Pakistan s Imports Dependency and Regional Integration. Nasir Iqbal, Ejaz Ghani, Musleh ud Din 1

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1 Pakistan s Imports Dependency and Regional Integration Nasir Iqbal, Ejaz Ghani, Musleh ud Din 1 Abstract: Pakistan s economy is characterized by a fairly open trade regime with imports accounting for a major share of total trade. The economy depends on a variety of imports to meet its production and consumption needs. The study argues that Pakistan s trade regime is increasingly affected by the growing trend towards global and regional economic integration. Such integration facilitates the free flow of goods and services and factors of production among countries through elimination of tariff and non-tariff barriers. Pakistan is actively pursuing a policy of enhancing regional economic cooperation and has entered into different regional and bilateral trade agreements which encompass various trade policies ranging from imports substitution to exports promotion. The paper analyzes the import structure of Pakistan with special reference to regional economic integration. In particular, the paper (i) examines the imports structure of Pakistan over the last few decades; (ii) reviews the importance of regional and bilateral agreements in diversifying imports; (iii) conducts an empirical analysis to estimate imports elasticities; and (iv) spells out policy options to reap the benefits of regionalization. 1. Introduction Pakistan s economy is characterized by a fairly open trade regime with imports accounting for a major share of total trade. Like many developing economies, Pakistan s economy depends on a variety of imports to meet its production and consumption needs. However, import demand in Pakistan is highly concentrated in few products and few imports markets. Major imports include items namely Machinery, Petroleum Products, Chemicals, Transport Equipment, Edible Oil, Iron, Steel, Fertilizer and Tea which together constitute around 80 percent of total imports. Among these commodity groups, petroleum products have the highest share (around 34 percent of total imports) and are followed by machinery and chemical respectively (GoP, 2013). Pakistan s major imports markets include Saudi Arabia, Kuwait, Japan, USA, Germany and UK. Like other developing countries, Pakistan has witnessed a substantial increase in the value of imports as a percentage of GDP. The value of imports as a percentage of GDP has shown upward trend which has increased from 12.8 percent in 1972 to 20.3 percent in 2012 (WDI, 2014). 1 The authors are Staff Economist, Dean Faculty of Economics and Joint Director at Pakistan Institute of Development Economics (PIDE), Pakistan 1

2 In this paper, we argue that Pakistan s trade regime needs to be seen in the context of increasing trend towards regional economic integration. Recent decades have witnessed a growing trend towards global and regional economic integration. According to WTO, as of 31 July 2013, some 575 Regional Trade Agreements (RTAs) have been notified to the GATT/WTO and about 379 were in force 2. The purpose of integration is to facilitate the free flow of goods and services and factors of production among countries through elimination of tariff and nontariff barriers. The implementation of regional trade agreements and substantial reduction in trade restriction, the imports of most of the developing countries are rising rapidly. Regional integration encourages free trade among member countries which leads to an expansion of trade among members and boosts economic growth. Pakistan too is actively pursuing a policy of enhancing regional economic cooperation and has entered into various regional and bilateral trade agreements which encompass various trade policies ranging from imports substitution to exports promotion. The objective of this paper is to analyze the import structure of Pakistan with special reference to regional economic integration. In particular, the paper aims to: (i) examine the imports structure of Pakistan over the last few decades; (ii) review the importance of regional and bilateral agreements in diversifying imports; (iii) conduct an empirical analysis to estimate the imports elasticities; and( iv) to spell out policy options to reap the benefits of regionalization. The rest of the paper is organized as follows. Section 2 presets some stylized facts on Pakistan s import structure. Section 3 reviews import trends with reference to regional economic integration. Section 4 describes data and methodology and section 5 discusses the empirical findings. Section 6 concludes the discussion. 2. Stylized facts A bulk of literature has shown that imports have a significant impact on economic growth. Endogenous growth models have emphasized the importance of imports as an important channel for foreign technology and knowledge flow into the domestic economy (Grossman and Helpman, 1991). Over the last four decades, Pakistan has witnessed an upward trend in imports as a percentage of GDP. The figure 1 depicts a strong positive relationship between the GDP growth rate and the growth rate of imports 3. Trend analysis shows that average GDP growth rate remains low during the period of low or negative growth rate of imports. Pakistan exhibits high growth during During this period the imports growth rate was high than the trend 2http:// 3 The simple correlation between these two variable is 0.6 2

