ([RPM.sub.t]), domestic real income ([Y.sub.t]), real value of
worker's remittances (REMIT) and trade liberalisation policy.
Following Khan (1996), Paulino and Thirlwall (2004) and Khan and Din
(2011) we specify import function in the following form:
[M.sup.Z.su.t] = M([RPM.sub.t], [Y.sub.t], [REMIT.sub.t],
[LIB.sub.t])... ... ... ... (8)
Where [M.sup.Z.sub.t] represent merchandised and capital goods
imports.
Theoretical literature suggest that real imports are positively
related to domestic real income, remittances and trade liberalisation
policy, whereas relative price of imports exert negative impact on
imports.
The trade balance (T[B.sub.t]) is defined as:
[TB.sub.t] = ([X.sub.t] - [M.sub.t]) ... ... ... ... ... ... ...
(9)
4. DATA AND METHODOLOGY
The applicability of the estimation methodology has been often seen
in the light of data availability. Due to the short time span,
structural break and data with low frequency, the number of feasible
estimation methods are limited. Therefore, we have employed a
single-equation based cointegration method advanced by Engle and Granger
(1987) to determine the long-run relationship between the variables
entered in equations (3-8). It is well documented in the recent
literature that most of the macroeconomic time series displays a
non-stationary behaviour. If two or more series are non-stationary at
their levels then ordinary least squares (OLS) method gives spurious
results even though the estimated coefficient is highly significant
[Khan and Din (2011)]. Engle and Granger (1987) suggest the estimation
of cointegration relationship in the first stage with static OLS method.
The resulted residuals are then tested for stationarity. If they are
found to be stationary stationary then OLS parameters of treated as
asymptotically efficient and super consistent. Although multivariate
cointegration method due to Johansen (1991) is superior to that of Engle
and Granger method, however, multivariate cointegration method requires
high frequency data, but we are dealing with limited number of
observations (32 observations), which makes possible to apply
Engle-Granger cointegration method to investigate long-run relationship.
4.1. Data Issues
The present study utilises annual data for the period 1972-2012 for
Pakistan. Data on GDP, industrial value added, agriculture value added,
industrial labour force, private industrial investment proxied by gross
fixed capital formation in private, government investment in industrial
sector proxied by gross fixed capital formation in government sector are
collected from various issues of Pakistan Economic Survey. These data
are expressed at constant prices. Data on natural gas consumption,
primary exports, manufactured exports, semi-manufactured exports,
capital goods imports, nominal exchange rate, worker's remittances
are also taken from Pakistan Economic Survey (Various issues) and
undated from State Bank of Pakistan's database. Data on
merchandised exports, merchandised imports, exports price proxied by the
unit value of exports (2000=100), imports price proxied unit value of
imports (2000=100), whole sale price index (2000=100), consumer price
index (2000=100), foreign output proxied by United States GDP, United
States consumer price index (2000=100) and taken from International
Monetary Fund's International Financial Statistics (IFS)-CD-ROM and
updated from various monthly IFS bulletins. Data on capacity utilisation
variable is calculated as industrial value added minus industrial value
added obtained after the use of HP-filter. Data on Liberalisation Policy
Index (LIB) is constructed using principal component method. All
variables are expressed in logarithmic form except for inflation rate.
