INTERNATIONAL JOURNAL OF BASIC AND APPLIED SCIENCE

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1 Analyzing the Relationship Between FDI, Trade Openness and Real Output Growth : An ECM Application for Pakistan Insan Akademika Publications INTERNATIONAL JOURNAL OF BASIC AND APPLIED SCIENCE www. insikapub. com P-ISSN: E-ISSN: Vol. 01, No. 02 Oct 2012 Analyzing the Relationship Between FDI, Trade Openness and Real Output Growth: An ECM Application for Pakistan Danish Ramzan 1, and Adiqa Kausar Kiani 2 1 M.Phil. Scholar, Federal Urdu University Islamabad bhatttidanish@yahoo.com 2 Chair, School of Economics, FUUAST adiqakian@gmail.com Key words Abstract FDI, Trade Openness, ECM The standard economic theory points to a direct and positive link between growth variables, FDI and openness indicators, that can affect each other. It is argued that capital inflows in the form of FDI flows can be induced by host country s economic growth, if the host country offers a large consumer market. Furthermore, it creates economies of scale and causes great reduction in cost of production. Similarly, openness to trade has also been considered as an important determinant of economic growth and welfare. Both the issues are well debated in the recent growth literature. Initially, the developing nations of the world followed restrictive trade policies but with the passage of time and emergence of globalization, all the nations realized the need to liberalize to their economies in terms of trade openness and enhancing FDI. The present study has applied an econometric technique of Error Correction Methods (ECM) for finding the relation between economic growth indicator, FDI, and trade openness. For this purpose study utilized annual data set ranging from 1975 to 2011and time series properties of data are explored prior to estimation by applying Augmented Dicky Fuller (ADF) of testing unit root..the findings suggested that FDI and trade promote growth of real sector of economy of Pakistan Insan Akademika All Rights Reserved 1 Introduction Current literature discusses the determinants of growth and documents a positive and direct relationship between growth, openness and capital inflow indicators. Collectively, these factors, along with the combination of others, enhance the development process, and improve standard of living. Over the time a growing concern has been observed among developing counteries to accelerate this process, for which they are implementing the policies favorable for growth and overall welfare. New ways are continuously being explored to achieve said goals. One of these ways is to open the trade among nations and making, flow of foreign direct investment smooth. FDI flows are induced by environment in the host country. If they are successful to provide the large consumer market, they cause greater economies of scale along with cost 427

2 Ramzan and Kiani International Journal of Basic and Applied Science, efficiency in these countries. On the other hand FDI raises the amount of available capital stock, encourages technological transfer, and enhances the process of competition (Khan, 2007; and Ellahi, 2011). financial resources move from one part of the world to the other in different forms including grants, foreign aid, official assistance, loans, and foreign direct investment. In this regard (Perkins, 2001) pointed that over the last couple of decades major share of these resources moved in the form of FDI, its flow rose up to 45% of net capital inflow during 1997, compared to 16% during the mid-eighties. Gradually, the countries continued to take it as a major source of funding and development. Empirical studies showed a significant role of FDI in accelerating economic growth of host (developing) countries, through its contribution in human resources development, technological spillover, capital formation and international trade. Similarly a wide majority of literature posited a positive correlation between FDI, and development indicators Craig and Dollar (1996). Contrary to this evidence a second school of thought showed that this aid and assistance is ineffective for boosting the economy and bringing development alongside. This ineffectiveness has been attributed to the poor governance structure and improper utilization of available resources. Other channels thorough which FDI affects growth is technological spillover, competition, skills acquisition. Basu, Chakraborty and Reagle (2007), and Trevino and Upadhyaya (2003). Along with this openness to trade is a key determinant of economic development and growth, and a well debated issue in the recent literature. Initially, the developing nations of the world followed restrictive trade policies but with the passage of time and emergence of globalization, all the nations realized the need to liberalize their economies in terms of trade openness. Trade of a country is a key determinant for the improvement of a country s industrialization. Moreover, development experienced by a country brings some changes in trade structure on the basis of endowments and comparative advantage (Hultman, 1967). The role of trade policy on economic growth has been the focal issue, export-led growth stated that liberalization process affects the level of output and economic activity. The inclination of foreign investors for investing their resources is always towards the markets and counteries with good infrastructure facilities and favourable policies. The dimension of the FDI flows into Pakistan can be explained in terms of its size and percentage of gross capital formation (GCF).The size of FDI inflows in Pakistan was not significant until 1991 due to the regularity policy frame work. However, under the new policy regime, it was expected to assume a larger role in catalysing Pakistan economic development. It is observed that there has been a steady build up in FDI inflow in post liberalization. Figure below provides a comparative analysis among major countries in SAARC region about the key economic indicators of FDI as a percentage of GDP, growth of real GDP per capita, openness of trade as a percentage of GDP, aid and governance. This show that Pakistan receives less FDI resources compared to other players in the region ans hence its growth is also comparatively low than others with high recipients. governance indicators show that poor governance is responsible for low indices of trade openness and FDI inflow. There is hence a need to improve it to achieve high volume of growth. www. insikapub. com 428

