Determinants of trade deficit of Pakistan

Aniqa Zeb
M. Phil Economics Department of economics University of Karachi

Abstract:
This study is conducted to find most influential variable(s) responsible in the huge trade balance in case of Pakistan trade deficit of the country. Time series data is taken since 1991-2010.The variables which are taken are trade deficit, Gdp, Exchange rate and money supply of Pakistan. The OLS technique is used to run a simple regression. Results revealed that all variables are significant and Gdp is positively related to trade balance of Pakistan, altetnative hypotheses are rejected. Money supply is positively related to trade deficit and alternative hypotheses is being accepted that means money supply increases and cause trade deficit to rise as well. Finally alternative hypotheses about exchange rate is being accepted which means exchange rate is negatively related to trade deficit (increase in exchange rate will decrease trade balance). Overall model is significant and adjusted R-squared is 0.96 which means 96% variations in trade deficit are being explained by the model in this paper. Key word: Trade deficit, money supply, exchange rate, Gdp

Introduction:
Pakistan is facing continual trade deficit for more than half century except two fiscal years. In 1951 Pakistan earned foreign exchange by the export of raw jute and cotton and trade surplus was Rs.176 million this increase in export demand was due to Korean War. In year 1972/3, Bhutto Government devalued rupee by 56% and imposed high tariff on imports of luxury goods. Trade surplus was Rs.153 million that year. Pakistans trade balance is in deficit primarily due to high imports of energy. Main imports are fuel (40% of total imports, machinery and transport equipment (18%) and chemicals (16% of total imports). Pakistan exports: cotton and knitwear (28% of total exports), bed wear, carpets and rugs (8%) and rice (8%). Pakistans exports are agriculture based where there is a lot of dependence upon climate & nature creates uncertainty about the crops which affect trade (exports). Exports are less than imports most of the times in case of Pakistan and imports are also expensive as compared to value of exports. This is also a significant reason of continuous trade deficit. The objective of this study is to find out the variables which are responsible for the trade deficit in Pakistan. There are many variables which may be taken but there are limitations of time and experience. A lot of work is done to determinants of trade deficit, some researchers used ARDL technique, Co-integration techniques, error correction models are also been used. Researcher in order to differentiate her work used simple regression OLS technique for her study. Section II is Theoretical literature review, section III empirical literature review , section IV modeling frame work, section V estimation results, section VI conclusion & policy implications, section VII direction for research, section VIII references.

Review of theoretical literature:

Charles (1901) when the country imports more than she exports she will lose foreign exchange. All great nations of the world with the exception of Russia and United States, declared to earn loses due to high imports. Fieleke (1987) finds that an increase in government borrowing lead to increase in interest rate other things remains constant, so when interest rate is high that lead to foreign investment in the country when the foreign investment increase there will be increase in money supply in the country when the money supply increase there will be inflation in the country, the domestic people will buy foreign goods so the imports will rise, which lead to current account deficit. This approach is discussed by the Keynesian in their absorption approach in the way that if there is increase in budget deficit that will lead to induce domestic absorption that lead to import expansion and decrease export and that lead to current account deficit. Mundell- Fleming (1962-1963) increase in trade deficit led by increase in budget deficit because consumer spending increase which means import of the country will increase and export will decrease.

Review of Empirical literature:

