Romanian Journal of Fiscal Policy
Volume 2, Issue 2, July - December 2011, Pages 11-19
Financial Development, International Trade and Economic Growth:
Empirical Evidence from Pakistan
Government Post Graduate Degree College for Women Sargodha
Masood Sarwar AWAN
Department of Economics, University of Sargodha
Department of Economics, University of Sargodha
Muhammad Amir ASLAM
Punjab Home Department
The study utilizes the Autoregressive-distributed lag (ARDL) approach for cointegration and
Granger causality test, to explore the long run equilibrium relationship and the possible
direction of causality between international trade, financial development and economic growth
for the Pakistan economy. Imports plus exports of goods and services is used as a proxy for
international trade, while broad money (M2) and gross domestic product (GDP) are used as the
proxies for financial development and economic growth, respectively. Result explores a long run
relationship between the variables. In case of Pakistan, economy supply leading hypothesis is
accepted. Moreover, unidirectional causality is observed from international trade to economic
growth and from financial development to international trade.
Keywords: Financial development, international trade, economic growth, Pakistan
JEL codes: F4, F13, G18, F02
Investigation of major determinants of economic growth is one of the main issues of
development economics. In early literature of development economic, economist relatively paid
little attention towards the role of financial development and international trade in economic
growth. Development in financial sector is considered as one of the key determinant of financial
liberalization. It is considered as the essence of financial liberalization process. Gurley & Shaw
(1955, 1967) and Goldsmith (1969) explored the importance of financial development in
economic growth. The seminal debate on this subject can be marked out to Schumpeter (1911)
who argued that financial development leads to economic growth. After this a flood of studies
has been emerged1 on this issue. Calderon and Liu (2003) considered that financial development
is necessary condition for economic growth. But here the question arises that does financial
development cause economic growth or does economic growth cause financial development? In
literature, to find out the causality between financial development and economic growth, there
are two hypotheses, developed by Pattrick (1966). One is the supply-leading hypothesis (SLH)
and the other is demand-following hypothesis (DFH). SLH posited a possible causality from
financial development (FD) to Economic growth (EG) and vice versa for DFH. Some studies give
support to SLH2, while some support to DFH3. Now come towards the second argument that
International trade is also one of the important determinants of economic growth (Chow, 1987;
Xu, 1996; Balaguer and Cantuella-Jorda, 2002; Kletzer and Bardha, 1987) conclude that financial
development gives comparative advantage to industrial sector of that country. Hence, financial
development and international trade are highly correlated with economic growth.
The purpose of this study is to find out the possible cointegration and causal relationship
between international trade, financial development and economic growth in Pakistan economy
for the period of 1973-2009. The findings of this study will help the policy makers, whether they
should follow financial development or they should follow economic growth, or whether follow
both financial development and economic growth at the same time.
Rest study is organized as follows: section two discusses about the data and methodology;
section three presents the results and last section gives the conclusion and policy implication.
2. Data and Methodology
Time series annual data for the period of 1973-2009 is used. Data on real imports of goods and
services, real imports of goods and services, real gross domestic product, real domestic credit
provided by banks and real M2, are gathered from IFS CD-Rom 2009. All the variables are
treated in real terms. Augmented Dicky Fuller (ADF) and Phillips Perron (PP) unit root tests are
employed in order to check the stationarity of the variables. To explore the long run relationship
between variables, bonds test for cointegration under ARDL approach is used. Pesaran and Shin
(1996); Pesaran and Pesaran (1997); Pesaran and Smith (1998); and Pesaran et al. (2001)
introduced this technique to test the cointegration among variables. The main feature of this
1 Patrick (1966), Katkhate (1988, 1972), Shaw (1973), McKinnon (1973), Wijnbergen (1982, 1972), Fry
(1986, 1988, 1978), Gupta (1984), Mazuar and Alexander (2001), Chang (2002), Calderon and Liu (2003)
and Jenkins and Katircioglu (2010).
2 McKinnon (1973), King and Levine (1993), Neusser and Kugler (1998), Levine et al. (2000) and Jenkins
and Katircioglu (2010).