3 growth rate of imports. After 2007, growth rate of imports show declining trend that slow down economic growth in Pakistan. The GDP growth has declined from 5.8 percent in 2006 to 2.9 percent in 2013 when growth rate of imports has declined from 31 percent to -0.5 percent during the same period. This shows that Pakistan s economic development is highly linked with the external sector development. Imports positively contribute to economic development of the country. Another notable feature of imports growth is its volatility. The figure 1 shows that the behavior of imports is very volatile. Pakistan has experienced huge volatility in growth of imports. The figure 1 shows that imports have experienced high growth rate of around 40 percent in 2005 and low or negative growth rate of percent in The trend growth rate in imports is 12 percent. This leads to volatility in economic growth. From these facts it can be inferred that for sustained and high economic growth, Pakistan needs to maintain at least 12 percent per annum growth in imports. Figure 1 Relations between Imports Growth Rates and GDP Growth Rates Imports Growth Trend Growth in Imports GDP Growth Source: SBP (2014); WDI (2014) The figure 2 shows that the value of imports as a percentage of GDP has increased from 12.8 percent in 1971 to 20.3 percent in However, the imports as a percentage of GDP of Pakistan remain quite low as compared with other countries including the South Asian economies. The annual average growth rate of imports as percentage of GDP is around 1.4 percent in Pakistan. India has shown marvelous increased in value of imports as a percentage of GDP. The figure 2 show that value of imports as a percentage of GDP has grown from 3.6 percent in 1971 to 31.5 percent in The annual average growth rate of imports as percentage of GDP is around 18.2 percent in India. Similarly, in Bangladesh, imports as percentage of GDP has increased from 8.1 percent in 1971 to 32.2 percent in 2012 which grew with rate of 7.1 per annum. Sri Lanka has witnessed an increase in imports from 23.9 percent of GDP in 1971 to

4 percent of GDP in These statistics reveal that although Pakistan has made significant progress in enhancing imports, imports as a percentage of GDP remains very low in Pakistan as compared to other neighboring countries Figure 2 Imports as Percent of GDP in South Asian Countries Source: WDI (2014) Pakistan India Bangladesh Sri Lanka The import composition remains stagnant in Pakistan. If we analyze the import behavior in Pakistan, we find that about three-fourth of the imports are consisting of machinery (14.5 percent), petroleum products (34 percent), chemicals (13.6 percent), transport equipments (4.8 percent), edible oil (5.4 percent), iron and steel (3.9 percent), fertilizer (2.8 percent) and tea (0.8 percent) in 2012 (table 1). We observe similar pattern over the last decades. 4

5 Table 1 Pakistan s Major Imports (Percentage share of Total Imports) Commodities Machinery Petroleum Products Chemicals Transport Equipments Edible oil Iron and steel Fertilizers Tea Sub-total Others Total Source: GoP (2013) Over the last four decades, the share of raw material has the highest share in the overall imports of the country. Table 2 shows that imports of capital goods have gradually declined from 29 percent in 1975 to 24 percent in During the period of , the imports of capital goods remain constant around 30 percent of total imports. On the other hand, the share of raw material for consumer goods has registered increasing trend over the last forty years. The share of raw material for consumer goods has increased from 40 percent in 1975 to 56 percent in Share of consumer goods show decreasing trend till 2008 but an increasing trend onward The share of consumer goods has increased from 10 percent in 2008 to 14 percent in

