Export, Import Potential Of Pakistan: A Gravity Model Approach

EXPORT, IMPORT POTENTIAL OF PAKISTAN: A GRAVITY

MODEL APPROACH

Submitted by:

Abdul Qayum Khan

Roll No.

2975

Class:

BS Economics & Finance 8th Semester

Submitted to:

Amir Mustafa

Department of Economics

Faculty of Management Sciences

National University of Modern Languages, Islamabad

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Table of Contents

Abstract …………………………………………………………………………………………………………………………. 3

Chapter 01 ……………………………………………………………………………………………………………………… 4

1.0 Introduction ………………………………………………………………………………………………………….. 4

Chapter 02 ……………………………………………………………………………………………………………………… 6

2.0 Literature Review………………………………………………………………………………………………….. 6

2.1 Empirical Global Literature Review: ……………………………………………………………………. 6

2.2 Empirical Regional Literature Review:…………………………………………………………………. 9

2.3 Empirical Pakistan’s Literature Review: ……………………………………………………………… 13

Chapter 03 ……………………………………………………………………………………………………………………. 21

3.0 Methodology ……………………………………………………………………………………………………… 21

3.1 The Model ……………………………………………………………………………………………………….. 21

3.3 Econometric Model ………………………………………………………………………………………….. 22

3.4 Panel Data Framework:…………………………………………………………………………………………. 24

3.5 Data ……………………………………………………………………………………………………………….. 25

Chapter 04 ……………………………………………………………………………………………………………………. 26

4.0 Results ……………………………………………………………………………………………………………….. 26

4.1 Exports Determinants ……………………………………………………………………………………….. 26

4.2 Export Potential ……………………………………………………………………………………………….. 28

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4.3 Imports …………………………………………………………………………………………………………… 30

4.4 Import Protentional of Pakistan………………………………………………………………………….. 33

Chapter 05 ……………………………………………………………………………………………………………………. 35

5.0 Conclusion …………………………………………………………………………………………………………. 35

References ……………………………………………………………………………………………………………………. 36

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Abstract

The word is globalizing day by day and having relations with other is a good thing, as these

relations helps in increasing the imports and exports as per numbers Pakistan exports are

decreasing rapidly with its reporting countries and imports are raising which is causing the trade

deficit so to know the potential of exports and imports this study uses the Augmented Gravity

Model. The data of top 34 importing and exporting countries ranging from 1995 t0 2018 is taken

for study. The results indicate the significance impact of all the variables for imports and for

exports FDI is insignificant. The highest export potential is with India, Russian Federation and

Vietnam and imports potential with India, Oman and Kuwait

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Chapter 01

1.0 Introduction

Because of globalization there are many fundamental changes in national and international

economic activities. In economic integration trade liberalization has an important role. The main

pillars of economic integration are International Monetary Fund (IMF), World Bank and World

Trade organization (WTO). The characterization of economic development is done by the

existence of free trade agreements (FTA) and economic integration. The dominant examples are

to be found by the names of South Asian Association for Regional Cooperation (SAARC), North

American Free Trade Agreement (NAFTA), Economic Cooperation Organization (ECO) and

Association of Southeast Asian Nations (ASEAN). The adaptation of regional integration is the

main concern of many countries to promote their economic growth. Sultan & Munir (2015)

Pakistan is a developing semi industrialized country which faces a various level of growth

in last 72 years and it passes through prosperity, decline and recovery many times. In the era of

1960, the manufacturing exports of Pakistan were higher than the total combined manufacturing

exports of Malaysia, Indonesia and Thailand. Pakistan’s economy showed resilience in different

international catastrophes events like economic sanctions, global recession of 2001–02 and Asian

financial crisis and many more. Pakistan also suffered different conflicts with neighboring

countries like India and Afghanistan and war on terror and massive influx of immigrants from

Afghanistan. Mohmand, Salman, Mughal, Imran, & Makarevic (2015)

The exports of Pakistan are usually unprocessed or semi processed goods like agricultural

products the bilateral trade seen increase of more than 19 and 70 billion USD in 1995 and 2011

respectively. In 2011 due to huge gape between imports and exports the trade deficit become 18

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billion USD. As per the data of United Nations Comtrade database Pakistan is facing trade deficit

since 1973. Pakistan is not diversifying in exports and the major exports of Pakistan are Food and

live animals, manufactured goods classified chiefly by material and miscellaneous manufactured

articles. The destinations of Pakistan’s export have not changed since last three decades and more

than 80% of exports are going only towards 28 countries and this number is decreasing as Pakistan

is losing markets rapidly. Ati, Haiyun, & Mahmood, (2016)

The main objective of study is quantifying the trade potential of Pakistan with its trading

partners all over the world. Following are the specific objectives of study:

• Analyzing the determinants of total trade, exports and imports of Pakistan

• To find the geographical friction role in trade of Pakistan

• To find the potential of total trade, imports and exports of Pakistan with geographically

bordered and other trading partners.