4.2. Trade Liberalisation Index
Wacziarg and Welch (2008) claimed that tariff and non-tariff
barriers restrict trade directly. Import liberalisation mostly depends
on the extent of restriction caused by the tariffs and non-tariff
barriers [Yen (2009)]. Similarly black market premium on exchange rate
could be considered as trade restriction. (6) Lowering of tariffs and
non-tariff barriers produces a significant impact on imports. In order
to quantify the impact of trade liberalisation, it is necessary to
obtain weights for liberalisation policy index with reference to tariff
and non-tariff barriers. As pointed by Wacziarg (2001), Pakistan was
signatory of World Trade Organisation (WTO) in 1995 but enforced
liberalisation measures in 2001. Therefore a time dummy (DUMWTO) for
non-tariff barriers removal was assigned value 1 for 2001 to 2012 and
zero for the previous period (1972-2000). The tariff rate is another
measure of trade liberalisation. However, changes in tariff rate are not
comparable across time as the tariff base changed and widening the total
tariff lines [Yen (2009)]. Therefore, we have used average tariff rate
(ATR) proxied by import tax revenue over total imports. The third
indicator is the existence of black market. Pakistan adopted free
floating exchange rate regime in July 2000 and with the establishment of
interbank foreign exchange market, black market is eliminated. Based on
these information we have constructed a dummy variable (DUMBM) that
takes value 1 for 1972-2000 and zero for 2001-2012. The liberalisation
index (LIB) can be expressed in Equation (10):
LIB = [[omega].sub.1] [ATR.sub.t] + [[omega].sub.2]DUMBM +
[[omega].sub.3] DUMWTO ... ... ... (10)
Where [[omega].sub.i] is the weight of the component constructed
using principal component method. The results are reported in Table 2.
We select the first principal component because it covers 92
percent of the total variations and has a fixed value of
[[omega].sub.i], with the weight based on the eigenvalue value to arrive
at Equation (11).
LIB = 0.2039,4 TR, +0.2093DUMBM - 0.211ZDUMWTO ... ... (11)
Using the weights of variables [[omega].sub.i], from Equation (11)
and multiplying the corresponding variables, the index for trade
liberalisation is calculated. Figure 1 presents trade liberalisation
index from 1973.
[FIGURE 1 OMITTED]
It is evident from Figure 1 that Pakistan has experienced
continuous liberalisation measures throughout 1990s and the process of
reforms is still going on, which can be easily observable from the
negative trend of trade liberalisation index. Downward trend of trade
liberalisation index indicates relaxing the tariffs and non-tariff
barriers since 1990.
5. EMPIRICAL ESTIMATES OF STRUCTURAL EQUATIONS
The behavioural equations in the model have been estimated using
OLS method. We have undertaken general-to-specific procedure to obtain
more parsimonious results. Since we have small data at hand with only 32
annual observations which constraint us to report only parsimonious
equations. (7) Before estimation of individual equations of, we have
started with Augmented Dickey Filler (ADF) unit root test to examine the
time series properties of the data and the results are reported in Table
3 (Appendix 1). The results shows that all the series under
consideration following I (1) processes. For each equation t-values of
the estimated coefficients are given in parentheses. Residual sum of
squares (RSS), standard deviation of dependent variables ([sigma]) and
the adjusted coefficient of multiple determination ([bar.R].sup.2]) are
listed below each equation. The ADF cointegration test performed on the
residuals obtained from the estimated equations is reported below each
equation. (8)
In addition, to access the appropriateness of the estimated
equations, we have employ a battery of diagnostics such as, Jarque-Bera
(JB) for normality, Langrange Multiplier (LM) for serial correlation,
autoregressive conditional heteroscedasticity (ARCH) for
heteroscedasticity, Remsay's RESET test for functional
specification and CUSUM and CUMSUMSQ for structural stability of each
equation. The more parsimonious results of each structural equation are
reported in below:
5.1. Industrial Productivity
The industrial value-added is positively and significantly
explained by the private industrial investment, industrial labour force,
capital goods imports, manufactured exports, agricultural value added
and trade liberalisation. Only inflation rate and natural gas
consumption exerts negative effects on industrial productivity.
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (12)
As evident from the Equation (12) that besides labour and
investment, trade related variables such as capital goods import (CM)
and manufactured goods export (MX) carries positive signs. The result
reveals that capital goods import and manufactured goods export
contributes 0.18 percent and 0.17 percent to industrial productivity as
the capital goods import and manufactured goods export increases by 1
percent. This result is consistent with the views of Golder and Kumari
(2003) who argued that exports and imports would make industrial sector
more competitive, vibrant and efficient, and would enable industrial
sector to achieve rapid growth. It is worth mentioning that import
liberalisation enhanced productivity of Indian industry in the
post-reform period [Golder and Kumari (2003)]. Furthermore, the positive
association between manufactured exports and industrial productivity and
between capital goods import and industrial productivity verifies the
Ricardo's comparative advantage theory and Heckscher-Ohlin's
factor abundance theory. Herzer, et al. (2006) finds an evidence of
productivity enhancing effects of manufactured exports and productivity
limiting effects of primary exports in the case of Chile.