6 Table 2 Composition of Imports in Pakistan (Percentage share of Total Imports) Year Capital Goods Raw Material for Consumer Goods Total Capital Goods Consumer Goods Source: GoP (2013) Over the last two decades, the imports from developed countries declined from 49 percent of total imports in 1995 to 21 percent of total imports in On the other hand, imports increased from 49 percent of total imports to 78 percent of total imports from developing countries over the same time period. The major increased is observed from Organization of Islamic Cooperation (OIC) countries during this period. Imports increase from 21 percent of total imports in 1995 to 41 percent of total imports in 2012 from OIC countries (table 3). About 75 percent of total imports come from ten countries. These include United Arab Emirates, China, Saudi Arabia, Kuwait, Malaysia, Japan, India, USA, Indonesia, UK and Korea (GoP, 2013). 6

7 Table 3 Origin of Imports (Percentage share of Total Imports) Region Developed Countries OECD Other European CMEA Developing Countries OIC SAARC ASEAN Central America South America Other Asian Countries Other African Countries Central Asian States Source: GoP (2013) 3. Import trend and Regional Integration Pakistan, like many other developing countries, is actively pursuing a policy of enhancing regional economic cooperation. The regional trade agreements include SAPTA and SAFTA. In 1993 SAARC Preferential Trade Arrangement (SAPTA) was signed, which aimed to promote and sustain mutual trade and economic cooperation within the SAARC region. The agreement dealt exclusively with trade in goods and constituted the first step in establishing an economic union. The other major milestone of economic cooperation in SAARC region was the agreement on South Asian Free trade Area (SAFTA). Pakistan signed the South Asian Free Trade Agreement (SAFTA) in 2004 when the SAPTA expired on 31 December This agreement requires that the member countries over a period of ten years would reduce custom tariffs for goods coming from member states. Pakistan has also signed various bilateral agreements including Pak-Afghanistan Trade Agreement, Pak-China Trade Agreements, Pak-Malaysia Trade Agreements, Pak-Sri Lanka Free Trade Agreement, Pak-Iran Preferential Trade Agreement, Pak- Mauritius Preferential Trade Agreement, and Pak-Indonesia Preferential Trade Agreement. Although, Pakistan has signed regional agreements, trade benefit remains limited. The table 4 shows that imports from SAARC countries remain same even after signing SAFTA. Among SAARC countries, India is the main import origin. The share of import is 4 percent of total imports from India. 7

8 Table 4 Imports SAARC Region (Percentage share of Total Imports) SAARC Afghanistan Bangladesh India Sri Lanka SAARC* Source: SBP (2014); only four above mentioned countries Pakistan has signed Free Trade Agreement with China in Under this agreement various products manufactured in Pakistan are to get access into Chinese market at zero duty. The products include; industrial alcohol, cotton fabrics, bed-linen and other home textiles, marble and other tiles, leather articles, sports goods, mangoes, citrus fruit, other fruits and vegetables; iron and steel products and engineering goods. The trade agreement with China certainly had a positive impact on imports from China. The figure 3 shows that the imports from China accounted for 12 percent of total imports of Pakistan in 2013 as compared to 5.6 percent of total imports in Figure 3 Imports as Percent of total imports from China Pakistan has signed bilateral trade agreements with some ASEAN countries. However, the total imports remain same over the last ten years. The total imports ranges between 10 percent of total imports to 15 percent of total imports over the period

9 Table 4 Imports ASEAN Region (Percentage share of Total Imports) ASEAN Indonesia Malaysia Singapore Thailand ASEAN Source: SBP (2014); only above mentioned four countries These statistics indicate that Pakistan fails to fully harvest the benefits of regional integration. There is no substantial increase in the imports from these countries. Various factors held responsible for low trade. These factors include trade facilitation measures; ease of doing business; regulatory framework, and infrastructure. Cost of doing business is very high with low quality of institutional and regulatory framework acting as a binding constraint in expansion of trade especially imports. 4. Methodology and data It is essential for policy makers to understand that how imports react to changing economic conditions for effective implementation of trade policies. Therefore, it is important to examine the behavior of imports demand. Various studies have estimated import demand functions for different countries including Pakistan. These studies highlight that import demand is mainly determined by income and relative prices (Sarmad and Mahmood, 1987; Sarmad, 1989; Afzal, 2001; Islam and Hassan, 2004; Rehman, 2007). These studies found that income elasticity is greater than unity while price elasticity is less than unity. Following Doroodian et al. (1994) and Rehman (2007) the following import demand model for Pakistan is estimated. Where: = log of volume of imports = log of real income/gdp = log of import prices = log of domestic prices 9