3 International Journal of Basic and Applied Science, Ramzan and Kiani. Fig.1: Comparison between SAARC Countries Source: Data Taken from IFS, Alesina and Dollar (2000), World Bank (2003). Following the discussion, present study is aimed to test the hypothesis that Foreign Direct Investment (FDI) and openness to trade jointly affect real outut growth of Pakistan. Starting with introduction, next section is a brief overview of literature review of previous studies. Section three is brief elaboration of methods and materials employed for empirical analysis. Section four is about presentation of results and interpretation and section five concludes this study. 2 Review of Previous Studies Empirical literature comprise of time series and cross section studies, explaining the impact of FDI and trade openness for economic growth. Zhang (2006) tested the growth driven by FDI for the China with panel data techniques. The study mentioned possible channels through which FDI causes positive as well as negative impacts on economic growth, findings suggested that FDI is an important channel for economic growth.. Causality link between growth, openness to trade and capital inflow has been explored by Iqbal etal. (2010) The study utilized quarterly data set over the period and applied Vector Auto Regressive (VAR) model to test the existence of long run relationship, while direction of causality is found by multivariate VECM. Findings suggested bidirectional causality between trade sector growth and economic FDI is detected, while a positive and robust link has been suggested between FDI and trade promotion in long run. A similar analysis by Abubaker Bujaasi Mayanja (2003), investigated whether FDI is important for accessing foreign technology by using industry level panel data from the census of production for 205 four-digit industries in United Kingdom. Kim and Bang (2008) studied the same link between FDI and economic growth for Ireland. Empirical findings found statistically significant effects of foreign direct investment on economic growth in short run as well as long run. Granger causality results indicated that foreign direct investment leads to economic growth. Katarina and John (2004) analyzed the relationship between foreign direct investment and economic growth for Western European and US economy and documented similar findings. Shah and Ahmad (2003) analyzed the diversity in modes of international transaction along with movement of resources across the border. andfound a direct effects on inward FDI flows in Pakistan. FDI inflow brings innovation and development in industrial sector as studied by Barua and Chakraborty (2006) for exploring the industrial performance in India with high market and openness effects on industrial 429 Insan Akademika Publications

4 Ramzan and Kiani International Journal of Basic and Applied Science, and exports performance. Major conclusion drawn suggested that liberalization leads to high price cost margins and reduction in concentration of industries, low producer surplus and hence boosts up consumer welfare. With regard to the openness of trade literature Adebiyi (2006) investigated the relationship between policies of trade openness and economic growth performance in Nigeria. Major findings suggest that sustained economic growth in Nigeria can be achieved by implementing a comprehensive trade openness programme. A number of case studies for Pakistan have also been conducted to analyze the relationship between trade openness and economic growth including Khan,et. al. (1995) showing that economic growth is enhanced through export promotion. Another analysis conducted by Iqbal and Zahid (1998) concluded that Pakistan had gained walfare effects through trade openness. Similarly Mohsin et al. (2001) found an evidence that trade openness has helped to eradicate poverty in Pakistan.. An evidence of positive relationship has been found for the South Asian region including Pakistan by Kemal et al. (2002). Khan and Qayyum (2007) also found a positive and robust relationship between trade and financial sector policies with economic growth. 3. Methodology The empirical relationship may be expressed as under in a modified form: Y t = f (FDI, TO, EXR, INF, GR)...(1) Where : Y = real GDP, FDI = Foreign Direct Investment, TO = Trade Openness, EXR = Exchange Rate, GR = Government Revenues, and INF = Inflation rate. Theoretically the relationship between trade openness and foreign direct investment with growth is positive. It depends on the efficiency and productivity of utilization of all factors. The study has utilized annual time series data on different variables over the period The dataset is compiled from different sources and retrieved from the International Financial Statistic (IFS) Yearbook published by International Monetary Fund (IMF). The data on a few variables is collected from various issues of Pakistan Economic Survey compiled by the Federal Bureau of Statistics, Government of Pakistan and from the Annual Reports of the State Bank of Pakistan. All the data is expressed in million rupees except inflation rate, and exchange rate. A brief introduction of variables includes: - Gross Domestic Product: It is the sum total of gross value added by all resident economic agents in the economy at current market prices during the accounting period. - Foreign Direct investment: It is the total investment done by other developing nations into our country and resources flowing into the country in physical infrastructure. This is investment not done for key welfare areas such as health, education and training, roads and railways etc. - Trade Openness: It is the sum of exports and imports and taking its ratio with GDP. - Inflation: The CPI reflects the annual percentage change in the cost to the average consumer in acquiring a given basket of commodities that may be fixed or variable at specific intervals. www. insikapub. com 430