Agricultural value added is positively associated to industrial
productivity with 0.60 percent contribution. This result is not
surprising in the case of Pakistan because Pakistan has been still
agrarian economy and demands for industrial products depend on the
performance of agriculture sector [Mazumdar (2005)]. Rashid (1995) and
Sastry, et al. (2003) finds similar results for India. This suggests
that agriculture productivity is an important determinant of industrial
productivity. Khan and Din (2011) also find an evidence of positive
correlation between agro-based raw materials and industrial
productivity.
One year lagged natural gas consumption of industrial sector exerts
negative but insignificant effects on industrial productivity. This
result could be possible because industrial sector uses only 25.3
percent natural gas and utilises 27 percent electricity and 5.9 percent
petroleum in energy mix. Although, the coefficient of natural gas
consumption is insignificant, but it provides very important information
that shortage of energy particularly electricity and natural gas
deteriorates industrial performance in recent years. Similarly,
macroeconomic uncertainty produces negative influence on industrial
productivity. This implies that increases in inflation rate influences
industrial productivity through cost-push channels.
Finally, the trade liberalisation variable (LIB) is found to be
positive and statistically significant, reveal that liberalisation
measures and increased flexibility of firms through reduction of
domestic constraints exerts positive and significant impact on
productivity and growth. This result implies that trade liberalisation
could lead positive growth of industrial sector.
5.2. Domestic Private Industrial Investment
The empirical literature on trade and investment suggests that the
effects of liberalisation on economic growth are mediated by the rate of
physical capital investment [Wacziarg and Welch (2003)]. Trade
liberalisation shifts relative prices in the favour of exports sector,
which increases the profits in the exports sector and hence induces
domestic investment. Levine and Renelt (1992), Baldwin and Seghezza
(1996) and Wacziarg (2001) have argued that investment rates are the
main channels linking trade and growth. To investigate the effect of
liberalisation on investment we have estimated the following regression:
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (13)
From Equation (13), It can infer that industrial investment is
positively related to industrial productivity. Industrial productivity
can be often treated as size of industrial sector. Our results suggest
that a 1 percent expansion of the size of industrial productivity
increases industrial investment by 0.41 percent. Furthermore, the
positive association of industrial real income and industrial investment
verifies the famous accelerator principle.
Import of capital goods and other equipment exerts positive impact
on industrial investment, whereas exports of primary goods and
manufactured goods produce negative and positive influence on industrial
investment. The positive association between imports of capital goods
and exports of manufactured goods suggest that trade play a significant
role in determination of industrial investment. The negative coefficient
of exports of primary goods and raw materials suggest that exports of
primary goods and raw materials create shortage of raw material for
domestic industries which constraints industrial investment. Similarly,
positive coefficient of manufactured exports implies that a 1 percent
increase in manufactured exports induces manufacturing investment by
0.39 percent. Inflation rate and government investment in industrial
sector exerts negative influence in industrial investment. This result
implies that macroeconomic uncertainty deteriorates industrial
performance, while government investment in manufacturing sector crowds
out industrial investment. The most striking result that we have
obtained is the positive association between liberalisation policy and
industrialisation. The coefficient of liberalisation policy variable is
0.37 which implies that trade liberalisation causes industrial
investment by 0.37 percent.
