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Does HarbergerLaursenMetzler
(HLM) Exist in Pakistan? Cointegration,
Causality and Forecast Error Variance
Decomposition Tests Talat Afza1 Khalid
Ahmed2 Muhammad Shahbaz3
Article in Global Business Review June 2016
DOI: 10.1177/0972150916645674

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Article

Does HarbergerLaursenMetzler
(HLM) Exist in Pakistan?
Cointegration, Causality
and Forecast Error Variance
Decomposition Tests

Global Business Review

17(4) 120
2016 IMI
SAGE Publications
sagepub.in/home.nav
DOI: 10.1177/0972150916645674
http://gbr.sagepub.com

Talat Afza1
Khalid Ahmed2
Muhammad Shahbaz3
Abstract
This article investigates the validation of HarbergerLaursenMetzler hypothesis using Pakistani data
over the period of 1978Q12012Q4. We have used GregoryHansen cointegration approach accommodating structural break in the series. The results confirm the presence of cointegration between
the variables. The impact of terms of trade is positive on Pakistans trade balance. Domestic income
improves local trade balance. Foreign income has a positive impact on Pakistans trade balance.
The causality analysis indicates the presence of feedback effect between terms of trade and trade
balance. Domestic income Granger causes trade balance. The unidirectional causality is running from
foreign income to Pakistans trade balance. This study opens up new directions for policymakers for
improvements in terms of trade to sustain trade balance in Pakistan.
Keywords
Terms of trade, trade balance, Pakistan

Introduction
Since the advent of industrialization, the economies have opened themselves to rest of the world, global
trade emerged and led the small and developing economies to grow faster and developed enormously.
The trade liberalization enabled global economies to gain prosperity through trade effect but simultaneously they are facing the major macroeconomic issues of exchange rate and external trade imbalances.

Vice Chancellor, Government Sadiq College Women University, Bahawalpur, Pakistan.

Assistant Professor, Institute of Business Administration (IBA), Sukkur, Pakistan.
3
Department of Management Sciences, COMSATS Institute of Information Technology, Lahore, Pakistan.
1
2

Corresponding author:
Khalid Ahmed, Assistant Professor, Institute of Business Administration (IBA), Sukkur 65200, Pakistan.
E-mail: khalid.ahmed@iba-suk.edu.pk

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Global Business Review 17(4)

In a small open economy, the common policy tool used in response of external trade deficit is to devalue
the currency but it causes inflation and high depreciation cost. The changes in terms of trade have a direct
effect on trade balance and an indirect effect on savings, income and inflation but unfortunately, this
effect varies from country to country. Therefore, researchers have tried to find out the exact relationship between terms of trade and its impact on balance of trade from different economies. The study of
Harberger (1950) and Laursen and Metzler (1950) described this phenomenon as terms of trade deterioration will result in a decline in savings due to decrease in real income, and therefore real depreciation
will increase real expenditures. This effect is known as the HarbergerLaursenMetzler (HLM) effect.
Recently, the relationship between terms of trade and exchange rate has been the recurrent research topic
in the macroeconomic literature. Further, HLM states that the temporary increase in terms of trade may
have a positive impact but if shock persists over long run, it would deteriorate the current account
and savings. Regrettably, most of the literature on this topic has focused on the short-run analysis and
implicitly ignored the long-run effect.
A number of studies on developing countries have examined the relationship between terms of trade
and trade balance using different methods, that is, Bahmani-Oskooee (1985) investigated the four developing countries for short-run impact and results support the pattern of movement and satisfied the
MarshallLerner1 (ML) condition. Fry (1986) studied the 14 Asian countries to test the HLM effect using
three equation model for savings, investment, economic growth and analyzed the terms of trade effect on
current account. Grilli and Yang (1988) tested the terms of trade impact over commodity prices rather than
on income and concluded that commodity prices effect is different in oil-exporting and non-oil-exporting
developing economies. Correia, Neves and Rebelo (1995) checked the same effect on small open economy
for terms of trade and real exchange rate. The later studies included Otto (2003), study of Broda (2004) on
Malaysian data confirming the long-run relationship, studies by Kaplinsky (2006), Hung-Ju and Hsu
(2009), Santos-Paulino (2010), Jawaid and Waheed (2011), Hirose and Ikeda (2012), Idrees and Tufail
(2012) and Jskel and Smith (2013) and the most recent studies of Bahmani-Oskooee and Xu (2013)
and Islam, Shahbaz and Tahir (2013) on the HLM effect on KoreaUS and Bangladesh, respectively.
During the last three decades, Pakistans economy has also been struggling with the consistent external imbalance shocks and currency devaluation is the sole policy measures taken by the government to
offset such shocks. Resultantly, country has been facing double digit inflation and current account has
been largely fragile to changes in global and national economic policies. As terms of trade is considered
as one of the key operators of change in real income, therefore, it directly impacts national savings and
increases dependency on foreign debts. Countrys current account balance has been under stress since
decades and expanding on a year-to-year basis. During the last two fiscal years (FY), deficit has increased
from US$2.072 billion (FY2012 est.) to US$2.36 billion (FY2013 est.). Again, $1.37 billion is recorded
for the first two months of FY2014. Therefore, it is imperative to investigate the effect of increased terms
of trade on Pakistans trade balance. Following Harberger (1950) and Laursen and Metzler (1950), HLM
effect suggests that an exogenous increase in terms of trade in a small but open economy results in an
improvement in that countrys trade balance which is appropriate for a developing economy (Berument
& Dincer, 2005; Bouakez & Kano, 2008; Chen & Hsu, 2006; Huang & Meng, 2007; Jawaid & Raza,
2013; Sobrino, 2011; Tsen, 2006). Similarly, Pakistan is also one of the developing countries that largely
depends on foreign debt liabilities and consecutively facing current account deficit problem. This notion
proposes to conduct this study in order to find out the exact relationship between terms of trade and trade
balance in Pakistan.
This study tests the HLM effect for Pakistan using autoregressive distributed lag (ARDL) bound
testing approach of cointegration and checks both long-run and short-run behaviours of variables in
vector error correction model (VECM). However, Granger causality test is also applied in order to