5 International Journal of Basic and Applied Science, Ramzan and Kiani. - Exchange Rate: The rate at which one currency can be exchanged for another, or the number of units of domestic currency available against one unit of the foreign currency, is called the exchange rate. The data on Exchange rate is retrieved from the Yearbooks of International Financial Statistics (IFS) 4 Results and Discussion Unit root testing is a pretesting procedure that helps time series analysis to be successful. It tests and diagnoses the time series properties of data. The results of ADF unit root test are reported below. All the variables are non stationary at their level, but become stationary after taking frst difference. Table 1: Unit Root Test Results of ADF Test INDICATORS First difference Level Unit root L(GDP) * First difference stationary L(FDI) * First difference stationary L(TO) * First difference stationary INF * * First difference stationary EXC RATE * First difference stationary L(GR) * First difference stationary Note: * represents that it is significant at 5% level of significance, calculated using Eviews 5.0 Results show that foreign direct investment has positive and significant effect on economic growth, it is because the effect of FDI in import substitution industries may be different from those of export Oriented industries since former target mostly the limited domestic market, while the latter target the larger international market. Moreover, it is more likely to generate more employment and, therefore spill over due to the expected larger production capacity associated with larger market.foreign direct investment brings capital inside the country from other countries and helps them getting maximum benefits from this inflow. Trade variable has positive and highly robust effects on GDP growth, trade openness is a key determinant for developing countries to increase their production by exporting raw materials from the developed nations and exporting their primary products to other nations, it is due to the fact that more open countries indeed have experienced faster productivity growth. Major exports of our country consist of primary products i.e. manufacturing and agricultural goods. Inflation is our third variable which possessed negative sign and this effect is highly significant and negative. Inflation not only reduces the level of business investment, but also the efficiency with which productive factors are put to use. The benefits of lowering inflation are great, lower the inflation rate, the greater are the productive effects of a reduction. Here reducing inflation by one percentage point may increase growth by 4.7 percent. Table 2 below showed that there is incidence of long run relationship between the variables of interest. After finding the existence of long run relation, next step involves finding the normalized coefficients and elasticities. 431 Insan Akademika Publications

6 Ramzan and Kiani International Journal of Basic and Applied Science, Table 2: Results of Johansen Tests for Co- integration H 0 H 1 Test Stat Maximum Eigenvalues Test ( λ max ) (T-K/T)Adjusted Max Statistic Critical Value (5%) r=0 r= * 29.16* r=1 r= r=2 r= * r=3 r= r=4 r= Trace Test ( λ trace ) r=0 r * 88.57* r=1 r * 54.69* r=2 r * 29.58* r=3 r r=4 r Note.* indicates significance at 5% level. Results are estimated through Eviews 5.0. Table 3 below shows normalized coefficients showing elasticities, it can be seen that R-squared is 0.69 implying that 69% variations in dependent variable has been caused by changes in independent variables, overall it is indicated that it has a moderate value and model is good fit. On the other hand value of Durbin Watson (DW) stat is approximately 2 stating that there is no incidence of autocorrelation in our data set and estimation results. Value of F statistics is also very moderate and hence showing that our model overall is very well and good. Furthermore, below here is given the graphs of cumulative sum and cumulative sum of square of residuals. These graphs are well inside the lines of critical bound, stating that overall model is better fitted. Table 3: Normalized Coefficients of Co integrating Vector on real GDP Variables Coefficients S.E t-statistics Ln(FDI) * ** Ln (TOPEN) * * Ln(INF) Ln(EXCR) C Ln(GR) R-squared = 0.69 F-statistic = D.Watson stat= 2.05 Note: * shows significant at 1%, ** shows at 5%, and *** shows at 10% www. insikapub. com 432