Since trade liberalisation is considered to be the important
channel of economic growth. To determine the effect of trade
liberalisation on industrial productivity, we multiply coefficient on
industrial investment in Equation (12) with coefficient of
liberalisation in Equation (13). The effect of liberalisation on
industrial productivity via industrial investment is estimated to be
0.055. This compares to the total effect of liberalisation on industrial
productivity of 0.05 percent (Equation 12). Hence, this calculation
reveals that investment channel accounts for about 17 percent of the
effect of liberalisation on industrial productivity. These results imply
that investment constitutes an important channel through which trade
liberalisation influences industrial growth. Our results are consistent
with earlier findings of Wacziarg and Welch (2008).
5.3. Merchandised Exports
Theoretically exports are determined by world income, relative
price of exports, exports potential, remittances and liberalisation
policy. Equation(s) (14a, 14b, 14c, and 14d) reports the estimated
results of merchandised export, primary goods export, semi-manufactured
export and manufactured export functions.
(i) Merchandised Exports Function
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (14a)
(ii) Primary Exports Function
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (14b)
(iii) Semi-Manufactured Exports Function
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (14c)
(iv) Manufactured Exports Function
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (14d)
Equation(s) 14a-14d predicts positive relationship between variant
of exports and world income. This suggests that expansion of world
markets for Pakistani products enable Pakistani firms to export more.
The estimates of export demand elasticity with respect to world income
varies from 0.30 to 0.76 which implies that Pakistani exports are
sensitive to external demand.
Industrial productive capacity (export potential) ([CAP.sub.t])
proxied by industrial productivity gap exerts positive and significant
effects on all variants of exports except for primary exports. This
implies that an expansion of productivity capacity of manufacturing
industries stimulates- semi-manufactured exports and manufactured
exports, which eventually increases merchandised exports. This result
suggests that domestic market conditions strongly influence exports. The
export elasticities with respect to relative price of exports produce
negative effects on all type of exports. The price elasticity of exports
ranges from 0.65 to 1.96 which implies that an increase in price of
exports relative to domestic price level discourages exports. The reason
could be that as exports price increases Pakistani exports becomes more
expansive in the world market. As results, foreign consumers reduce the
demand for Pakistani products. These results are consistent with the
earlier findings of Arize (1999) and Narayan (2004). Real value of
remittances which is used as proxy for out-migration turns out to be
another important determinant of exports. This result could be justified
on the grounds that high percentage of remittances in Pakistan is spent
on the purchasing land, construction and durable goods. Any increase in
remittances is consider as an important source in building
infrastructure for the export sector and provides necessary cash
reserves, allowing for continued growth and to achieve economies of
scale in production [Kader, et al. (1987)].
Finally, liberalisation variable exerts positive impact on exports
in all cases. This result implies the lowering of trade barriers may
have positive effects on exports growth.
(v) Merchandised Import Function
The merchandised import function is determined by domestic income,
relative price of imports, foreign capital inflows proxied by
worker's remittances and liberalisation policy. Equation (15a-15b)
presents estimates of merchandised imports and capital goods and
equipments imports respectively.
(vi) Merchandised Import Function
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (15a)
(vii) Capital Goods and Equipments Import Function
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (15b)
Estimates reported in equation (15a-15b) reveals that domestic
income, remittances and liberalisation policy exerts positive impact on
merchandised imports and capital goods imports, whereas relative price
of imports produces negative but insignificant effect on both variants
of imports. All variables enter in import function with expected signs
and statistically significant, only the relative price of imports shows
an insignificant effect. Income elasticity of merchandised and capital
goods imports is inelastic (0.40 for merchandised imports and 0.35 for
capital imports), implying that a 1 percent increase in real income
could lead to an increase in the merchandised imports and capital
imports by 0.40 percent and 0.35 percent respectively. Foreign capital
produces significant positive effects on merchandised and capital goods
imports. This result suggests that an increase in foreign capital could
increases merchandised import demand by 0.14 percent and capital goods
imports by 0.176 percent. The tariffs liberalisation variable
([LIB.sub.t]) produces positive and significant impact on both variants
of imports with reasonable coefficient. This means that lowering tariffs
and other trade impediments could lead to an increase in imports with
the contribution of liberalisation with respect to capital goods imports
is 0.17 and 0.27 with reference to merchandised imports. The indirect
effect of imports channel on industrial productivity through capital
goods imports is equal to 0.031 percent, while the direct effect of
capital goods imports on industrial productivity is equal to 0.18
percent (Equation 10). This suggest the besides export-led productivity
growth, merchandised and imports of capital goods also play significant
role in enhancing industrial productivity. However, trade liberalisation
shows low impact on imports as compared to exports.
