PIDE Working Papers

2007:19

Trade Liberalisation, Financial

Development and Economic Growth

Muhammad Arshad Khan

Research Associate
Pakistan Institute of Development Economics, Islamabad

and

Abdul Qayyum
Associate Professor
Pakistan Institute of Development Economics, Islamabad

PAKISTAN INSTITUTE OF DEVELOPMENT ECONOMICS

ISLAMABAD
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© Pakistan Institute of Development

Economics, 2007.

Pakistan Institute of Development Economics

Islamabad, Pakistan

E-mail: [email protected]
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Designed, composed, and finished at the Publications Division, PIDE.

 CONTENTS

Page

Abstract v
1. Introduction 1
2. Review of Existing Literature 3
2.1. Finance and Economic Growth 3
2.2. Trade and Economic Growth 8
3. Overview of the Financial and Trade Policies in Pakistan 10
3.1. Financial Sector Reforms 10
3.2. Trade Liberalisation 16
4. Model Specification, Methodology and Data Issues 18
4.1. Data Description 21
4.2. Construction of Financial Development Index (FSDI) 22
5. Empirical Results 23
6. Conclusions 27
References 27

List of Tables
Table 1. Interest Rate Behaviour in Pakistan 13
Table 2. Indicators of Financial Deepening (in percent) 15
Table 3. Growth Rates of Exports and Imports and Degree of
Openness (in percent) 18
Table 4. Financial Sector Development Index (FSDI) 22
Table 5. Statistics for Selecting Lag Order and the Existence of
Long-run Relationship 23
Table 6. ARDL Estimates 24
Table 7. Error Correction Representation of ARDL Model 25
2

Page
List of Figures
Figure 1. Financial Development Indicator Relative to GDP 16
Figure 2. Exports, Imports, and Degree of Openness (in percent) 18
Figure 3. Financial Sector Development Index (FSDI) 22
Figure 4. Plot of Cumulative Sum of Recursive Residuals 26
Figure 5. Plot of Cumulative Sum of Squares of Recursive Residuals 26
 ABSTRACT
This paper empirically investigates the impact of trade and financial
liberalisation on economic growth in Pakistan using annual observations over
the period 1961-2005. The analysis is based on the bound testing approach of
cointegration advanced by Pesaran, et al. (2001). The empirical findings suggest
that both trade and financial policies play an important role in enhancing
economic growth in Pakistan in the long-run. However, the short-run responses
of the real deposit rate and trade policy variables are very low, suggesting
further acceleration of the reform process. The feedback coefficient suggests a
very slow rate of adjustment towards long-run equilibrium. The estimated
equation remains stable over the period of study as indicated by CUSUM and
CUSUMQ stability tests.

JEL classification: F43, G10, O10, C22

Keywords: Trade Liberalisation, Financial Development, Economic
Growth, Bound Test
 1. INTRODUCTION*
The relationship between trade liberalisation, finance reforms and
economic growth has been well documented in the economic literature. A
considerable body of literature suggests a strong and positive link between trade
liberalisation, financial development and economic growth. It has been argued
that trade and financial liberalisation policies reduce the inefficiency in the
production process and positively influence economic growth. This argument is
strengthened by the fact that countries with more open trade and financial
policies may grow faster than those with restricted trade and financial policies.
An increasing openness is expected to have positive impacts on economic
growth [Jin (2000); Fry (1995, 1997); Darrat (1999); Levine (1997); Mckinnon
(1973); Shaw (1973) and World Bank (1989)]. There is growing consensus that
both liberalisation policies are expected to exert positive impacts on economic
growth.
Shumpeter (1911) argued that services provided by financial
intermediaries are essential for economic development. Financial liberalisation
deepens financial markets and thereby promotes economic growth [Mckinnon
(1973) and Shaw (1973)]. Steps towards financial and trade liberalisation were
taken by many developing countries including Pakistan to achieve higher level
of growth. Thus, an empirical research is needed to determine the effectiveness
of financial and trade liberalisation policies with regard to growth in a
developing country like Pakistan. Examining the impacts of both policies is
particularly important in the case of Pakistan, which followed restrictive policies
till early 1990s. The costs of these restrictive policies have been enormous and
reflected in a low level of financial savings, investment and economic growth.
The positive relationship between financial and trade variables and
economic growth is explained by incorporating efficiency effects which mainly
results from the reduction of rent seeking and from the gains in internal and
external economies of scale due to financial and trade liberalisation [Bhagwati
(1988); Lee (1993); Krueger (1998); Fry (1995, 1997)]. This efficiency effect
considered as a major source of long-run growth. The endogenous growth theory

Acknowledgements: We are grateful to Dr Nadeem Ul Haque, Vice-Chancellor, PIDE for

providing an opportunity to complete this study. We are also thankful to Dr Ejaz Ghani, Senior
Research Economist, PIDE for his invaluable comments which helped to improve this study. Thanks
are also due to Mr Khalid Mirza, Chairman, Monopoly Control Authority, Islamabad and other
participants of the 22nd AGM of PSDE for their valuable comments and suggestions.
Muhammad Arshad Khan is Associate Professor at Government Postgraduate College
Muzaffarabad (Azad Kashmir) and currently he is working as Research Associate at the Pakistan
Institute of Development Economics, Islamabad. Abdul Qayyum is Associate Professor at the
Pakistan Institute of Development Economics, Islamabad.
2

predicts that both financial and trade liberalisation along with investment in
physical and human capital enhance economic growth [Romer (1986); Lucas
(1988); Rivera -Batiz and Romer (1991) and King and Levine (1993)].
Research suggests that financial deepening effectively channels savings
to productive investment opportunities, improves corporate governance, reduces
transaction and information costs, and enhances specialisation, and so forth
[Bencivenga and Smith (1991); De Gregorio and Guidotti (1995); Greenwood
and Jovanovic (1990); Levine (2004)].
Financial development can affect growth through three main channels
[Aziz and Duenwald (2002)]: (i) it can increase the marginal productivity of
capital by collecting information to evaluate alternative investment projects and
by risk sharing; (ii) it can raise the proportion of savings channeled to
investment via financial development—by reducing the resources absorbed by
financial intermediaries and thus increasing the efficiency of financial
intermediation; and (iii) it can raise the private saving rate. Moreover, Ansari
(2002) has noted that financial development contribute to economic growth in
the following ways: (i) financial markets enable small savers to pool funds, (ii)
savers have a wider range of instruments stimulating savings, (iii) efficient
allocation of capital is achieved as the proportion of financial saving in total
wealth rises, (iv) more wealth is created as financial intermediaries redirect
savings from the individuals and the slow-growing sectors to the fast-growing
sectors, (v) financial intermediaries partially overcome the problem of adverse
selection in the credit market, and (vi) financial markets encourages
specialisation in production, development of entrepreneurship, and adoption of
new technology.
Similarly, removal of trade restrictions helps to stabilise the development
process by improving efficiency and return economies from distorted factor
prices to production frontiers. Moreover, trade openness will improve domestic
technology, production process will be more efficient, and hence productivity
will rise [Jin (2000)]. Trade liberalisation and growth relations may occur
through investment, and trade openness may provide greater access to
investment goods [Levine and Renelt (1992)]. Countries that liberalise their
external sector and reduce impediments to international trade can experience
relatively higher economic growth. It is generally agreed that an open trade
regime is crucial for economic growth and development [Sukar and
Ramakrishna (2002)].
The main objective of both liberalisation policies is to increase
productivity through reducing inefficiency in investment. The existing literature
examines the impact of financial1 and trade liberalisation2 separately despite
their shared importance in increasing efficiency of investment. The empirical