Mbayani (2006) studied determinants of trade deficit in Tanzania. Data from the period 1970 2002 is used; variables are trade balance, FDI, real exchange rate, private consumption, Government expenditure, real income to the rest of the world and dummy variable trade liberalization. From the results is being concluded that Government expenditures and private consumption are main factors causing trade balance. Policy instrument trade liberalization and protectionism also impacted trade balance in Tanzania. Sulaiman (2010) used Johnson co-integration approach and error correction Model (ECM) to find out the long run and short run determinants of trade deficit of Pakistan. Variables are foreign income, FDI, domestic household consumption and real effective exchange rate. Author finds that all variables are significantly affect trade deficit. Waliullah et al (2010) used ARDL Co integration approach for the determinants of trade balance. Annual data for the period 1970 to 2005 has been used to investigate long run relationship between trade balance and its determinants. Variables which are used are trade balance, income, money supply and exchange rate. Variance decompositions (VDCs) and Impulse Response Functions (IRFs) are also used to draw further inferences. The results of the study revealed that there is a stable long run relationship between trade deficit, money supply, income and exchange rate. Edward (2010) studied determinants of trade deficit in Kenya. Data is taken from the period 1970-2010. Variables used are trade balance, real exchange rate, and Government consumption expenditure, and Domestic income, income from rest of the world, FDI and money supply. Technique used is OLS. Results found that real exchange rate, government consumption expenditure, domestic income, FDI and money supply are significant determinants of trade deficit in Kenya while income from rest of the world is insignificant determinants of trade deficit. Rauf, Qayyum (2011) found that Twin Deficit which are budget deficit and trade deficit have relationship in case of Pakistan. Annual for the period 1980-2009 is used. Granger Causality test and OLS technique is used in the study. Results found by the authors are that, trade deficit cause budget deficit. Aurangzeb, Haq (2012) used multiple regression analysis technique and Granger causality test in their study, data collected from the period 1981 to 2010. Factors used in analysis are exchange rate, Gdp, remittances FDI. Results of the multiple regressions indicate that exchange rate in negatively related to trade deficit, while Gdp, remittances and FDI are positively related to trade deficit. Exchange rate, FDI and remittances have bi directional relation with trade deficit while Gdp is uni directional to the trade deficit. .It is recommended by the authors to policy makers to evaluate these factors on continuous trade deficit

Modeling Frame work:

DTB=f DTB = Expected signs >0 1<0 2<0 3>0

Estimation Results:
Annual time series data of variables has been taken. Data is from the period1991 to 2010 Statistical descriptive

BTD Mean 7206.615 Median 2587.150 Maximum 35221.10 Minimum 1015.500 Sum 144132.3 Observations 20 Source: Authors estimation

Gdp 124255.3 73409.50 718909.0 51934.00 2485106. 20

EX. Rate 48.93067 50.91275 83.80170 22.42270 978.6134 20

MS 2238451. 1513369. 5777231. 418263.0 44769027 20

As data is taken from 1991-2010 total observations are 20. Mean value of trade balance deficit here is7206.615 million Rs. Mean values of Gdp, Ex. rate and money supply are 124255.3 Mln Rs, 48.93 Rs. And 2238451 mlns Rs. respectively. Maximum value of balance of trade deficit Rs.35221mlns. Maximum value of Gdp, Ex. Rate and money supply in these 20 years was 718909.0 mlns Rs. 83.80 Rs, and 577231 mlns Rs. respectively. Minimum values are 1015.500 Mln Rs, 51934.0 mlns Rs, 22.422 Rs. and 418263.0 mlns Rs for trade deficit, Gdp, Ex. Rate and money supply respectively. Correlation matrix BTD BTD GDP Ex. rate 1.000000 0.867762 0.348898 GDP 0.867762 1.000000 0.084440 0.093294 Ex. rate 0.348898 0.084440 1.000000 0.918944 MS 0.482778 0.093294 0.918944 1.000000

MS 0.482778 Source: Authors estimation

From the correlation matrix, it is revealed that trade deficit strongly correlated with Gdp, less than that (Gdp) to money supply and then to exchange rate. Money supply and exchange rate are also positively correlated.