The relative price variable enters in import function with expected
negative sign, but statistically insignificant in both cases. This
result suggests that Pakistan's imports are insensitive with
respect to imports price. This finding could be justified on the grounds
that our imports are price inelastic which implies that an increase in
imports produces on significant negative impacts on imports because of
inelastic import demand. This result could be possible in the case of
Pakistan because Pakistan imported machinery and other industrial
equipments from the rest of the world which accounts for 93 percent of
the total imports in 2011. The value of price elasticity of imports is
consistent with the earlier findings of Khan (1996). The sum of the
price elasticities of merchandised exports and imports is -1.06, which
implies that Marshal-Lerner conditions for a successful devaluation are
satisfied.
5.4. Direct and Indirect Effects of Liberalisation on Industrial
Productivity
The direct and indirect contributions of trade liberalisation with
regard to channel equations can be reported in Table 3.
It is evident from Table 3 that there is significant effect of
liberalisation on industrial productivity through channels. The overall
impact of trade liberalisation is 0.164 percent on industrial
productivity in Pakistan. This provides an indication that private
industrial investment ([I.sup.IND.sub.t]), manufactured exports
([MX.sut.t]) and imports of capital goods ([CM.sub.t]) are the key
factors through which trade liberalisation affects industrial
productivity and hence economic growth in Pakistan. It is worth
mentioning here that technological capability accelerated through
exports as results of diversifying trade partners after import
liberalisation [Yen (2009)]. Import liberalisation enhances private
industrial investment by providing cheaper capital goods and raw
materials to domestic market and enables domestic traders to compete
foreign products at international market. The indirect contribution of
trade liberalisation to industrial productivity through private
industrial investment is nearly 72 percent, followed by 20 percent
contribution of manufactured exports and imports capital goods and
equipments respectively.
Finally, our results provide a clear indication that for
effectiveness of trade liberalisation policy and to reap the benefits of
open door policy, there is a need to encourage private industrial
investment and manage external sector of Pakistan's economy.
6. CONCLUSIONS AND IMPLICATIONS
This paper develops a macroeconometric model to examine the impact
of trade liberalisation on industrial productivity, private industrial
investment, variants of exports and imports in Pakistan over the period
1972-2012. Our finding supports the hypothesis that lowering tariffs and
non-tariff barriers and adopting more open door policies leads to
efficient utilisation of domestic resources which in turn, accelerates
the pace of industrial productivity and economic growth. The
relationship between industrial productivity, capital goods imports and
manufactured goods exports seems highly significant, which verifies the
hypothesis that trade is engine of economic growth. Besides exports and
imports, domestic factors such as private industrial investment,
industrial labour and agricultural productivity have highly significant
impact on industrial productivity. Capital goods imports,
semi-manufactured goods exports, manufactured goods exports and tariffs
liberalisation promotes industrialisation significantly. Only primary
goods exports influences industrialisation negatively.
Tariffs liberalisation contributes positively in enhancing exports
and imports. Other factor such as, capacity utilisation, relative prices
of exports and imports, world output, domestic absorption and home
remittances appears as important determinants of exports and imports.
Furthermore, the contribution of private industrial investment,
merchandised exports and capital goods imports to industrial
productivity is 32 percent and 20 percent each respectively. In other
words, private industrial investment contributes 32 percent while
technology transmission group (i.e., exports and imports) contributes 40
percent to industrial productivity in Pakistan. In overall term,
liberalisation contribution accounts for 0.164 percent which implies
that a 1 percent increase in tariffs liberalisation instigates
industrial productivity by 0.164 percent.