1
Khan, et al. (2005).
2
Din, et al. (2003).
 3

evidence related to the joint impact of financial and trade variable on economic
growth is underdeveloped. The joint impact of trade and finance was initially
highlighted by Roubini and Sala-i-Martin (1991) and Barro (1991). The
inclusion of both variable by Roubini and Sala-i-Martin (1991) highlighted the
importance of both financial and trade variables in the economic growth. Thus
our testable hypothesis is that both financial development and trade
liberalisation jointly increase economic growth.
This paper makes three main contributions to the empirical literature on
trade, finance and growth. First, it examines the joint impact of trade
liberalisation and financial development on growth in Pakistan. Second, unlike
previous studies instead of using different indicators of financial development
separately, we used financial development index as a proxy for government
financial policy to assess its impact on real GDP. Thirdly, it applies recent
econometric techniques of cointegration namely, the bound testing approach to
cointegration developed by Pesaran, et al. (2001) to examine the relationship
between trade, finance and growth. This modeling technique does not require
any precise identification of the order of integration of the underlying data.
Furthermore, ARDL estimation is applicable even the explanatory variables are
endogenous, and the existence of a long run relationship is independent of
whether the explanatory variables are I (0), or I (1).
The rest of the paper is organised as follows: Section 2 deals with the
brief overview of the financial and trade policies being pursued by Pakistan.
Section 3 explains the model specification, data issues and econometric
methodology. Empirical findings are discussed in Section 4, while some
concluding remarks are given in the final section.

2. REVIEW OF EXISTING LITERATURE

A large body of theoretical and empirical literature provides ample
evidence of significant contributions of finance and economic growth and trade
liberalisation to the economic development. This section is devoted to review
some theoretical and empirical literature.

2.1. Finance and Economic Growth

The importance of financial development for economic growth can be
traced back as Bagehot (1873), Schumpeter (1911) and Hicks (1969). More
recent work includes Levine (1998), King and Levine (1993, 1993a), Rousseau
and Wachtel (1998), Rajan and Zingales (1998), and Okedokun (1998).
Bagehot (1873) and Hicks (1969) argued that the financial system was an
important catalyst in the industrialisation of England by facilitating the
movement of large amount of funds for “immense” work. Bagehot (1873) noted:
…. We have entirely lost the idea that any undertaking likely to pay, and
seen to likely, can perish for want of money; yet no idea was more
4

familiar to our ancestors, or is more common in most countries. A citizen

of London in Queen Elizabeth’s time … would have thought that it was
no use inventing railways (if he could have understood what a railway
meant), for you would have not been able to collect that capital with
which to make them. At this movement, in colonies and all rude
economies, there is no large sum of transferable money; there is no fund
from which you can borrow, and out of which you can make immense
work… (pp. 3-4)
Schumpter’s view is that a well-functioning financial system would
induce technological innovation by identifying, selecting and funding those
entrepreneurs that would be expected to successfully implement their products
and productive processes.
By studying 80 countries over the period 1960-89, recently, King and
Levine (1993a) found a highly significant relationship between the initial value
of the ratio of liquid liabilities to GDP in 1960 and real per capita income.
Furthermore, the lack of financial development could be possibly inducing some
form of “poverty trap” because of the possible existence of multiple steady state
equilibria [Sinha and Macri (2001)]. However, the other economists have
questioned the casual relationshis established in the empirical studies. For
example, Robinson (1952) claim that “where enterprise leads, finance
follows”—it is economic development which creates the demand for financial
services not vice versa. Moreover, Lucas (1988) has argued that economists
“badly over stress” the importance of the financial system in economic
growth—it is simply a “sideshow” for economic activity. In addition, Ram
(1999) using data on 95 countries, found that the “empirical evidence does not
support the view that financial development promotes economic growth”.
However, many theoretical and empirical studies suggest a positive first order
relationship [Levine (1997)].
Levine (1997) argued that a financial system perform five basic tasks: (1)
facilitate the trading, hedging, diversifying, and pooling of risk, (2) allocate
resources, (3) monitor managers and exert corporate control, (4) mobilise
savings, and (5) facilitate the exchange of goods and services. There is however,
a considerable debate on the exact channels through which financial
development induces economic growth [Gupta (1984); Spears (1992)]. The
theories can be subdivided into two broad schools of thoughts: (1) the
structuralists, and (2) the repressionists. The structuralists contend that the
quantity and composition of financial variables induces economic growth by
directly increasing saving in the form of financial assets, thereby, encouraging
capital formation and hence, economic growth [Goldsmith (1969); Gurley and
Shaw (1955); Patrick (1966); Thornton (1996); Demetriades and Luintel (1996);
Berthelemy and Varoudakis (1998)]. Thus factors such as, financial deepening
and the composition of the aggregate financial variables are important for
 5

economic growth. Kwan and Zhang (1998) show, by employing exogeneity tests
for several high performing Asian countries, that financial deepening has had a
positive impact on output growth [Sinha and Macri (2001)].
Recently financial deepening literature has been extended by incorporated
the stock market as a measure of financial development. Levine and Zervos
(1998) utilised that data for 47 countries over the period 1976-93 and found that
stock market liquidity and banking development had a positive effect on
economic growth, capital accumulation and productivity, even after controlling
for various other important factors such as, fiscal policy, trade openness,
education and political stability. Singh and Weisse (1998) examined stock
market development and capital flows for LDCs. Levine (1998) and Jayaratne
and Strahan (1996) examined the relationship between the legal system, banking
development and its impact on long-run rates of growth, capital stock and
productivity and found that when intrastate banking restrictions were relaxed,
real per capita GDP rose quite significantly.
The financial repressionists, led by McKinnon (1973) and Shaw (1973)
believe that financial liberalisation in the form of an appropriate rate of return on
real cash balances is a vehicle of the rate of capital formation and promoting
economic growth. According to this hypothesis, a low or negative real interest
arte will discourage saving. This will reduce the availability of loanable funds
for investment, which in turn lower the rate of economic growth. Mckinnon-
Shaw model posits that a more liberalised financial system will induce and
increase in saving and investment and therefore, promote economic growth.
Ahmed and Ansari (1995) investigated that Mckinnon and Shaw hypothesis for
Bangladesh and found that weak support for their hypothesis. They focused
more on the price variable as the relevant factors for economic growth. Khan
and Hasan (1998) examined the Mckinnon-Shaw hypothesis for Pakistan and
found strong support.
Greenwood and Jovanovic (1990) employ a general equilibrium approach
and conclude that as saver gain confidence in the ability of the financial
intermediaries they place an increasing proportion of their savings with their
intermediaries. Greenwood and Smith (1997) use two models with endogenous
growth formation and examine the way banks and stock markets allocate funds
to the highest value users. King and Levine (1993b) employ an endogenous
growth model in which the financial intermediaries obtain information about the
quality of individual projects that is not readily available to private investors and
public markets. This information advantage enables financial intermediaries to
fund innovative products and productive processes, thereby inducing economic
growth [De La Fuente and Marin (1994)].
There is a considerable body empirical and theoretical literature that
postulates a positive relationship between financial sector development and
economic growth, using time series analysis. The results have been largely
mixed. Jung (1986) used vector autoregressions (VARs) in levels on post—1960
6