Regression Results Dependent Variable: BTD Method: Least Squares Sample: 1991 2010 Included observations: 20 Coefficien t 4516.557 0.051625 -310.8359 0.005131 0.972307 0.967115

Variable C GDP EXC MS R-squared Adjusted R-squared

Std. Error 1649.150 0.002602 54.44393 0.000565

t-Statistic 2.738718 19.84326 -5.709285 9.082610

Prob. 0.0146 0.0000 0.0000 0.0000 187.2544 0.000000

F-statistic Prob(F-statistic)

Source: Authors estimation

From the regression results it is found that Gdp ids positively related to trade deficit which means alternative hypotheses about Gdp is rejected. But it is statistically significant. Exchange rate is negatively related to trade deficit which means as exchange rate decreases, trade deficit increases. An alternative hypothesis is accepted. Exchange rate is also statistically significant. Money supply is positively related to trade deficit which indicates that an increase in money supply will increase it (trade deficit). From the F-statistics it is also clear that overall model is significant.

Actual- Fitted- Residual graph

40000 30000 20000 4000 2000 0 -2000 -4000 92 94 96 98 00 02 Actual 04 06 08 10 10000 0

Residual

Fitted

Source: Authors estimation Actual fitted-residual graph mirrors the actual and fitted (estimated) regression run. For this graph to be good it should follow the turning points of the actual line. In this graph nature of data is the reason for not following turning points. There may be punching error. Gdps data nature is the reason behind the peak of the graph.

Conclusion & Policy implications:

From the above results it is shown that overall model is significant. Adjusted R-squared is 0.96% which means that 96%of the variations in the trade deficit are explained by these variables. Starting from Gdp, an alternative hypothesis was that with the increase of Gdp, trade deficit will decrease. Here in this study trade deficit is positively related to Gdp which means that domestic production increases demand for intermediate goods rise (which are our imports). As imports increases which are always greater than exports, increases the balance of trade in deficit. Alternative hypotheses about money supply have been accepted which means a rapidly growing money supply boosts demand including demand for imports. This has two effects i) it generates inflationary pressure ii) it directs too much investment in other nation into exports industries. Alternative hypotheses of exchange rate: with the increase in exchange rate (depreciation of domestic currency) trade deficit will be reduced. Depreciation of domestic currency will make exports cheaper and imports expensive. On the net exports will increase and trade deficit will decrease. Pakistans exports comprises of agriculture products which are used as raw material in the production of value added goods in other countries. Following are some recommendations which if adopted by policy makers and concerned authorities will help in reducing the gap between exports and imports of the country. Need of the time is to produce value added goods at home and then exports them to earn foreign exchange to pay for heavy imports bill. Diversification of exports will also increase export volume. Devaluation of the domestic currency also helps in narrowing deficit. Tight monetary policy will also reduce deficit.

Direction for further Research:

Due to less time and lack of experience author used only 3 independent variables and run a simple regression line. There should be conducted another study using more variables like FDI, external debt, interest rate and political stability and many others. Simultaneous equations could be used to check the direction of variables towards trade balance are uni -directional or bi directional.

Reference:
Abdul Rauf, Dr Abdul Qayyum (2011) An empirical study to find the relationship between Trade deficit and Budget Deficit in Pakistan, Academic Research International Vol.I, Issue 3. November 2011 Aurangzeb, Anwar ul Haq (2012) Factors affecting the trade balance in Pakistan, Economics & Finance Review ; Jan 2012, Vol.1, Issue 11, p25 Charles J. Bullock (1901) Theory of balance Trade. The North American Review, Vol.173, No.536, Jul., 1901. Page [111-133]. Edward- Njenga (2010), The determinants of trade balance. An empirical analysis (1970-2010) School of Economics, University of Nairobi Mbayani Saruni(2006) Determinants of Trade Balance in Tanzania 1970-2002, Economist, Ministry of Planning & Empowerment Tanzania May 2006 Mohammad Asif(2011) Impact of devaluation on trade balance of Pakistan Oeconomics of knowledge, Volume3, Issue 3,3Q, Summer2011 State bank of Pakistan Sulaiman D Mohammad(2010) Determinants of Trade deficit: Case study of Pakistan European Journal of Scientific Research, ISSN1450-216X Vol.41 No.1 (2010),pp.13-20 Unctad Statistical Year Book2012