3 Gurley and Shaw (1967), Goldsmith (1969) and Jung (1986).
approach is that it can be applied whether the series are I(0) or I(1). This approach has an
advantage on other cointegration test due to certain reasons that this approach is based on OLS
method. This approach integrates short run dynamics from long run equilibrium without loosing
long run information (Banerjee et al. 1993). This is more flexible approach because it deals with
different types of integrating orders, e.g I(0) or I(1) (Pesaran and Pesaran, 1997). In a
conditional unrestricted Error Correction Mechanism (ECM), F-statistic or Wald test is used in
order to test the significance of lagged levels of the variables (Pesaran et al. 2001). This
approach is more significant than other approaches because it is more robust for small samples
(Ghatak and Siddiki, 2001). Under this approach the model takes sufficient numbers of lags in
order to capture the data generating process in general to specific modelling (Laurenceson and
Chai, 2003). This approach also evades the unit root pre-testing (Pesaran et. al. 2001). The main
purpose of unit root test is to determine whether series is I(1) or I(0). This approach deals with
both I(1) or I(0) so this evades the unit root approach (Bahmani-Oskooee, 2004). It avoids all the
things which Johansen’s approach has (Waqas et al., 2011). There is no need to determine
whether data has deterministic trend or not, optimal lag orders and order of Vector Auto
Regressive (VAR). ARDL approach was applied by Pesaran et al. (2001) and Error Correction
version of the ARDL is as follows:
DGDPa bDGDP c DMT
i t ii t i
i t i
i t i
d DDC f DIT
ti t i
i t i
i t i
i t i
DMTa bDMTc DGDP d DDCf DIT
ti t i
i t i
i t i
DDCa bDDC c DGDP d DMTf DIT
ti t i
i t i
i t i
i t i
DITabDITc DGDP d DMTe DDC
3. Results and discussion
Table 1 gives the results of ADF and PP, commonly used unit root tests. All the variables are
stationary at first difference under both tests, except GDP and MT. Under ADF results GDP is
stationary at first difference but in PP it is not stationary. The study preferred ADF test result
and considered GDP stationary at first difference. MT is stationary at level under ADF result but
PP result shows that MT is stationary at first difference. Study again preferred ADF and deals MT
Table 1 ADF and PP unit root tests
Notes: DC is real banking sector’s domestic credit; GDP is real gross domestic product; IT is real imports
plus export of goods and services and MT is real broad money. P* shows the maximum lag length, as
determined by using AIC. Under PP test Q* shows Newey-West Bandwith, as determined by Bartlett-
*** shows 99% significance level; ** shows 95% significance level and * represents 90% significance level.
The ARDL cointegration approach is used in order to explore the long run equilibrium
relationship among variables. ARDL approach is adopted because three variables are stationary
at first difference and one is stationary at level. Table 2 shows the results of bonds test for
cointegration. Results illustrated the long run relationship between the variables because the F-
statistics lies above upper bonds.
Table 2 Results of bonds test for cointegration
F-Statistics Variables Conclusion
F (GDP/MT, DC, IT)
F (MT/GDP, DC, IT)
F (DC/GDP, MT, IT)
F (IT/GDP, DC, MT,)
Note: AIC and SBC were used for the lag length. * Indicates that the statistic lies below the lower bound,
** it falls within the lower and upper bounds and *** it lies outside the upper bound.
Moreover, financial development and credit disbursed by commercial banks are positively
related with economic growth, which shows that financial development and disbursement of
credit by domestic banks increased economic growth. International trade is negatively related
with economic growth (Table 3).
Variables ADF PP
Table 3 Long run estimates
Estimated Long Run Coefficients using the ARDL Approach
ARDL (1,0,0,0) selected based on Schwarz Bayesian Criterion (SBC)
Note: GDP is dependent variable.
*** shows 1% significance level; ** shows 5% significance level and * represents 10% significance level.
The next step is to estimate the short run dynamics among variables. ECM model is estimated,
associated with long run estimates we obtain from SBC-ARDL (1,0,0,0). Coefficient of error
correction is significant and negative in sign, which shows speed of convergence towards
equilibrium. Large value of ECM term shows slow speed of convergence towards equilibrium
and vice versa, after once shocked. Coefficients of financial development and credit disbursed
by domestic banks are positively significantly related with economic growth. Moreover,
international trade significantly negatively affects the economic growth (Table 4).