annual time series data for 56 countries, of which 19 are developed industrial
economies, and found bi-directional causality between financial and real
variables in most cases. Demetriades and Hussein (1996) conducted causality
tests for 16 developing countries and find little evidence that financial sector
development causes economic growth, though they did find many bi-directional
relationships. They concluded that causality patterns varied across countries.
They also find that there have been stable long-run relationships between real
per capita income and at least one of the key financial indicators in 13 out of 16
countries, most of which have following financial reforms. In these long-run
relationships, financial variable exerts positive impact on real per capita income.
Rousseau and Wachtel (1998) applied VAR approach to five industrialised
countries over the period 1870–1929 and found strong uni-directional link from
finance to growth. They also estimated a vector error-correction model (VECM)
for each country and found evidence of an economically important long-run
relationship between the two sectors. Bell and Rousseau (2001) used this
approach for post-independence India and found that financial intermediaries
played a more emphatic role in promoting investment than in increasing total
factor productivity, and interpreted this as evidence for the presence of a factor
accumulation. Rousseau and Vuthipadadorn (2005) used time series approach to
investigate whether the intensity of financial intermediaries promoted
investment and growth in 10 Asian economies including Pakistan over the
period 1950–2000. They used VAR and VECM to examine the nature of the
causality between measures of financial and real sector activity. They find
strong uni-directional causality from finance to investment in most cases, and
weaker support for a casual link from finance to the level of output. These
findings are consistent with a factor accumulation channel as the primary
mechanism through which the financial sector influenced macroeconomic
outcomes in these countries. Sinha and Macri (2001) have examined the
relationship between financial development and economic growth using time
series date for eight Asian countries including Pakistan over the period 1950-97.
The regression results show a positive and significant relationship between the
income and financial variable for India, Malaysia, Pakistan, and Sri Lanka. The
multivariate causality tests show a two-way causality between income and
financial variables for India and Malaysia, one-way causality from financial
variables for Japan and Thailand, and reverse causality for Korea, Pakistan and
Philippines. Thus, their results clearly support the general view of a positive
relationship between financial development and economic growth.
Ghatak (1997) examines the impact of financial development on
economic growth in Sri Lanka over the period 1950–87. He concludes that
interest rates and financial deepening increase economic growth. Demetriades
and Hussein (1996) explore the relationship between financial policies and
economic growth for Nepal over the period 1962-92. The study concludes that
real per capita income is positively associated with financial deepening and
 7

negatively with bank branches. The negative association between per capital
income and bank branches reflects inefficiencies in financial intermediation for
a given level of financial development. The authors also find that financial
repression in the form of selective intervention has a positive impact on
economic growth.
Fry (1997) find inverted U shaped relationship between the annual rate of
economic growth and financial development measured by real interest rates. The
results of this study imply that too high or too low real interest rates are
deleterious for economic growth. The results also indicate that economic growth
maximised when interest rates are within the range of –5 percent to +15 percent.
Similarly, using the Chilean and Korean experience, Clark (1996) suggests that
the equilibrium real interest rate is undefined and unstable, since the interest rate
plays a dual role. In one hand, it equilibrates saving and investment, on the other
hand, it determines portfolio readjustment, including capital inflows. Portfolio
adjustment causes fluctuations in interest rates. These fluctuations are intensified
by the uncertainty and volatility of expected returns to investment and potential
inflows of capital, which may distort the real exchange rate and increase the cost
of borrowing.
Arestis, et al. (2001) examine the relative imp act of stock markets and
banks on long-term economic growth in Germany, the USA, Japan, the UK and
France. They find that both stock markets and banks have made important
contributions to output growth in Germany, France and Japan, with the stock
market’s contribution ranging from about one-seventh to one-third of the bank’s
contribution. These results are consistent with the view that bank-based financial
system may be more able to promote long-term growth than stock market-based.
The authors further find that there is a weak relationship between financial
development and economic growth in the UK and the USA. The results also
suggest that stock market volatility has negatively affected economic growth in
France and Japan.
Khan, et al. (2005) tested the relationship between financial development
and economic growth for Pakistan over the period 1971–2004, using
Autoregressive Distributed Lag (ARDL) technique. The results of the study
suggest that in the long-run financial depth and real interest rate exerted positive
impact on economic growth. However, the relationship between growth and
financial development is though positive but remained insignificant in the short-
run. Their results suggest that growth is an outcome of financial development.
Chang and Ho (2000) studied the joint impact of trade and finance on
economic growth for South Korea over the period 1953–99. Applying Johansen-
Juselius multivariate cointegration approach, the study finds the existence of
single cointegrating vector among economic growth, financial development and
the degree of openness. Through Granger causality tests based on error
correction model, they found that causality running from financial development
8

to economic growth and not the reverse. Hence, the study supports the supply-
leading hypothesis for South Korea.

2.2. Trade and Economic Growth

The literature on trade liberalisation can be grouped into two categories.
The first Category, examines export-growth nexus, while the second relates to
the nexus between trade liberalis ation and growth using with and without and
before and after approaches. However, there has been a great deal of
controversy. Using cross-section data, Feder (1983), Balassa (1978), Tyler
(1981) and Michaely (1973) have found positive association between exports
and economic growth. However, the results of these studies involve a spurious
correlation due to the fact that exports themselves being part of national product.
This concern led to a version of cross-sectional studies, which estimate
aggregate production function that includes exports as explanatory variable
along with other proposed economic growth determining fundamentals such as
labour, capital, and investment.3
The cross-country studies utilise different indicators of openness to
examine the relationship between trade liberalisation and growth. The most
important studies include Dollar (1992), Sachs and Warner (1995) and Edward
(1998). Dollar (1992) used an index of real exchange rate distortions and an
index of real exchange rate volatility as indicators of trade orientation. The
results indicate that each indicator is negatively related to growth in a sample of
95 developing countries.
Sachs and Warner (1995) construct a binary index of openness to
examine various aspects of trade policies including average tariff rates, non-
tariff barriers, and black market premium on exchange rates etc. According to
this index, they find that countries that are more open enjoy higher growth rates.
Yang and Huang (1997) suggest that a decline in the economy -wide tariff leads
to more equitable distribution of income in China using a Computable General
Equilibrium (CGE) model. Similarly, Edwards (1998) investigated that
robustness of the openness-growth nexus by utilising different indicators of
openness. He concluded that there is positive and significant association
between trade openness and economic growth.
Greenaway, et al. (2002) analysed the relationship between trade
liberalisation and growth rate of GDP for 73 developing countries. The analysis
is based on three different measurements of liberalisation. Firstly, through non-
tariff barriers, average tariff, and black-market exchange rate premium.
Secondly, through level of quotas, tariff, and export impediments and exchange
rate misalignment. Lastly, with a dummy variable for the structural adjustment
programme.

3
For further detail, see Ram (1985), Balassa (1985), Michaelpoulos and Jay (1973).
 9

The empirical results of this study were obtained using ordinary least
squares (OLS) technique with three different time period and three different
indicators. The results for the short-run from the first two indicators showed the
positive and significant impact of trade liberalisation on growth. The last
indicator showed insignificant impact of trade liberalisation on growth.
However, the results from all indicators showed that liberalisation affects the
growth rate of GDP with a lag in the long-run.
Irwin, et al. (2002) examined the relationship between trade liberalisation
and income growth for countries engaged in bilateral trade for different time
periods. They utilised instrumental variable (IV) technique of estimation. The
results of the study suggest that more liberal economies enjoy a higher level of
per capita income. Yanikkaya (2003) utilised various measures of trade volumes
and trade restrictions as alternative indicators of openness in a panel of 100
developed and developing countries. He finds a positive relationship between
openness and economic growth when trade volumes are used as an indicator of
openness. The study also finds a positive relationship between trade barrier and
economic gro wth.
A very few studies have examined the impact of liberalisation on
economic growth in the case of Pakistan. Khan, et al. (1995) examined the
causality between exports and economic growth in Pakistan. The evidence of
the study suggests that exports promo te economic growth. Iqbal and Zahid
(1998) investigated macroeconomic determinants of growth including trade
openness. The results suggest the openness has a beneficial impact on
economic growth. Mohsin, et al. (2001) examine the impact of impact of
openness on poverty level in Pakistan for the period 1963-64 to 1993-94.
The study demonstrates that poverty has declined in Pakistan with trade
liberalisation. Kemal et al. (2002) tested the relationship between exports
and economic growth in South Asian Count ries including Pakistan. They
find a positive association between exports and economic growth for all
countries. Din, et al. (2003) examined the link between economic growth
and openness for Pakistan over the period 1960-2001. The analysis is based
on the Engle and Granger (1987) two-step cointegration technique and error
correction models (ECM) are used to determine the short-run causality
between growth and openness. The results indicate the there is significant
long-run relation between economic growth and openness. However, there is
no evidence of short -run causality between economic growth and openness
and vice versa. Since Granger causality is based on the statistical property of
the data and not on the structural relationships implied by economic theo ry.
Furthermore, there is variety of economic, institutional and political factors
influencing economic growth. They recommended that multivariate model
might be more appropriate to examine the relationship between economic
growth and openness.
10

