Impact of Financial Development on Trade Balance: An ARDL Cointegration and Causality Approach for Pakistan

Abstract

This article aims to examine the relationship among financial development, trade balance, exchange rate and inflation by using time series data from 1972 to 2014 for Pakistan. We have tested the unit root properties of variables by using augmented Dickey–Fuller (ADF), Phillips–Perron and breakpoint unit root tests. The autoregressive distributive lag (ARDL) approach is applied to examine the cointegration between variables due to mixed orders of integration between series I(0)/I(1). The ARDL findings suggested that long-run relationship exists among financial development, trade balance, exchange rate and inflation. Error correction model (ECM) is applied to analyze short-run relationship. The lagged value of the error correction term (ECM_t−1) is negative and significant at 1 per cent level of significance. The value of ECM_t−1 is −0.91 which states that digression from the short run towards long run is corrected by almost 91 per cent by every year. Financial development, exchange rate and inflation have significant impact on trade balance in the long run. But in the short run, only exchange rate and inflation have statistically significant impact on trade balance. Diagnostic statistics have confirmed the characteristics of model in the short run as well as in the long run. The causal relationship between variables are examined by vector error correction model (VECM) Granger causality and robustness of causal analysis is tested by variance decomposition approach (VDA). The results of VECM have predicted that unidirectional causality from financial development to trade balance exist in the long run. The results of VDA explained that 19 per cent of trade balance is explained by shocks stimulating financial development. Government should enhance financial development by managing lending interest rates to improve trade balance.