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Afza et al.

explore the exact direction of causality. The results of this study would potentially provide policy guidelines which would lead in achieving steady growth and immutable balance of trade. Subsequently, it may
contribute to resist the shocks and stabilize saving and inflation rates in our economy. The remaining
article is divided into following sections: the second section presents a brief literature review, model
construction and data is given in the third section, the fourth section presents the methodological framework, results and discussion are given in the fifth section and the sixth section presents the conclusion
and policy recommendations.

Literature Review
Significant amount of literature is produced which examined the relationship between terms of trade
and trade balance but the evidence so far remains inconclusive. However, the scholars generally agree
that the impact of change in terms of trade on trade balance may not be similar in every economy. In the
theoretical perspective, this notion is known as the HLM effect, based on the seminal works of Harberger
(1950) and Laursen and Metzler (1950). The HLM effect predicts that an increase in terms of trade originating from an exogenous shock to a small open economy leads to an improvement in that countrys
trade balance. Otto (2003) examined the HLM effect for a number of developing and small Organisation
for Economic Co-operation and Development (OECD) economies.2 The study found that a positive
shock to terms of trade improves trade balance but deteriorates later as the shocks become persistent.
Dibooglu (2000) pointed out that positive shock to terms of trade is important in the short run but
may not sustain in the long run once other factors tend to offset the initial effect. Hoque (1995) found
the long-run relationship among current account deficit, terms of trade, domestic income and foreign
income using fixed exchange rate regime in the case of Australia. Kouassi, Decaluwe and Colyer (1998)
investigated the relationship between terms of trade and current account deficits using the VECM. For
Cote dIvoire, they find a long-run relationship but point out that current account deficit in Cote dIvoire
cannot be explained by terms of trade. A strong unidirectional causality runs from current account deficit
to terms of trade. The dynamic simulations indicate that a significant portion of fluctuations in terms
of trade is explained by current account deficit. The study of Santos-Paulino (2010) provides a similar
evidence from small island developing states. Tsen (2009) investigates the impact of terms of trade and
oil process on trade balance of Asian economies. The empirical results found that the impact of income
terms of trade is different across economies.
A large proportion of available literature exploring the direct relationship between trade balance and
terms of trade focus on the correlation between two variables. Only a few have examined the longrun relationship between two series. Haynes and Stone (1982) found a positive relationship between US
terms of trade and trade balance. Warner and Kreinin (1983), Gylfason and Risager (1984), BahmaniOskooee (1986) and Marquez (1990) found that a deteriorating terms of trade improves trade balance.
Bahmani-Oskooee and Jonardhanan (1995) in a 24-country study reported no long-run relationships
between two series. Wong (2006) shows that there is a long-run relationship between trade balance and
commodity terms of trade but none between income terms of trade and trade balance for Malaysia. Later,
these results were validated by Tsen (2006) for Malaysia. Nwachukwu and Egwaikhide (2007) examined
the determinant of private saving in Nigeria using HLM hypothesis and found that external terms
of trade have a positive impact on private savings. Berument and Dincer (2005) and Zortuk (2008)
studied the Turkish economy to examine the long-run impact between terms of trade (income terms of
trade and commodity terms of trade) and trade balance. Their study utilized Johansens cointegration
method, the VECM and Granger causality approaches to test the relationship between income terms of