Though there are several studies on this issue. Studies regarding Pakistan
are very less. Therefore, it is felt necessary to study such relationship. This study
receives special importance to have an idea whether the financial development and
trade liberalisation causes economic growth in the context of Pakistan or the
reverse case. It is well-known fact that economy of Pakistan has undergone severe
changes since independence. Though the economy of Pakistan is basically Agro-
based, but over the period wider industrial development has been taken place.
There is also widespread financial sector development, which has taken place,
especially after the globalisation and liberalisation policy of 1990s. During this
period there has been a significant improvement in the growth rate of the
economy. The economy is also growth at a reasonable rate along with the financial
sector development. This growth and development has very important
implications on the external sector. Although, Pakistan is a small open economy,
but is an important player in international market in terms of exports and imports,
which significantly affect the economic growth and financial sector development.
Keeping the importance of both trade and finance in economic development, it is
felt necessary to study and test the hypothesis that both trade and finance enhance
economic growth in the country and try to find whether financial development and
trade liberalisation causes economic growth or vice versa.

3. OVERVIEW OF THE FINANCIAL AND TRADE

POLICIES IN PAKISTAN
Economic growth of developing countries is heavily based on the
financial sector’s credit allocation. Overall financial development is necessary
for economic growth at the macro-level [Andersen and Tarp (2003); Khan and
Senhadji (2000); Levine (2002)]. A more advanced intermediation enables firms
to raise and manage large amount of funds more effectively, resulting in a rapid
economic development. Particularly, the development of financial sector is an
important for developing countries because bank-based system has greater
impact on growth at the early stage than does a market-oriented system [Fase
and Abma (2003); Tadesse (2002); Iimi (2004)]. This section briefly reviews
the financial and trade liberalisation policies pursued by the government to
enhance growth.

3.1. Financial Sector Reforms

In Pakistan, the banking sector reforms were initiated under broader
macroeconomic structural adjustment programmes in the early 1990s. Through
these reforms, the government has been aiming to make the financial industry
more competitive and transparent by privatising formerly nationalised
commercial banks, liberalising interest rates and credit ceilings, strengthening
the supervisory capacity of central bank and standardised accounting and
auditing systems [Iimi (2004)].
 11

Prior to the 1990s, the financial sector in Pakistan remained heavily

controlled.4 Interest rates were set administratively and were usually remained
negative in real terms. Monetary policy was conducted primarily through direct
allocation of credit. Money market was under-developed, and bond and equity
markets were virtually nonexistent. Commercial banks often had to lend priority
sectors with little concern for the borrowing firm’s profitability. Despite the
opening of non-bank financial sector for private investment in mid-1980s, state-
owned financial institutions hold almost 93.8 percent of the total assets of the
entire financial sector at the end of 1980s. Moreover, the status of financial
institutions were precarious due to, inter alia, high intermediation costs resulting
from overstaffing, large number of loss-incurring branches, poor governance
with low quality banking services, accumulation of non-performing loans and
inadequate market capitalisation. These inefficiencies and distortions caused
severe macroeconomic difficulties in the late 1970s and 1980s. In order to
remove these distortions and spur economic growth, the government of Pakistan
undertook a wide range of reforms in the early 1990s to strengthen its financial
system and to provide an adequate macroeconomic environment.
The objectives of these reforms were to prepare industrial conditions for
market competition, strengthening corporate governance and supervision, and
adopting a market-based indirect system of monetary, exchange and credit
management. In the first phase of financial reforms 5 , the government liberalises
the market entry of private and foreign banks6 in order to gain efficiency and
enhance competition within the financial sector. Secondly, small-nationalised
banks, such as MCB and ABL, were partially privatised. Thirdly, major state-
owned commercial banks and DFIs were downsized in terms of branches and
employees. Fourthly, credit ceiling as an instrument of credit control was
abolished, credit-deposit ratio (CDR) was also abolished and open market
operation is now instrument of monetary policy and SBP at regular intervals
conducted auctions of government securities. Fifthly, loan recovery process was
strengthened by establishing banking courts and standardising loan classification
and accounting rules. Finally, State Bank of Pakistan (SBP) was granted full
autonomy.
Despite these efforts of financial liberalisation, financial markets
segmentation continued owning continuing controls on interest rates on
government debts and to specialised credit programmes. As a result, the second

4
All commercial banks were nationalised in January, 1974, with the aim at making credit
availability to highly priority sectors of the economy which previously had limited access to
investable funds [see Haque and Kardar (1993) for detailed account].
5
The early phase of financial reforms started in the late 1980s to earlier 1990s.
6
10 new private banks started their operations in 1991 and 23 private domestic banks
operating in the country including HBL, ABL, MCB and UBL. The process of liberalisation started
in the early 1990s and except NBP more than 50 percent shares of the public sector have been
privatised. There are about 14 foreign banks have been operating in the country.
12

phase of banking sector reforms 7 was introduced in 1997. These reforms

addressed the fundamental causes of crisis and corruption and strengthen the
corporate governance and financial discipline. In this regard, the cost structure
of banks was firstly restructured through capital maintenance and increased by
public funds. Secondly, partially privatised commercial banks were privatised
completely. Third, bank branches were fully libera lised and allow private banks
to grow faster and increase their market share. Fourthly, loan collateral
foreclosure was facilitated and strengthened to reduce default costs and to
expand lending to lower tier markets, including consumer banking. Fifthly,
national savings schemes were reformed so as to integrate with the financial
market. Sixthly, mandatory placement of foreign currency deposits was
withdrawn. Lastly, Strengthened SBP to play more effective role as regulator
and guardian of the banking sector and phase out the direct and concessional
credit programmes to promote market integration.
To promote intermediation and to attract funds held abroad by Pakistani
nationals, the resident Pakistanis were allowed to open foreign currency
accounts (FCAs), which were freely transferable abroad. These accounts were
exempted from income and wealth tax, and no question was to be asked about
the source of foreign exchange. Persons holding FCAs could also obtain rupee
loans against such accounts.
To facilitate the flow of sufficient short- term liquidity at variable rate it
was necessary to expand the money market potential by making it accessible to
new operators. Particularly, to those who were experiencing an excess of
liquidity, such as insurance companies, mic rofinance institutions, SME bank as
well as investment banks. This widening the range of operators on the money
market by the creation of new financial products, such as deposit certificates,
treasury bills and bonds, which are naturally negotiable.

3.1.1. Impact of financial Reforms

The object of the financial and operational reform policies was to
strengthen the microeconomic foundations of the banking system. However, the
pace of deposit mobilisation remained slow and the reforms were partially
effective [Khan (2003)]. Generally, financial sector developments include:8 (1)
Financial deepening, which consists of the growth of financial instruments
commonly measured by the ratio of monetary aggregates to GDP. (2) Financial
broadening, which implies an increase in the number of financial institutions,
financial transactions through cheques, and financial instruments. (3) Financial
liberalisation, which indicates deregulation of interest rates, free movement of
foreign capital, and removal of other restrictions.