The study will provide a through insight into direction of trade with bordered and other

trading partners of Pakistan. To find the trade potential of Pakistan with its 50 of border sharing

and other trading countries for the period ranging from 1995 to 2018 at annual frequency,

augmented gravity model is used. A lot of different policy implications will be given for exploiting

the trade potential of Pakistan. It will help find out the determinants that are affecting more or has

no impact on imports, exports and total trade of Pakistan. Through this the future can be predicted

for the future protentional possibilities of Pakistan’s trade with its border sharing and other

countries.

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Chapter 02

2.0 Literature Review

A lot of literature can be found on the importance of trade and development. Trade has

many dimensions but most attractive of it is to find the determinants of trade and expansion

possibilities of a country for the future. And for this purpose, augmented gravity model has been

widely used for the measurements of trade flows.

2.1 Empirical Global Literature Review:

Tinbergen (1962) the concept of Newton gravitational law was firstly used as a model by

Tinbergen to find the trade flows among countries. In his work “Shaping the World Economy” he

said that countries bilateral trade flows are directly related with size of economy and indirectly

related with distance between them. But initially model doesn’t have strong theoretical

background. For the justification of theoretical foundations its equation was derived from different

trade models. Linneman (1966) derived from partial equilibrium model of export supply and

import demand by incorporating three kind of transport cost like physical cost, time related cost

and cost incurred due to cultural differences. From constant elasticity of substitution (CES)

between traded and nontraded goods the gravity model was derived by Anderson (1979).

Bergstrand (1985) and Bergstrand (1989) find out that the model is reduced form of demand and

supply’s general equilibrium. Deardorff (1995) derives this model from H-O model of complete

specialization.

Romer & Frankel (1999) analyzed the impact of trade on people standard of living. A cross-

country analysis was conducted by them on 63 countries. They use the geographical factors to find

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out the causation between income and trade. This study indicated that there is a positive relation

between income and trade and physical and human capital formation and geographical factors are

helpful in the increase of trade.

Anderson & Wincoop (2003) justified the gravity model theoretical foundation. They took

the pool data from 30 states of Canada and USA for finding the relation between trade cost and

benefits using McCallum’s gravity equation. The finding of the study shows that the national

borders reduce the trade between these two countries at greater magnitude as compared to with

other states.

Carpenter, Watkinson & Rowcliffe (2004) aimed to get better specification with gravity

model by indulging the time-invariant country specific static as well as dynamic effects in terms

of potential trade. The study includes 32 importer and 11 exporter countries and data raging from

1991 to 2000 and estimated the export of goods and services. The study results incorporate that

the dynamic specification is providing more accurate results of actual as well as potential trade

than static formulation of gravity model.

Rahman (2010) estimated the trade potential of Australia by utilizing the cross-sectional

data of 50 countries for the years ranging 2001 to 2005. They used the Ordinary Least Square

method to estimate the gravity model equation. They took openness, distance, GDP, per capita

GDP, and common language as bilateral trade determinants of Australia. The study results show

that Australia has higher trade potential with Singapore, Argentina, Russian Federation, Portugal,

Greece, Chile, Philippine, Norway, Brazil and Bangladesh.

Simwaka (2011) attempts to estimate the expected trade potential of Southern Africa

Development Community’s Free Trade Agreement and to determine the difference between actual

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and potential trade between member countries. He used Maximum Likelihood Method with the

annual data from 1991 to 2001 to estimate gravity model. The study finds out that the observed

intra-regional trade is less than the trade potential and there is a lot of trade potential in sub-regions.

This is also found by the study that Free Trade Agreement in Southern Africa Development

Community leads to trade creation in the region.

Salim & Al-Mawali (2011) tested the hypothesis for Gulf Cooperation Council (GCC) that

is there trade enhancement for GCC member countries. The annual data from 1980 to 2008 is taken

for the estimation. Standard augmented gravity model and stochastic frontier gravity model is used

for estimation. The study finds significant effects for trade enhancement for member countries.