The above finding is a bit realistic for industrial success in
Pakistan since economic reform policy aims at opening up international
trade to facilitate private sector in Pakistan. It is expected that
imports liberalisation upgrades technological capability of industrial
sector which in turn, industrial productivity and economic growth. If
the country promotes manufactured exports and elevates technology
transfer through imports, the impact of import liberalisation to
economic growth will be enlarged [Yen (1999)]. Our result confirms the
role of channels through which trade liberalisation influences
industrial productivity. Therefore, there is need to import capital
goods and technology-oriented products to make domestic industries more
efficient, competitive and vibrant and accelerate exports to earn
foreign exchange. To increase the supply of exports there is need to
expand export potential and reduce profit differential between producing
for the home market and producing for the global market. Furthermore,
there is need to use remittances for the development of infrastructure
for exportable industries.
Although this study provides important information regarding the
channels through which trade liberalisation affects industrial
productivity and concentrates only on (i) a role of domestic factors,
(b) role of external factors, and (c) impact of liberalisation on
industrial output. In future, the study could be extended by taking in
to account the disaggregate component of exports and imports
APPENDIX 1
Table 1
Unit Root Test
Series Specification Lags ADF-Levels
[Y.sup.IND.sub.t] C 1 -1.6903
[Y.sup.AGR.sub.t] C 1 -0.9354
[Y.sup.W.sub.t] c 1 -1.6059
[Y.sup.AGR.sub.t] c 1 -2.8498
[I.sup.IND.sub.t] c 1 -1.5002
[L.sup.IND.sub.t] C, T 1 -0.5304
[M.sub.t] C 1 -0.2879
[CM.sub.t] C 1 -1.8659
[X.sub.t] C 1 -0.0812
[PX.sub.t] C 1 -0.6314
[MX.sub.t] C 1 -1.0899
[GAS.sup.IND.sub.t] C, T 1 -1.6861
[RPX.sub.t] C, T 1 -0.5451
[RPM.sub.t] C 1 -1.1583
[INFL.sub.t] C 1 -2.1159
[CAP.sub.t] C 1 -2.9243
[REM.sub.t] C 0 -1.7979
[LIB.sub.t] C, T 3 -2.4465
ADF-First
Series Difference Decision
[Y.sup.IND.sub.t] -6.3321 * I(1)
[Y.sup.AGR.sub.t] -5.2825 * I(1)
[Y.sup.W.sub.t] -4.0809 * I(1)
[Y.sup.AGR.sub.t] -2.9632 *** I(1)
[I.sup.IND.sub.t] -4.3348 * I(1)
[L.sup.IND.sub.t] -4.8611 * I(1)
[M.sub.t] -4.7767 * I(1)
[CM.sub.t] -4.7808 * I(1)
[X.sub.t] -3.8065 * I(1)
[PX.sub.t] -5.9756 * I(1)
[MX.sub.t] -4.4026 * I(1)
[GAS.sup.IND.sub.t] -3.7607 * I(1)
[RPX.sub.t] -4.0284 * I(1)
[RPM.sub.t] -3.1412 * I(1)
[INFL.sub.t] -4.7491 * I(1)
[CAP.sub.t] -4.0214 * I(1)
[REM.sub.t] -2.9124 *** I(1)
[LIB.sub.t] -7.4156 * I(1)
Note: *, **, *** indicates significant at the 1
percent, 5 percent and 10 percent level. C and
T represents constant and trend terms.
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(1) Trade liberalisation may be defined as set of measures which
includes elimination of government distortions, dismantling quantitative
restrictions on imports, reducing import tariffs, making currency
convertible for current account transactions, eliminating bureaucratic
red tape and other impediments to foreign direct investment and
improving customs procedures [Rodrik (2006)]. The outcomes of trade
liberalisation lead to increase specialisation, promote
industrialisation and technological progress, increasing competition and
improvement in the living standards of the population [Cruz (2008)].