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Global Business Review 17(4)

trade and trade balance which showed that there is no causality between the series. Bahmani-Oskooee
and Tankui (2008) summarized the relationship between terms of trade and trade balance for 20 African
countries. They adopted Pedronis (2004) approach using cointegration and confirmed the long-run relationship between both the variables. The results validated the ML requirements where income terms of
trade showed a positive impact on trade balance. Another study of Wong (2009) examined the HLM
effect for Korea, Hong Kong and Singapore. The empirical results for the long-run relationship between
variables indicate that an increase in the terms of trade causes a decline in trade balance. The feedback
hypothesis is found between income terms of trade and trade in Hong Kong and Singapore while trade
balance Granger causes income terms of trade in Korea. For other Asian countries, Wong (2009) tested
the same relationship and found a long-run relationship between the variables but affect of terms of trade
on trade balance varies across countries. The empirical evidence showed that domestic demand, foreign
income, terms of trade and oil prices are major determinants of trade balance in short run as well as in
long run. Besides the work of Wong (2006), very few studies from the above-mentioned literature examined the long-run relationship and most of them used commodity terms of trade3 which is a form of barter
terms of trade. Appleyard and Field (2001) approximate income terms of trade4 by ratio of exports value
to import price. Commodity terms of trade focuses on the relationship between export price and import
price, while income terms of trade quantifies the trend of export-based capacity of a country to imports
of goods. The high value of commodity terms of trade implies that price of exports is high relative to
import prices. However, the direction between commodity terms of trade and income terms of trade may
not imply the same thing. An increase in price of exports relative to import could lead to higher commodity terms of trade but income terms of trade could worsen if offset by a decline in quantity of exports.
The income terms of trade is a better measure of terms of trade compared to commodity terms of trade
because the former can rise faster relative to the latter (see Appleyard & Field, 2001).
Therefore, the present study aims to focus on the income terms of trade for validating that hypothesis
in order to draw meaningful insights for Pakistan and provide a certain policy guidelines. Moreover, the
methodology and empirical techniques utilized to investigate the relationship between terms of trade and
trade balance also play a crucial role in deriving inconclusive and challenging results, hence misleading
the policymakers. Therefore, it is imperative to adopt relevant and current techniques which could ensure
maximum accuracy in order to derive conclusive evidence which could provide guidelines to policymakers. For example, Idrees and Tufain (2012) test HLM effect using VAR test in a recursive form, and
this type of technique only captures the linear interdependence of multiple time series; however, the
study of Islam et al. (2013) and Jawaid and Raza (2013) employed ARDL, the VECM Granger test to
check HLM effect for Bangladesh and India, respectively. The later study uses the latest technique of
estimation and also finds the long-run relationship among the series and hence gives more reliable
results for policy design. Therefore, this study uses ARDL model approach of cointegration to empirically examine the small open developing economy of Pakistan. Being a part of a globalized village and
to ensure sustainable development goals, it is now imperative to know the relation between terms of
trade and balance of trade for Pakistan. The contribution of this article seems significant and the policy
implications of this study are highly valuable for both government and international institutions.

The Model Construction and the Data

The aim of the present study is to examine the relationship between income terms of trade and trade
balance in Pakistan. The equation of trade balance can be derived by the exports and imports equations,
respectively, indicated as follows:

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Afza et al.