10 The log-linear form is considered most appropriate by various empirical studies (see e.g. Boylan et al. 1980). This functional form gives elasticity coefficients directly. Data for empirical estimation is taken from World Development Indicators (WDI) published by World Bank, Various Annual Reports published by State Bank of Pakistan (SBP) and International Finance Statistics (IFS) published by International Monetary Fund (IMF) over the time period A brief definition of all variables used in analysis is given below: Imports: Imports of goods and services represent the value of all goods and other market services received from the rest of the world. Imports of goods and services is measured at constant 2005 US$ GDP per capita: GDP per capita is gross domestic product divided by midyear population. GDP per capita is measured at constant 2005 US$ Domestic price: GDP deflator is used as a proxy of domestic price index Import price: Unit value of imports is used a proxy of import price index The stationarity properties of the variables are examined using standard unit root test Augmented Dickey Fuller (ADF). After establishing the time series properties of the variables, we estimate import demand function for Pakistan using Autoregressive distributed lag (ARDL) bound testing approach to cointegration proposed by Pesaran et al. (2001). To examine the stability of the ARDL bounds testing approach to cointegration, we apply Stability test namely CUSUM and CUSUMSQ. Akaike Information Criteria (AIC) is used to select the optimal lag length. 5. Empirical Results The time series properties of the data are tested using Augmented Dickey-Fuller (ADF) test. The results are presented below in table 5. The results show that all series are non stationary at level and become stationary at first difference. This implies that all series are integrated of order 1. Table 5 Results of Unit Root Test Variables Test with Intercept Test With Intercept & trend At Level Non stationary Non stationary Non stationary Non stationary At First Difference Stationary Stationary Stationary Stationary Note: The critical values are -3.60, and at 1%, 5% and 10% respectively with intercept and -4.20, and at 1%, 5% and 10% respectively with intercept and trend. 10

11 The long run and short rum impact of income and prices on imports are estimated using ARDL bound testing approach to cointegration. The appropriate lag length is one based on the AIC. The F-statistics that we obtained for the demand function is 5.8 which supports the hypothesis of cointegration for the proposed model. The results are presented in table 6. We have used various diagnostic tests to ensure that the model is adequately specified. F-statistics confirms the adequacy of the estimated model. The results of serial correlation test, normality test and heteroscedasticity test are consistent with requirements. The CUSUM and CUSUMSQ tests are applied to examine the stability of long run parameters and results are plotted in figure A1. The figure portraits that plotted data points are within the critical bounds implying that the long run estimates are stable. The straight lines represent critical bounds at 5 percent significance level. The long run estimates show that income has a positive impact on imports. The long run income elasticity is greater than unity. This shows that an increase in income leads to increase in imports in long run. We find that import price has a negative and significant impact on imports in long run. However, the estimated coefficient is very small implying inelastic long run import price elasticity. We also find that domestic price has positive but insignificant impact on imports in the long run. On the other hand, short run estimates show that income and domestic price have a positive impact on imports while import price has negative impact on imports. These statistics reveals that imports are mainly influenced by country s development and import prices. The estimated elasticities indicate that changes in real income and import prices significantly affect the import demand in the long run. But variations in domestic price level do not affect significantly the imports demand in the long run. Table 6 Long Run and Short Run Estimates Variables Coefficient T-Statistics p-value Long Run Constant Log of GDP per capita Log of Domestic Prices Log of Import Prices Short Run Constant D(Log of GDP per capita) D(Log of Domestic Prices) D(Log of Import Prices) ECM(-1) Diagnostic test 0.55 F-Statistics 3.15*** Serial Correlation [.438] 11