(2) Detailed discussions of empirical literature and references can
be seen in Qayyum and Khan (2009) and Jaffari (2006).
(3) Framework for Economic Growth Pakistan: May 2011, Planning
Commission, Government of Pakistan.
(4) We would like to thank Ms Naila Jabeen PhD Scholar, Pakistan
Institute of Development Economics, Islamabad for providing data on
tariff revenues.
(5) A number of laws were promulgated such as anti-dumping,
countervailing measures and intellectual property rights.
(6) For example, exports have purchase to foreign inputs using
foreign currency obtained on the black market but remit their foreign
exchange receipts from exports to the government at the official
exchange rate, the black market exchange rate acts as trade restrictions
[Wacziarg and Welch (2008)].
(7) We have used PcGets approach to select an appropriate model.
For details of PcGets modelling approach, see Hendry and Krolzig (2004).
(8) **, ** and *** indicate significant at 1 percent, 5 percent and
10 percent level.
Muhammad Arshad Khan <arshad.khan@comsats.edu.pk> is
Associate Professor, COMSATS Institute of Information Technology,
Islamabad. Ayaz Ahmed <chayaz_1961@yahoo.com> is Senior Research
Economist, Pakistan Institute of Development Economics, Islamabad.
Table 1
Growth Rates of Exports, Imports, Share of Trade to
GDP and Average Tariff
Manufa-
during Trade as
Value- percentage
Year GDP added Exports Imports of GDP
1970s 4.8 5.5 6.07 8.35 23.22
1980s 6.5 8.2 14.97 18.78 31.38
1990s 4.6 4.8 8.52 4.54 34.75
2000s 4.8 7.0 5.61 3.22 35.33
2001 2.0 9.3 9.07 6.25 30.37
2002 3.1 4.5 2.32 -7.53 30.54
2003 4.7 6.9 19.14 20.13 32.85
2004 7.5 14.0 13.84 20.04 30.30
2005 9.0 15.5 16.8 39.6 35.25
2006 5.8 8.7 14.3 31.6 38.45
2007 6.8 8.3 4.4 8.0 35.54
2008 4.1 4.8 18.2 31.2 36.73
2009 1.7 -3.6 -6.4 -10.3 33.25
2010 3.8 5.5 2.9 -1.7 32.32
2011 3.0 3.1 29.3 14.5 27.83
Tariff
Import Simple Revenue as
Dependence Average Percentage
Year Ratio Tariff of Imports (4)
1970s 14.84 -- --
1980s 20.02 -- 26.79
1990s 22.37 71.37 28.49
2000s 19.14 46.58 19.99
2001 15.71 20.2 10.31
2002 15.31 17.2 7.13
2003 16.13 16.8 9.14
2004 14.63 16.2 8.70
2005 19.56 14.61 7.64
2006 23.22 14.79 8.04
2007 21.34 14.9 7.14
2008 23.28 14 5.99
2009 20.34 14.71 6.24
2010 18.73 13.9 5.66
2011 15.93 -- 5.41
Source: Khan and Qayyum (2006), Economic and Social
Survey of Asia and the Pacific 2012 and World Bank-
World Development Indicators 2012.
Table 2
Eigenvectors of the Policy Variables
Eigenvectors
Variable PCI PC2 PC3
ATR 0.564991 0.812806 0.141883
DUMBM 0.579945 -0.513522 0.632423
DUMWTO -0.586898 0.275028 0.761519
Eigenvalues 2.771218 0.172953 0.055828
Table 3
Direct and Indirect Contributions of Trade Liberalisation
Contribution
Channels Impact (in %)
Direct channel 0.05 30.49
Private industrial investment 0.052 31.71
([I.sup.IND.sub.t]) channel
Exports: Manufactured exports 0.031 18.9
([MX.sub.t]) channel
Imports: Capital goods and equipments 0.031 18.9
([CM.sub.t]) channel
Total effect of liberalisation on industrial 0.164 100
productivity