7 International Journal of Basic and Applied Science, Ramzan and Kiani CUSUM of Squares 5% Significance CUSUM 5% Significance Fig.2: CUSUM and CUSMSQ test 5. Conclusion The study tries to empirically estimate the joint effects of FDI and trade openness on growth of real output in Pakistan.It used neo-classical production function where FDI and trade openness are considered being an additional input, a number of target and control variables are also included in the model to capture the effect. The Error Correction Method (ECM) results revealed that the outcome of major variables of Foreign direct investment and openness to trade have significant and robust link according to expectations. Furthermore the results of target and control variable have also been found to be supportive as stated in theory. Overall conclusion can be drawn as follows: FDI has been one of the important and renowned features of the pakistan economy. FDI remained relatively greater over the past a few of decades as it adopted market oriented policies under regime of liberalization during the era of 1980s, findings are in line with the study conducted by Atiq et al, (2005). Trade openness also castes a positive impact on real output growth of Pakistan. Refrences Ahmed, Y., & Anoruo, E. ( ). Openness and Economic Growth:Evidence from Selected ASEAN Countires. The Indian Economic Journal, 47 (3), Atique, Z., Hamid, H. M., & Azhar, U. (2004). The Impact of Fdi on Economic Growth under Foreign Trade Regimes: A case study of Pakistan. Pakistan Development Review, 43 (4), Barua, A., & Chakraborty, P. (2006). Does Openess affects Inequality? A case study of manufacturing sector of India. International Conference, Economic Integration and Economic Development. Beijing. Burnside, C., & Dollar, D. (1996). Aid, Policies, and Growth. World Bank mimeo. Chakraborty, C., & Reagle, D. (2007). Liberalization, FDI, and Growth in Developing Countries: A Panel Cointegration Approach. Economic Inquiry, 41 (3), Ellahi, N., & khan, M. A. (2011). Testing Finance-Growth Nexus:An Auto Regressive Distrubuted Lag ARDL Methodology Approach for Selected SAARC Countries. South Asian Journal of Management, 18 (2), Insan Akademika Publications

8 Ramzan and Kiani International Journal of Basic and Applied Science, Hulton, W. C. (1967). Exports expansion and economic growth:a survey, Land Economics. 43, Iqbal, M. S., Sheikh, F. M., & Shar, A. H. (2010). Causality Relationship between Foreign Direct Investment, Trade and Economic Growth in Pakistan. Asian Social Science Journal, 06. Iqbal, Z., & G, M. Z. (1998). Macro economic determinants of Economic Growth in Pakistan. Pakistan Development Review, 37 (2), Katerina, L., & John, P. (2004). Foreign Direct Investment and Economic Growth in Transition Econnomies. South Eastern Euorpe Journal of Economics, Kemal, A. R. (2003). An assessment of the impact of Trade Liberalization in Welfare in Pakistan. Technical Paper Series 16, PIDE. Khan, M. A., & A, Q. (2007). Trade Liberalization, Financial Development and Economic Growth. Pakistan Institute of Development Economics Working Paper. Khan, A. H. (1995). Exports, growth and causuality. Pakistan Development Review, 34 (4), M, A. A. (2006). Trade Liberalization Policy and Industrial Growth Performance in Nigeria: An Error Correction Mechanism Technique. Mohsin, M. H. (2001). Impact of Trade Reforms on Poverty. PIDE general Annual Meeting. Islamabad. Perkin. (2001). Economics of Development. New York: W. W. Norton and Company. Shah, Z., & Ahmad, Q. M. (2003). The Determinants of Foreign Direct Investment in Pakistan: an Empirical Investigation. The Pakistan Development Review, Trevino, L., & Upadhyaya, K. P. (2003). Foreign Direct Investment and Economic Growth. Transnational corporations, 12, Yanikkaya, H. (2003). Trade Opennesss and Economic Growth: a cross country empirical Investigation. Journal of Development Economics, 72, www. insikapub. com 434