Table 4 Results of Error Correction Model
Error Correction Representation for the Selected ARDL Model
ARDL(1,0,0,0) selected based on Schwarz Bayesian Criterion
R-Squared 0.51287 R-Bar-Squared 0.48672
S.E. of Regression 0.030033 F-stat. 3.1498[.029]
Note: R-Squared and R-Bar-Squared measures refer to the dependent variable dGDP and in cases,
where the error correction model is highly restricted, these measures could become negative.
Brown et al. (1975) proposed two tests Cumulative Sum and Cumulative Sum of Square, to
check the structural stability. CUSUM test captured the systematic changes in regression
coefficients, while CUSUMSQ detain the departure of parameters from constancy. Hence,
parameter consistency is checked by using these two tests. Following graphs shows the stability
of model for whole sample because the residuals are within 5% critical bonds (Figure1 and
Figure 1 Cumulative Sum of Recursive Residual
The straight line represent critical bonds at 5% significance level
Figure 2 Cumulative Sum of Square Recursive Residual
The straight line represent critical bonds at 5% significance level
Table 5 Results of Pair wise Granger Causality Tests
Pair wise Granger Causality Tests
GDP does not Granger Cause DC
DC does not Granger Cause GDP
IT does not Granger Cause DC
DC does not Granger Cause IT
MT does not Granger Cause DC
DC does not Granger Cause MT
IT does not Granger Cause GDP
GDP does not Granger Cause IT
MT does not Granger Cause GDP
GDP does not Granger Cause MT
MT does not Granger Cause IT
IT does not Granger Cause MT
According to the obtained results supply-leading hypothesis is accepted in case of Pakistan,
because there is unidirectional causality among financial development and economic growth.
The results are in line with Khan et al. (2005); Anwar et al. (2011). Moreover, unidirectional
causality is observed from international trade to economic growth and from financial
development to international trade (Table 5).
The aim of this study is to check the possible direction of causality and long run equilibrium
between economic growth, financial development and international trade using the annual data
for the period of 1973-2009. ADF and PP unit root test results shows that GDP, IT and DC are
I(1), while broad money is I(0). Bonds test for cointegration result shows a long run relationship
between financial development, international trade, domestic credit and economic growth.
Granger causality test results reveals unidirectional causality from financial development to
economic growth, from international trade to economic growth and from financial development
to international trade. As a final point, this study rejected the demand following hypothesis in
case of Pakistan. Findings of this study enlighten that in order to stimulate economic growth,
financial development must be enhanced, e.g development of financial institutions and stock
markets. Moreover, steps for financial sector liberalizations must be taken and attention should
be given to long run policies.
Anwar, S.; Shabir, G.; Hussain, Z., 2011. Relationship between Financial Sector Development and
Sustainable Economic Development: Time Series Analysis from Pakistan. International
Journal of Economics and Finance, Vol. 3, pp: 262-270.
Balaguer, J.; Cantavella-Jorda, M., 2002. Tourism as a long-run economic growth factor: the
Spanish Case. Applied Economics, Vol. 34, pp: 877–84.
Banerjee, V.; Newman, A.F., 1993. Occupational Choice and the Process of Development.
Journal of Political Economy, Vol. 101, pp:274-298.
Bahmani-Oskooee, M.; Nasir, A., 2004. ARDL Approach to Test the Productivity Bias Hypothesis.
Review of Development Economics J., Vol. 8, pp: 483-488.
Brown, J. C.; Dryburgh, J. R.; Ross, S. A., and Dupre, J., 1975. Identification and actions of gastric
inhibitory polypeptide. Recent Progress in Hormone Research, Vol. 31, pp:487-532.
Calderon, C.; Liu, L., 2003. The direction of causality between financial development and
economic growth. Journal of Development Economics, Vol. 72, pp: 321–34.
Chang, T., 2002. Financial development and economic growth in mainland China: a note on
testing demand following or supply-leading hypothesis. Applied Economic Letters, Vol.
Chow, P. C. Y., 1987. Causality between export growth and industrial development: empirical
evidence from the NICs. Journal of Development Economics, Vol. 26, pp:55–63.
Ghatak, S.; Siddiki, J. U., 2001. The use of the ARDL approach in estimating virtual exchange
rates in India. Journal of Applied Statistics, Vol.28, pp:573-583.