12 6. Concluding Remarks This paper has examined Pakistan s import structure with particular emphasis on regional economic integration. Over the last four decades, Pakistan has witnessed a growing trend in imports as a percentage of GDP although import growth has exhibited significant volatility. Pakistan imports have remained concentrated in a few product categories as well as in terms of origin of imports. It is important to note here that despite several regional trading agreements, Pakistan has not been able to source its imports from the regional trading partners. This has been due to several factors including problems in trade facilitation, regulatory framework and physical infrastructure. Empirical analysis has shown that changes in real income and import prices significantly affect the import demand in the long run. But variations in domestic price level do not affect significantly the imports demand in the long run. If Pakistan is to grow at 7-8 percent per annum as envisaged in the development plans, Pakistan will continue to experience strong growth in imports to meet its growing industrial and consumer needs. However, Pakistan needs to develop a strategy to use the regional integration schemes as a platform for enhancing its trade ties including both imports and exports. This will ensure greater trade and investment ties with the regional trading partners helping to lower transactions costs of trade and boosting economic growth. 12

13 References Afzal, M. (2001) Import function for Pakistan: A simultaneous equation approach. The Lahore Journal of Economics, Volume 6(2), pp Boylan, T. Cuddy, M. and Muircheartaigh, I. (1980) The functional form of the aggregate import demand equation. Journal of International Economics, Volume 56, pp Doroodian, K., Rajindar K. and Saleh A. (1994), An examination of the traditional aggregate import demand function for Saudi Arabia. Applied Economics, pp Grossman, G.M. and Helpman E. (1991) Innovation and Growth in The Global Economy, Cambridge: MIT Press Government of Pakistan (2013) Economic Survey of Pakistan , Ministry of Finance, Pakistan Islam, M. and Hassan, K. (2004) An econometric estimation of the aggregate import demand function for Bangladesh: Some further results. Applied Economic letters, Volume 11, pp Pesaran M. H., Shin, Y and Smith, R.J (2001) Bounds testing approaches to the analysis of level relationships, Journal of Applied Econometrics, 16: Rehman, H. (2007) An Econometric Estimation of Traditional Import Demand Function for Pakistan, Pakistan Economic and Social Review, vol. 45(2), pp Sarmad, K. and Mahmood, R. (1987) Disaggregated import demand functions for Pakistan. Pakistan Development Review, vol. 26(1), pp Sarmad, K. (1989) The determinants of import demand in Pakistan. World Development, vol. 17(10), pp State Bank of Pakistan (SBP) Annual Reports (various editions) World Bank (2014) World Development Indicators (WDI), World Bank 13

14 Appendix Table A.1: Summary of Trade Agreements No Agreement Scope Type Status/Year 1 Pakistan-China Bilateral FTA & EIA In force since Pakistan-Malaysia Bilateral FTA & EIA In force since Pakistan-GCC Bilateral FTA Under negotiation since Pakistan-Iran Bilateral PTA In force since Pakistan-Mauritius Bilateral PTA In force since Pakistan-MERCOSUR Country-Bloc PTA Under negotiation since Pakistan-Morocco Bilateral PTA Under negotiation since Pakistan-Singapore Bilateral FTA Under negotiation since Pakistan-Sri Lanka Bilateral FTA In force since Pakistan-Turkey Bilateral PTA Under negotiation since Pakistan-US Bilateral Framework Under negotiation since 2003 Agreement 12 SAFTA Regional FTA In force since Pakistan-Bangladesh Bilateral FTA Under negotiation since Indonesia-Pakistan Bilateral PTA In force since 2013 Source: UNESCAP/tid/APTIAD/trade agreement database; Ministry of Commerce, Pakistan. Figure A1: Plot of Cumulative Sum and Cumulative Sum of Squares of recursive residuals Cumulative Sum of recursive residuals Cumulative Sum of Squares of recursive residuals CUSUM 5% Significance CUSUM of Squares 5% Significance 14