7
The second phase of banking sector reforms started from 1997 to 2001.
8
See for example Ansari (2002), p.79.
 13

After liberalisation, the price of financial services was intended to be

determined by the banks on competitive basis, with little intervention from the
SBP. To achieve the twin objectives of reducing government cost of borrowing
on domestic debt and encouraging private sector credit expansion, the SBP has
been pursuing a relatively easy monetary policy since July 1995 to July 2000.
The weighted average lending rate gradually come down from 15.6 percent in
1998 to 8.819 percent in June 2005, but the real interest rate has increased from
3.6 percent in 1996 to 10.9 percent in 2000 and then following the declining
trend and reached to –0.49 percent in June 2005 (see Table 1). This reduction in
lending rate indicates a little improvement in the profitability of the banks but
purely ad hoc and not in the lines of the liberalisation. Similarly, the weighted
average deposit rate reduced from 6.8 percent in 1998 to 1.37 percent in June
2005; the real deposit rate remained negative except for the period 1999-2002.
This reduction in the deposit rate will reduce the savings even further.

Table 1
Interest Rate Behaviour in Pakistan
Weighted average Weighted Average Interest Rate
Lending Rate Deposit Rate Spread
Year Inflation Rate Nominal Real Nominal Real Nominal Real
1990-95 10.57 12.55 1.98 6.53 –4.05 6.02 5.95
1996 10.8 14.4 3.6 6.4 –4.4 8.00 8.00
1997 11.8 14.6 2.8 6.8 –5.0 7.8 7.8
1998 7.8 15.6 7.8 6.8 –1.0 8.8 8.8
1999 5.7 14.8 9.1 6.5 0.8 8.3 8.3
2000 3.6 13.52 10.9 5.47 1.9 8.05 9.00
2001 4.4 13.61 9.21 5.27 0.87 8.34 8.34
2002 3.5 13.19 9.69 3.61 0.11 9.58 9.58
2003 3.1 9.40 6.3 1.61 –1.49 7.79 7.79
2004 4.6 7.28 2.68 0.95 –3.65 6.33 6.33
2005 9.3 8.81 –0.49 1.37 –7.93 7.44 7.44
Source: SBP Annual Reports (Various Issues).

The interest rate spread10 is an important indicator for the financial

sector’s competitiveness and profitability. Spread typically declined when
competition among banks increases to access the financial market to increase
their customer’s base. But in Pakistan, the high lending rate and low deposit rate
have generated large spread11 nearing 7.44 percent in June 2005 as against 6.33
percent in 2004. The high lending rate will increase the cost of borrowing and

9
Although in 2004 the rate fell to 7.28 percent.
10
Interest Rate Spread = (Average Lending Rate – Average Deposit Rate).
11
High interest rate spread is generated by factors such as high administrative costs,
overstaffing and unavoidable burden of non-performing loans (for further detail, SBP’s financial
sector assessment 2003-2004).
14

hence discourage investment. The low deposit rates discourage both

consumption and savings, resulting high debt/GDP ratio, deterioration of banks
balance sheet, lowering economic growth, and increase in poverty. Furthermore,
the large spread also reflects perceived sovereign risk [Khan (2003)]. Hence,
measures should be taken to bring down the interest rate spread close to zero in
order to enhance both savings, investment in the country.
To measure the improvement in the financial sector following the
financial reforms process, the standard indicators used in this study include the
ratios of M2/GDP, BDL/GDP, MCH/GDP, PSC/GDP, SMC/GDP, CC/M2 and
CC/GDP. 12 Table 2 represents the entire situation regarding the financial sector
of Pakistan. Table 2 shows that the ratio of M 2 /GDP increased steadily. It should
be noted that a large ratio of M2 /GDP represents a more developed and efficient
financial sector. In 1990 the average monetary assets were around 32.27 percent
of GDP, while it was reached to 49.4 percent of the GDP in 2004 and slightly
come down to 48.6 percent of the GDP in 2005 because the other instruments
outside the M2 become available. 13 Since M2 is more saving-investment oriented
and the steady growth in M2 /GDP caused positive impact on economic growth.
However, M2 /GDP recorded gradual growth, showing an improvement in the
financial sector. The ratio of bank deposit liabilities to GDP assesses the degree
of monetisation in the economy. A steady growth in this ratio over the period of
study also indicates an improvement in the financial sector. Similarly the
amount of money clear by banks through cheques relative to GDP increases
gradually also showing an improvement of financial services offered of financial
institutions. Figure 1 depicted the trend behavior of each financial indicator.
The ratio of private sector credit to GDP indicates an efficient
allocation of funds by the banking sector. Even though this ratio has been
increasing gradually over the years, there is ample room for further growth
given the recent privatisation of the large public sector commercial
enterprises. The other tools of financial development include currency to M2
ratio and currency to GDP ratio reflecting the increase in total deposits
relative to currency in circulation and degree of monetisation in the
economy, which was 23 percent and 11.18 percent of the GDP in 2005
respectively. The stock market capitalisation, which was 4.68 percent of
GDP in 1990, is now 30.95 percent of GDP in 2005.

12
M2/GDP, BDL/GDP, MCH/GDP, PSC/GDP, SMC/GDP, CC/GDP are respectively ratio
of broad money (currency+demand deposits+time deposits+foreign currency accounts) to gross
domestic product, ratio of bank deposit liabilities to gross domestic product, ratio of money cleared
through clearing house to gross domestic product, ratio of private sector credit to gross domestic
product, ratio of stock market, capitalisation to gross domestic product, and currency in circulation
to gross domestic product.
13
This is due to the lack of access to the banking system, the use of credit as means of
payments etc. As financial liberalisation began and other financial instruments were developed, this
ratio tends to decline [Khan (2003)].
 15

Table 2
Indicators of Financial Deepening (in percent)
Indicators 1961-70 1971-80 1981-90 1990 2000 2001 2002 2003 2004 2005
1
Broad Money/GDP 34.03 33.90 34.02 32.27 38.59 39.64 43.80 46.99 49.36 48.61
Total Bank Deposit iabilities/GDP2 23.52 34.47 32.36 27.91 37.51 33.23 36.03 40.32 44.16 45.02
Amount of clearing house/GDP* 90.74 97.70 111.63 126.88 141.23 138.68 152.48 182.72 213.26 248.26
Currency/M 2 45.13 32.29 32.28 37.56 27.80 26.02 25.30 25.04 23.99 23.00
Currency/GDP 16.06 13.53 13.29 14.73 10.82 10.31 11.08 11.77 11.84 11.18
Private Sector Credit/GDP 19.60 19.24 21.45 19.92 22.33 22.02 21.92 24.87 29.30 28.44
Stock Market Capitalisation/GDP 8.42 4.08 3.75 4.68 10.24 8.15 9.26 15.48 24.05 30.95
Source: IFS CD-ROM and Pakistan: Financial Sector Assessment 1990-2000, 2001-2002 (Published by SBP).
Note: 1 Broad money (money + quasi money). Broad money includes the sum of currency outside the banks plus demand, time, savings and foreign currency deposits of
residents other than the central government.
2
Total Bank Deposit Liabilities are equal to liquid liabilities minus currency in circulation. Demetriades and Luintel (1996) argue that without deducting
currency in circulation, we are left with primarily a measure of monetisation, not financial depth (p.360).
* The amount of money cleared through cheques by the clearing house can also be used as an indicator of financial services development.
16

Fig. 1. Financial Development Indicator Relative to GDP

300 35

30
250

25
200
M2/GDP, BDL/GDP

PSC/GDP, SMC/GDP
20
150
15

100
10

50
5

0 0
1961-70 1971-80 1981-90 1990 2000 2001 2002 2003 2004 2005

Year
Broad Money/GDP1 Total Bank Deposit Liabilities/GDP 2 Amount of clearing house/GDP*
Private Sector Credit/GDP Stock market capitalization/GDP

3.2. Trade Liberalisation

Pakistan has pursued a mixed economy approach to development
following import substitution industrialisation policies in order to: (i) strengthen
the industrial base (ii) achieve self reliance, (iii) protect domestic infant
industries, (iv) insulate the domestic economy into external shocks stemming
from international capital markets, and (v) reduce the chronic balance of
payments deficits and use scarce foreign exchange resources.
To achieve these objectives, the government imposed various
quantitative and qualitative restrictions on trade to protect domestic industries.
During the 1960s a more liberal policies being opted by the government where
the private sector was encourage to play a greater role. 14 Consequently, both
industrial production and exports registered a reasonable increase during this
period. However, this trend was reversed during 1970s because of
nationalisation of industries, financial institutions and an increasing
domination of public sector in the economic activities. Although, the
government took various measures such as, devaluation of Pak-rupee vis-à-vis
US-dollar, elimination of export bonus scheme and discontinuation of
restrictive import licensing scheme to boost exports. But these steps do not
register any significant impacts on exports.