Goldsmith, R.W., 1969. Financial Structure and Development. New Haven, CT: Yale University
Gurley, J.; Shaw, E., 1955. Financial aspects of economic development. The American Economic
Review, Vol. 45, pp: 515–38.
Gurley, J.; Shaw, E., 1967. Financial structure and economic development. Economic
Development and Cultural Change, Vol. 34, pp: 333–46.
Gupta, K. L., 1984. Finance and Economic Growth in Developing Countries. London: Croom
Jenkıns, H. P.; Katırcıoglu, S. T., 2010. The bounds test approach for Cointegration and causality
between financial development, international trade and economic growth: the case of
Cyprus. Applied Economics, Vol. 42, pp: 1699–1707.
Jung, W. S., 1986. Financial development and economic growth: international evidence.
Economic Development and Cultural Change, Vol. 34, pp:336-46.
Khan, M.A., 2010. Financial Development and Economic Growth in Pakistan: Evidence Based on
Autoregressive Distributed Lag (ARDL) Approach. South Asia Economic Journal, Vol. 9,
Khatkhate, D. R., 1972. Analytic basis of the working of monetary policy in less developed
countries. IMF Staff Papers, Vol. 19, pp:533–58.
Khatkhate, D. R., 1988. Assessing the impact of interest rate in LDCs. World Development, Vol.
King, R. G.; Levine, R., 1993. Finance and growth: Schumpeter might be right. Quarterly Journal
of Economics, Vol. 108, pp: 717–38.
Kletzer, K.; Bardhan, P., 1987. Credit markets and patterns of international trade. Journal of
Development Economics, Vol. 27, pp:57–70.
Laurenceson, J., and Chai. J., 2003. Economic development and financial reform in China.
Edward Elgar, Cheltenham.
Levine, R., Loayza, N.; Beck, T., 2000. Financial intermediation and growth: causality analysis
and causes. Journal of Monetary Economics, Vol. 46, pp: 31–77.
McKinnon, R.I., 1973. Money and Capital in Economic Development. Washington D.C.: The
Mazuar, E. A.; Alexander, W. R. J., 2001. Financial sector development and economic growth in
New Zealand. Applied Economic Letters, Vol. 8, pp: 545–49.
Neusser, K.; Kugler, M., 1998. Manufacturing growth and financial development: evidence from
OECD Countries. Review of Economics and Statistics, Vol. 80, pp:638–46.
Patrick, H. T., 1966. Financial development and economic growth in underdeveloped economies.
Economic Development and Cultural Change, Vol. 14, pp:174–89.
Pesaran, M. H.; Shin, Y., 1996. Cointegration and speed of convergence to equilibrium. Journal
of Econometrics, Vol.71, pp:117-143.
Pesaran, M. H.; Smith, R. P., 1998. Structural Analysis of Cointegrating VARs. Journal of
Economic Surveys, Vol. 12, pp:471-505.
Pesaran, M.H.; Pesaran, B., 1997. Working with Microfit 4.0: Interactice Econometric Analysis,
Oxford University Press.
Pesaran, M. H., Shin, Y.; Smith, R. J., 2001. Bounds testing approaches to the analysis of level
relationships. Journal of Applied Econometrics, Vol. 16, pp:289–326.
19 Download full-text
Schumpeter, J. A., 1911. The Theory of Economic Development. Cambridge, MA: Harvard
Shaw, E.S. ,1973. Financial Deepening in Economic Development. New York: Oxford University
Wijnbergen, V., 1982. Stagflationary effects of monetary stabilization policies: a quantitative
analysis of South Korea. Journal of Development Economics, Vol. 10, pp:133–69.
Wijnbergen, V., 1985. Macroeconomic effects of changes in bank |interest rates: simulation
results for South Korea. Journal of Development Economics, Vol. 18, pp:541–54.
Xu, X., 1996. On the causality between export growth and GDP growth: an empirical
reinvestigation. Review of International Economics, Vol. 4, pp:172–84.
Waqas, M.; Awan, M. S.; Aslam, M. A., 2011. We are living on the cost of our children.
Interdisciplinary Journal of Contemporary Research in Business, Vol. 2, pp:607-623.