Elshehawy, Shen & Ahmed (2014) investigates affecting factors of Egypt’s bilateral export flows.

Egypt’s bilateral export flows has been estimated through gravity model of trade. The paper uses

the panel data of 42 main trading partners dated from 2000 to 2013. The outcome of gravity model

in its fixed effect data shows 84% of fluctuations in exports. The main affecting factors according

to results were both countries GDP, importer’s GDP, importer’s population, regional trade

agreements (RTA) and the geographical border between Egypt and its trading partner. Only

distance is found to be negative and insignificant.

Agyekum (2015) examined the potential effect of the Trans-Pacific Partnership (TPP)

agreement on U.S agricultural trade. The model uses the panel vector autoregressive model (VAR)

and impulse response function (IRF) for the estimation. The model uses three independent

variables like agricultural trade, real exchange rate, and price ratio of imports to exports and a

system of three VAR equations was developed for these variables. She took 11 countries data from

Asia-Pacific region for the period of 1980 to 2012. The results of estimation show that US is net

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exporter to all member countries, but Japan, Mexico and Canada are main agricultural trading

partners of US.

Abbas & Waheed (2015) investigates the trade potential of Bahrain’s bilateral trade with

its trading partners. The augmented gravity model is used for the purpose of estimation. The panel

data of 31 countries have been taken for the period ranging from 1994 to 2013. For explanation of

export flows generalized least square estimation technique is used. The study took real exchange

rate depreciation and foreign currency reserves of partner countries, FTA and GCC as dummy

variables. The result show that all the augmented variables are significant. According to result

Bahrain has a higher potential of exports with European states.

Fontoura, Martínez-Galán & Proença (2016) analyze the 25 European Union member

countries trade potential in the era of its eastern enlargement of its manufacturing products. They

use Poisson Pseudo-Maximum Likelihood Method instead of Ordinary Least Square Method to

estimate gravity model as it was better than Ordinary Least Square Method. This study also

incorporates the Commodity Composition of Trade. According to the results during the

enlargement the Central and Eastern European Community (CEEC) has exhausted their export

potential but if we talk about imports from European Union countries then the same case doesn’t

exist.

2.2 Empirical Regional Literature Review:

Karemera, Smith, Cole & A. (1999) used gravity model for checking the benefits and

determinants of trade in Pacific Rim by using the pool data from 1984 to 1993 with the

incorporation of GDP, exchange rate domestic whole sale price index, population, volume of trade

flows, imports and exports values, distance, geographical factors, spot rate and inflation and

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dummy variables. Results incorporates that all the variables are significant and are determinants

of trade in Pacific Rim.

Hirantha (2004) used gravity model to examine the prospects of SAFTA and progress of

SAPTA. He conducted the separate analysis for panel data from 1996 to 2002 and cross-section

data of 1996, 1999 and 2002 to estimate the gravity model by applying generalized least square

method. The study’s results supported trade creation argument of SAPTA, and no evidence was

found for trade diversion with rest of the world. The results showed encouragement for further

regional integration because it may help to bring about more trade prospective to SAARC region.

Furthermore, with the reduction of tariff along with other more non-tariff barriers among the

member states can help to increase the intra-regional trade.

Lai & Zhu (2004) found the determinants of bilateral trade of 34 countries by using cross-

section and panel data with incorporating following variables: distance, average tariffs, time-

varying tariff, and productivity of labor and factors adjusted wages. The findings were that tariff

liberalization is more beneficial for less developed or poor countries as compared to rich or

developed countries.

Rehman (2005) analyzed the performance of Bangladesh with its major trading partners

for the theoretical justification of augmented gravity model. He took panel data of 23 countries

from Middle East, SAARC, ASEN, NAFTA, and EEC ranging the period of 1972-99. The study

gives the consistent results with the theoretical foundation of augmented gravity model. The study

results show that the major determinants of Bangladesh’s trade are economic size, distance, trade

openness and demand for imports.

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Rehman, Shadat, & Das (2006) examined the effects of trade creation and trade diversion

particularly on SAFTA and RTAs. The study utilizes the panel data 61 of countries from 1991–

2003. Traditional gravity model is utilized by some important variables like bilateral FTAs and

bilateral exchange rate. They use the country specific pair with gravity model and year specific

fixed effects with gravity model is used. They use the Tobit Model and Ordinary Least Square to

estimate the gravity model. The conclusion of study shows that SAFTA caused export creation

and export diversion effects within the block.