14
Although highly protected trade regime remained effective in this period. However, some
additional policies such as, an overvalued exchange rate, export bonuses, preferential credit access to
industries with export potential and automatic renewal of import licenses, were introduced to
encourage exports [Yasmin , et al. (2006)].
 17

In the late 1980s, Pakistan was faced with high macroeconomic

imbalances as a result of the growing inefficiency and losses in the public sector.
To restore the business confidence and to reduce inefficiency and losses in the
public sector, the government implemented a wide range of structural and
institutional reforms in the early 1990s. The most specific measure undertaken
by the government includes:

• Reduction of maximum tariff rate on imports from 225 percent in 1986-

87 to 25 percent in 2005 [Husain (2005); Kemal (2001) and Anwar
(2002)]. The average tariff rate has come down to 11 percent as
compared to 65 percent a decade earlier [Husain (2005)]. Similarly, the
number of custom duty slabs was reduced from 13 in 1996-97 to 4.
• Quantitative import restrictions were lifted except 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 anti-export bias and promote competitive and efficient industries. A number
of laws 15 were also been promulgated to bring the trade regime in line with
WTO regulations.
Despite the substantial reduction in tariff rate, removal of all non-tariff
barriers and successive devaluation of the currency,16 the growth in exports in
the 1990s was only 5.6 percent per annum as compared to 14.97 percent in the
1970s and 8.5 percent in the 1980s (see Table 3 and Figure 2). However, the
overall trade to GDP ratio has risen from 26.31 percent in 1970s to 37.65
percent today in Pakistan. This gives an indication of higher level of trade
integration
In order to encourage foreign direct investment, restrictions on capital inflows
and outflows were gradually lifted. Investors were also allowed to purchase up to
100 percent of the equity in industrial companies on repatriable basis without any
prior approval. Furthermore, investment shares issued to non-residents could be
exported and remittance of dividend and disinvestments proceeds was permissible
without any prior permission of SBP. In 1994, restrictions on some capital
transactions were partially relaxed, and foreign borrowing and certain outward
investments were allowed to some extent. Full convertibility of the Pak-rupee was
established on current international transactions. The establishment of an interbank
foreign exchange market also marked an important step towards decentralising the
management of foreign exchange and allowing market forces to play a greater role
in exchange rate determination.

15
Such as anti- dumping, countervailing measures and intellectual property rights.
16
The average annual depreciation of exchange rate was about 10 percent in the 1990s (i.e.
Rs 24 in 1990 to Rs 60 in 2000).
18

Table 3
Growth Rates of Exports and Imports and Degree of Openness (in percent)
Year 1961-70 1971-80 1981-90 1991-00 2001 2002 2003 2004 2005
Exports ($) 6.07 14.97 8.52 5.61 9.07 2.32 19.14 13.84 15.93
Imports ($) 8.35 18.78 4.54 3.22 6.25 –7.53 20.13 20.04 37.64
(X+M)/GDP 18.28 26.31 29.93 32.90 28.91 28.68 29.89 32.99 37.65
Source: State Bank of Pakistan (Handbook of Pakistan Economy, 2005).

Figure 2: Exports, Imports, and

Fig. 2. Exports,Degree
Imports, of
andOpenness
Degree of Openness
(%) (in percent)

40 40
Exports, Imports

35
30

Openness (%)
30
(million $)

20 25
20
10 15
10
0
5
-10 0
01

02

03

04

05
-90
-70

-80

-00

20

20

20

20

20
81
61

71

91
19
19

19

19

Year
Year

Exports ($) Imports ($) (X+M)/GDP

4. MODEL SPECIFICATION, METHODOLOGY AND

DATA ISSUES
Theoretical literature predicts that real income; financial development and
real interest rate are positively correlated. The positive relationship between the
level of output and financial development resulted from the complementarity
between money and capital [Mckinnon (1973)]. Furthermore, the removal of
ceilings on deposit rate results in positive real interest rate, which increase
savings and hence economic growth. King and Levine (1993, 1993a) predict a
positive relationship between real income, financial development and real
interest rate.
Based on these theoretical postulates, the relationship between real output
and financial development can be specified as:

LRGDPt = α 0 + α 1 LFSDt + α 2 RDRt + εt … … (1)

Where RGDP is real output, FSD is the financial sector development, RDR is
the real deposit rate and ε is an error term. Except real deposit rate, all the
variables are expressed in logarithmic form.
 19

Theoretical and empirical research indicates a strong and positive

correlation between trade liberalisation and economic growth over long period
of time. Sachs and Warner (1995) has pointed out that open economies has
grown about 2.5 percent faster than closed economies and the difference is
larger among developing countries. Jin (2000) argued that trade liberalisation
and openness has provided an important base of economic activity. Thus, an
increasing openness is expected to have a positive impact on economic growth.17
Barro (1991) provided evidence that increasing openness had a positive effect
on GDP growth per capita. Edwards (1992) also found a positive and significant
effect of openness on GDP growth. It can be argued that through the openness
countries are able to benefit from information spillovers such as scientific
advances and improvements. Sukar and Ramakrishna (2002) argued that
countries that liberalise their external sector and reduce impediments to
international trade could experience relatively higher economic growth. Thus,
we extend Equation (1) by incorporating the variable TOPEN which capture the
impact of trade liberalisation on real output. Now Equation (1) can be written
as:

LRGDPt = α 0 + α1 LFSDt + α 2 RDRt + α 4 LTOPEN + εt … (2)

To examine the long run relationship between real GDP, trade

liberalisation, financial development, and real deposit rate, we employ bound
testing approach to cointegration within the framework of Autoregressive
Distributed Lag (ARDL) developed by Pesaran, et al. (2001). There are several
reasons for the use of bound test. Firstly, the bivariate cointegration test
introduced by Engle and Granger (1987) and the multivariate cointegration
technique proposed by Stock and Watson (1988), Johansen (1988, 1991) and
Johansen and Juselius (1990) are more appropriate for large sample size. While
the bound testing procedure of cointegration is more appropriate for a small
sample size [Pesaran, et al. (2001); Tang ( 2001, 2002)]. Secondly, bound testing
approach avoids the pre-testing of unit roots. Thirdly, the long run and short run
parameters of the model are estimated simultaneously to tackle the problem of
endogeneity and simultaneity. Fourth, all the variables are assumed to be
endogenous. Finally, this method does not require that the variables in a time
series regression equation are integrated of order one. Bound test could be
implemented regardless of whether the underlying variables are I (0), I (1), or
fractionally integrated.