Ruiz & Vilarrubia (2007) tries to find out the trade potential in Eastern and Southern

Mediterranean countries. To remove the biasness, they included importer and exporter countries

important variables. They used the 102 countries panel data from the period of 1976 to 2005.

Gravity model is used with country and yearly dummies for importer and exporter countries. The

study results incorporated that the estimation of export potentials and estimation regarding free

trade agreements were strongly affected by omission of multilateral trade resistance variable. The

study also incorporates that with USA there are a lot of trade expansion opportunities are present.

Wang, Wei & Liu (2010) modified the gravity model equation to check the trade flows in

19 OECD countries. The study incorporated foreign direct investment (FDI) stocks and domestic

research and development in the traditional gravity model for the period of 18 years from 1980 to

1998 to check the long run relationship. They found out that although the distance is most

important determinant of trade flows, but foreign direct investment (FDI) stock and total domestic

research and development also has importance in determining the trade flows in OECD countries.

Kaur & Nanda (2010) quantified the India’s export potential with SAARC member

countries by using panel data of 7 countries from 1981 to 2005. They use fixed effect, pool effect

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and random effect for the estimation of gravity model. According to study results export potential

of India is higher for Nepal, Maldives, Bhutan and Pakistan. The India’s exports can be expanded

with SAARC member countries if India removes its trade barriers as its common border with four

countries in SAARC region gave India geographical advantage for its export’s expansion.

Akhter & Ghani (2010) attempted to analyze regional-integration’s benefits and potential

of trade through SAFTA for members and non-member countries. The study uses the gravity

model on the pool and cross-sectional data for the period of 2003 to 2008 to measure the bilateral

trade benefits and flows of SAARC countries. The results of study indicated that the regional trade

agreement for SAARC countries specially between Pakistan, India and Sri Lanka can increase the

potential and benefits of trade both members as well as non-members countries.

Raimondi & Olper (2011) examined the trade tariff elimination impact on food industry by

using cross-sectional data for 99 importing and 193 exporting countries of different type of 18

food industries. With the implication of CES and gravity model equation they proved that due to

trade liberalization the export of food towards developed countries greatly increased but in

countries who are suffering the loss are underdeveloped. The study gave consistence results with

current evidence obtained from general equilibrium model analysis.

Roy & Rayhan (2012) examined the Bangladesh’s import structure and find the factors that

are affecting it. They took 14 countries data in time series, pool data and cross-sectional data

ranging from 1991 to 2007 in order to present the overview different methodologies that are related

to augmented gravity model. The study finds out that Bangladesh’s imports main determinants are

GDP of home and partner countries, exchange rate and distance and they are affecting the most.

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From cross sectional data the gravity model demonstrates that the potential of imports of

Bangladesh is with India in SAARC region.

Koh (2013) investigates the Brunei Darussalam’s determinants of trade. Stochastic frontier

method is used for estimation of augmented gravity model of trade. For the estimation of trade

potential panel data for the period of 2001 to 2011 is used. GDP, population, colonial relationship,

distance and trade agreements are used as variables. The study found out that all the variables have

positive relationship except distance as it has negative relation. It is found that there is low trade

potential of Brunei.

Irshad, Xin, Shahriar, & Arshad (2018) explains trade pattern of China with OPEC

countries. The study employed the gravity model for the period of 1990 to 2016. The results of

study show that that the gravity model’s equation fits the data pragmatically. The result show that

the energy is considered as most traded commodity between China and OPEC countries. The

outcome implies that income, GDP and trade openness has positive impact and negatively

impacted by distance.

2.3 Empirical Pakistan’s Literature Review:

Achakzai (2006) estimated the true intra-ECO trade potential of Pakistan. The main

purpose of study is to explore that Pakistan and ECO has great trade potential, but Pakistan got a

little share than its true potential. The study uses the OLS method on pool data of 137 countries

for the year 2005 to estimate the standard gravity model. The results indicate that intra-regional

trade is significantly impacted by ECO. It means that trade flow predicted by gravity model is

much higher than the actual trade flow between Pakistan and ECO member countries. The

suggestions of analysis were that regional integration between ECO member countries has a

greater scope especially for the countries who share geographical border.

Butt & Riazuddin (2008) examined the Pakistan’s export potential with global as well as

bilateral trading partner countries for nineteen sectors of the economy. They use the Pseudo

Maximum Likelihood method to estimate the gravity model. In gravity model this study

incorporated geographical, historical and cultural factors. The estimation results show consistency

with theoretical background of these variables. They concluded that the Pakistan’s trade potential