17
More recent studies after the Asian Economic Crisis of 1997-99, have challenged some of
these findings. Rodrigues and Rodrik (1999) have raised question about measuring the degree of
openness, and have identified many other factors that affect growth. They concluded that trade
liberalisation does always leads to higher growth. Batra (1992), Batra and Slottje (1993) and Leamer
(1995) concluded that freer trade is the primary source of economic downturns.
20

An ARDL (p, q) model of Equation (2) in the form of unrestricted error-

correction can be formulated as:
p −1 p −1
∆ Yt = ∑ γ j ∆Yt − j + ∑ δ j ∆X t − j + ϕ[Yt −1 − {β 0 + β1 X t −1}]+ εt … (3)
j =1 j= 0

Where Y is the growth of real GDP and X is a vector of explanatory variables

(i.e. LFSD, RDR, LTOPRN), γ and δ are the short-run coefficients related to
growth and its determinant, β are the long-run coefficients, ϕ is the speed of
adjustment to the long-run relationship, and ε is error term. The term in square
brackets contains the long-run relationship, which acts as forcing equilibrium
condition:

Yt = β 0 + β1X t + ut where ut ~ I ( 0) … … (4)

For the presence of a long run relationship amongst the variables of equation (2)
is tested by means of bounds testing procedure proposed by Pesaran, et al.
(2001). The bounds testing procedure is based on the F-stat (or Wald statistics)
for cointegration analysis. The asymptotic distribution of the F-statistic is non-
standard under the null hypothesis of no cointegration between the examined
variables, irrespective of whether the explanatory variables are purely I (0) or I
(1). To implement the bound test, the null hypothesis is tested by considering the
unrestricted error correction model (UECM) for real GDP in Equation (2) and a
joint significance test was performed as:

H0 : β 0 = β1 = β 2 = 0 ,
H1 : β0 ≠ β1 ≠ β2 ≠ 0 .

Pesaran, et al. computed two sets of critical values for a given

significance level. One set assumes that all variables are I (0) and other set
assumes that they are all I (1). If the computed F-statistic exceeds the upper
critical bounds value, then the H0 is rejected. If the F-statistic falls into the
bounds then the test becomes inconclusive. If the F-statistic lies below the lower
critical bounds value, it implies no cointegration.18
Once the long run relationship is identified, then the long run and short-
run estimates of the ARDL model can be obtained from Equation (3). At the
second stage of ARDL cointegration method, it is also possible to perform a
parameter stability test for the appropriately selected ARDL representation of
the UECM. A general error correction representation of Equation (3) can be
formulated as follows:

18
This is similar to the Johansen and Juselius multivariate cointegration procedure, which
has five alternative cases for long run.
 21

k k k
∆LRGDP t = β 0 + ∑ β1i ∆LRGDPt −i + ∑ β 2i ∆LFSDt −i + ∑ β 3i ∆RDRt −i
i =1 i =0 i =0
k
+ ∑ β 4i∆ LTOPEN t −i + λ ECt −1 + ηt … … (4)
i= 0

Where λ is the speed of adjustment and EC is the error-correction term obtained

from the estimated cointegration model of Equations (2).

4.1. Data Description

The present study is based on the annual data covering the period from
1961-2005. The recent literature on financial development suggests several
indicators used as proxy for the ability of financial intermediation. But in this
study we basically calculated four financial development (FD) indicators related
to banking and stock market. Firstly, total bank deposit liabilities relative to
GDP which is calculated by taking the difference between liquid liabilities of the
financial system minus currency in circulation divided by GDP.19 This
considered the broadest measure of the financial intermediation. Secondly, ratio
of private sector credit to GDP, which measures how much intermediation, is
performed by the banking system. Third, amount of money cleared through
clearing house relative to GDP. Lastly, the ratio of stock market capitalisation
to GDP is calculated as the stock market capitalisation divided by GDP.
But the problem is that each indicator of financial development exerted
different impact on real GDP and the derived coefficients may be biased. To
avoid this problem, and following Kelly and Mavrotas (2003) we use total bank
deposit liabilities ratio, value of clearing house ratio, credit allocation to private
sector ratio and stock market capitalisation ratio, to construct financial sector
development index (FSDI). We used FSDI as a proxy of government financial
policy.
Real GDP is obtained as a ratio of nominal GDP 20 to consumer price
index (CPI 2000=100). Data on these variables are taken from IFS CD-ROM.
The variable trade openness relative to GDP (TOPEN) is calculated by taking
the ratio of sum of exports and imports to GDP. Data on exports, imports and
deposit rate (DR) are taken from Handbook of Pakistan’s Economy published by
State Bank of Pakistan (2005). Inflation is calculated as a percentage by taking
the log-difference of CPI, while real deposit rate is calculated by taking the
difference between deposit rate and inflation rate.

19
The standard measure of financial development is the ratio of M2 to GDP [World Bank
(1989)]. However, this ratio measures the extent of monetisation rather than financial development.
In developing countries, monetisation can be increasing without financial development; therefore,
M2/GDP is not a satisfactory indicator of financial development. Therefore, we define ratio total
bank deposit liabilities to GDP as proxy of financial development.
20
Nominal GDP is adjusted for 1999-00 base.
22

4.2. Construction of Financial Development Index (FSDI)

Measuring financial development is very complex and complicated
process because there is no clear-cut definition as to what financial development
is. Bandiera, et al. (2000) argued that an ideal index of financial sector
development should include various aspects of regulatory and institutional
reforms. However, measuring this aspect of government policy is very difficult
if not possible task [Kelly and Mavrotas (2003)]. Inclusion all the policy
variables separately in the same model cause serious estimation problems such
as, multicolinearity etc. In order of avoid these problems, we use four different
types of financial development indicators to construct the financial sector
development index by using principal component method.21 These indicators
include the ratio of total bank deposit liabilities to GDP which give an indication
of the absolute size of the financial institutions, the ratio of clearing house
amount to GDP which indicate the wide spread provision of financial services,
the ratio of the private credit to GDP which measures the activities of the
financial intermediaries and the ratio of the stock market capitalisation to GDP.
The index represents a particular government financial policy variable. The
financia l development index also indicates a steady improvement in the financial
sector (see Table 4 and Figure 3).

Table 4
Financial Sector Development Index (FSDI)
Year 1961-70 1971-80 1981-90 1990 2000 2001 2002 2003 2004 2005
FSDI 68.57 66.14 73.55 78.29 105.29 104.28 114.11 135.87 156.17 179.23
Source: Author’s calculation based on IFS and State Bank of Pakistan’s data.

Fig. 3. Financial
Figure Sector
3: Financial SectorDevelopment
Development Index (FSDI)
Index (FSDI)
FSDI
200
180
160
140
120
FSDI (%)

100
80
60
40
20
0
1961-70 1971-80 1981-90 1990 2000 2001 2002 2003 2004 2005
Year

21
The method of principal components is discussed in detail in Theil (1971).
 23

5. EMPIRICAL RESULTS
Two-step ARDL cointegration procedure is implemented in estimation of
Equation (2) for Pakistan using annual observations over the period 1961–2005.
In the first stage, the order of lags on the first-differenced variables for Equation
(3) is obtained from UECM by mean of Schwarz Bayesian Criterion (SBC).22
The SBC gives a more parsimonious number of lags than other criteria such as
Akaike Information Criterion (AIC). 23 Given the limited number of
observations, we experimented up to 2 lags on the first-difference and computed
F-statistics for the joint significance of lagged levels of variables in Equation
(3). The computed F-test statistic for each order of lags is presented in Table 5.

Table 5
Statistics for Selecting Lag Order and the Existence of
Long-run Relationship
No. of Lag AIC SBC CHSQSC (1) F-statistic
1 97.6794 87.9928 0.2184 28.2522*
2 97.3983 86.9723 0.0811 31.4732*
*Indicate significant at the 1 percent level of significance.

Based on the minimum value of SBC, the lag length of order 2 is selected
for each series. When 2 lags are imposed, there exists a long-run relationship
between LRGDP, LFSDI, RDR and LTOPEN because the calculated F-statistic
(31.4732) is greater than the critical values of the upper level of the bound (i.e.
5.83) at the 5 percent level of significance. This result gives strong indication of
cointegration among the variables included in Equation (2). 24
Given the existence of a long run relationship, in the next step we used
the ARDL cointegration method to estimate the parameters of Equation (2) with
maximum order of lag set to 2 based on SBC. The long run results of Equation
(2) based on SBC are reported in panel A of Table 6. The diagnostic test results
of Equation (2) based on short run estimates are displayed in panel B of Table 6.
The empirical results presented in Table 6 indicate that the estimates
possessed expected signs and are statistically significant at the 1 percent level of
significance. The overall results are in accordance with the prediction that trade
and financial policies have a positive impact on real GDP. These results also
imply that liberalisation policies enhance economic growth rather than growth
inducing liberalisation. The contribution of financial policy is more than the

22
Bahmani-Oskooee and Bohl (2000) and Bahmani-Oskooee and Ng (2002) argued that the
results of this stage are sensitive to the order of VAR.
23
See Bernstein (2000).
24
At lag 2, the residuals are white noise as indicated by the Lagrange Multiplier test of serial
correlation. i.e. CHSQSC(1).
24

trade policy to development, which is consistent with the fact that financial
liberalisation facilitates trade liberalisation.
The study also found a positive and significant impact of FSDI and RDR on
real GDP. This positive impact supports the prediction of Mckinnon and Shaw
hypothesis that an increase in real interest rate facilitates financial savings and real
income. Moreover, an acceleration of financial development raises the capacity of
financial intermediaries to supply funds, which help to enhance investment and
economic growth. These results are also in the lines with King and Levine (1993,
1993a), Levine, et al. (2000), Beck, et al. (2000), Levine (1999) and Khan and
Senhadji (2000) find positive effects of financial depth on economic growth.25
These results provide clear evidence that there is a long-run relationship between
output and financial policy, and therefore the casual relationship runs from financial
policy to output.26 Since the magnitude of financial policy (financial sector
development index) is higher than that of real interest rate which support the
argument that in a developing country like Pakistan the availability of funds rather
the cost of funds is an important to raise real income. The low coefficient of real
interest rate implies that an increase in interest rate alone is unable to expedite
economic growth. These findings are consistent with earlier findings derived by
Khan, et al. (2005).
Table 6
ARDL Estimates
Dependent Variable: LRGDP
Regressor Coefficient t-values
Panel A: Long-run Coefficients
LFSDI 1.0291 3.4511*
PDR 0.0329 3.0555*
LTOPEN 0.3715 8.3371*
Intercept 9.9908 33.5708*
Panel B: Short-run Diagnostic Test Statistics
χ SC(1)
2
0.16400
χ2 FF(1) 2.9289
χ NO(2)
2
1.6418
χ Het(1)
2
1.6413
Note: ARDL (1, 1, 1, 0) selected on the basis of SBC. The full tables of the short run estimates are
available from the author. χ2 SC , χ2 FF, χ2NO and χ2 Het are Lagrange multiplier statistics for test
of residual correlation, functional from mis-specification, non-normal errors and
heteroskedasticity, respectively. These statistics are distributed as Chi- square values with
degree of freedom in parentheses.

25
These studies utilised panel data for the empirical purpose.
26
We have also implemented cointegration test by taking financial sector development index
(FSDI) as dependent variable, but we does not find any evidence of cointegration. The results are
available from the authors.
 25

We also find a positive and significant impact of trade liberalisation

policy on real GDP. This result imply that trade liberalisation allows market
forces to channel resources towards relatively productive sectors and hence
leads to a rise in efficiency. It also increases markets for new products and
generates economies of scale. These results confirmed the earlier findings of
Din, et al. (2003).
To find the short-run causality between real output and financial
liberalisation policy and output and trade liberalisation policy, we have the
error-correction model. The results of the error-correction model are given in
Table 7. The estimated lagged error-correction term (ECMt–1 ) is negative and
highly significant. This result supports the cointegration among the variables

Table 7
Error Correction Representation of ARDL Model
Dependent Variable: ∆LRGDP
Regressor Coefficient t-values
Panel A: Results of Error -Correction Model
∆LFSDI –0.0806 –1.7654
∆RDR 0.0057 4.2958*
∆LTOPEN 0.0334 2.6122**
∆ Intercept 0.8974 3.3162*
ECMt–1 –0.0898 –3.0555*
R2 0.36
2
R adj 0.25
F-stat 5.066
AIC 97.4013
SBC 91.2371
S.E Regression 0.02
R.S.S 0.20
Equation-LL 104.4013
DW-stat 2.12
Panel B: Short-run Causality Tests between Output and Financial
Development and Output and Trade Liberalisation
∆LGSDI = 0 ∆LTOPEN = 0
χ (1) = 3.1167
2
χ2 (1) = 6.8237*
Note: ARDL (1, 1, 1, and 0) selected on the basis of SBC. R.S.S, LL, AIC and DW are respectively
residual sum of squares; log likelihood, Schwarz Bayesian Criteria and Durbin Watson stat.
*, ** indicate significant at the 1 percent and 5 percent level of significance respectively.
ECM = LRGDPt − 1.0291* LFSDIt − 0.0329 * RDRt − 0. 3715* LTOPENt − 9. 9908* Intercept
26

represented by Equation (2). The feedback coefficient is -0.09, suggesting a

slow adjustment process. Nearly 9 percent of the disequilibria of the previous
period’s shock adjust back to the long run equilibrium in the current year. The
results further suggest that in the short-run financial sector development index
exerted negative and insignificant impact on the economic growth. This result
implies that economic growth is long run process not short-run.
The χ2 -test for the hypothesis that the changes in financial sector
development (∆LFSDI) do not contribute to growth is not rejected, therefore
there is not evidence of short-run causality between output and financial sector
development. However, the hypothesis that there is short-run causality between
output and trade liberalisation does not rejected as indicated by the χ2 test (panel
B of Table 7). This result implies that there is interdependence between output
and trade liberalisation. The short- run response of real deposit rate is significant
but very small, suggesting that there is a need for further liberalisation of interest
rate. Furthermore, the changes in the trade policy exerted positive and
significant impact on economic growth in the short-run. However, the impact of
trade policy changes is so small in the short run.
To assess the structural stability of the estimated model, we also
performed the CUSUMSQ test of stability. Figures 4 and 5 plots the CUSUM
and CUSUMSQ.

Fig. 4. Plot of Cumulative Sum of Recursive Residuals

20
15
10
5
0
-5
-10
-15
-20
1963 1968 1973 1978 1983 1988 1993 1998 2003

The straight lines represent critical bounds at 5% significance level

Fig. 5. Plot of Cumulative Sum of Squares of Recursive Residuals

1.5

1.0

0.5

0.0

-0.5
1963 1968 1973 1978 1983 1988 1993 1998 2003

The straight lines represent critical bounds at 5 percent significance level

 27

It can be seen respectively from the Figures 4 and 5 that the plots of
CUSUM and CUSUMSQ statistic is well within the critical bounds implying
that all the coefficients in the estimated model are stable.
The financial markets liberalisation affects the cost of external finance
and facilitates trade liberalisation. Thus the policy makers should focused their
attention on the creation of modern financial institutions, in the banking and
stock markets.

6. CONCLUSIONS
This paper examines the impact of trade and financial policies and real
interest rate on real GDP in Pakistan over the period 1961-2005. The study
utilised bound testing approach of cointegration advanced by Pesaran, et al.
(2001). Empirical results reveal the presence of a long-run relationship between
real GDP, trade liberalisation, financial development and real interest rate. The
results further show that in the long-run FSDI, RDR and LTOPEN exerted
positive impact on real GDP. However, in the short run FSDI exerted negative
association with economic growth, but remain statistically insignificant. The
study also found a positive impact of trade openness on economic growth both
in the long as well as in the short-run. This result highlighted the importance of
trade liberalisation in order to enhance economic growth. However, financial
liberalisation has relatively higher impact of real GDP than does trade
liberalisation in the long-run. The low effectiveness of real interest rate indicates
that interest rates alone are unlikely to expedite economic growth. The feed
back coefficient is negative and significant, but the speed of adjustment is rather
slow.
Based on these findings, the study suggests that Pakistan should go more
of trade and financial liberalisation to enhance more economic growth. Further,
the continuation of such policies with strong commitment is also recommended
in order to promote and sustained economic growth.

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