X t = f (Px t)(1)

M t = f (Pm t)(2)

TB t = X t - M t(3)

TB t = f (Px t /Pm t)(4)

ln TB t = a 11 + a 22 ln TT + n t(5)

ln TB t = b 11 + b 22 lnTT + b 33 ln Yt + b 44 ln YFt + n t(6)

where Xt (Pxt) is real exports (unit price of exports) per capita, Mt (Pmt) is real imports (unit price
of imports) per capita, TBt is trade balance which is the difference between exports and imports. The
ratio (Pxt/Pmt) between unit value of exports to unit value of imports is termed as terms of trade. Real
domestic income per capita is indicated by Yt proxies real gross domestic product (GDP) per capita.
Real foreign income (YFt) per capita is proxied by real GDP of trading partners of Pakistan. If terms of
trade is positively linked with trade balance, then we expect ^TTt/^TBt > 0 otherwise ^TTt/^TBt < 0. The
rise in domestic income has a burden on import bill due to hike in imports demand and we expect
^Yt /^TBt < 0, otherwise ^Yt /^TBt < 0. If an increase in foreign income will increase the demand
for Pakistans exports, then foreign income has a positive impact on trade balance and we expect
^YFt /^TBt > 0, otherwise ^YFt /^TBt < 0. We have converted all the series into logarithm for results
reliability and efficiency. The study covers the period of 1978Q12012Q4. We have collected data for
real effective exchange rate, unit value of export and unit value of imports from International Financial
Statistics (CD-ROM, 2013). The real GDP per capita of Pakistan and her trading partners is collected
World Development Indicators (CD-ROM, 2013).5

Methodological Framework
This study employs ARDL bounds testing approach to cointegration proposed by Pesaran, Shin
and Smith (2001) to check the long-run relationship among terms of trade, domestic income, foreign
income and trade balance in the case of Pakistan over the period of 1978Q12012Q4. The ARDL
cointegration framework using bound testing approach is a more suitable approach because it analyzes
the relationship between dependent variable and regressors even when it is uncertain whether the
regressors under observation are trend or stationary. In this process, two separate critical values are associated with all regressors that generate critical value bounds and classified as purely I(1) or purely I(0)
or mutually I(1)/I(0) cointegrated. Following this process, a conclusion can be drawn on the basis of
F-statistics6 without knowing the order of integration of variables and this method is also suitable for
small sample analysis, that is, Pakistan. Assuming the possibility of structural break in the underlying
series, in addition to the ARDL approach to cointegration, we also utilized GregoryHansen structural
break cointegration test developed by Gregory and Hansen (1996). This test has a uniqueness to point
out the structural break in the series and these dates are endogenously determined without affecting the
rest of the series. Moreover, a dynamic unrestricted error correction model (UECM) is also generated
from the ARDL bounds testing through a simple linear transformation. The UECM combines the

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Global Business Review 17(4)

short-run dynamics with the long-run equilibrium without losing any long-run information. The UECM
is expressed as follows:
DlnTB t = j 1 + j T T + j TB lnTB t - 1 + j TT lnTTt - 1 + j Y lnYt - 1 + j YF lnYFt - 1

i=1

j=0

k=0

l=0

+ | j i DlnTB t - i + | j j DlnTTt - j + | j k DlnYt - k + | j l DlnYFt - l + n t

(7)

DlnTTt = a 1 + a T T + a TB lnTB t - 1 + a TT lnTTt - 1 + a Y lnYt - 1 + a YF lnYFt - 1

i=1

j=0

k=0

l=0

+ | a i DlnTTt - i + | a j DlnTB t - j + | a k DlnYt - k + | a l DlnYFt - l + n t

(8)

DlnYt = b 1 + b T T + b TB lnTB t - 1 + b TT lnTTt - 1 + b Y lnYt - 1 + b YF lnYFt - 1 + | b i DlnYt - i

q

j=0

k=0

l=0

+ | b j DlnTB t - j + | b k DlnTTt - k + | b l DlnYFt - l + n t

i=1

(9)

DlnYFt = t 1 + t T T + t TB lnTB t - 1 + t TT lnTTt - 1 + t Y lnYt - 1 + t YF lnYFt - 1 + | t i DlnYFt - i

i=1
q


s
r
+ | t j DlnTB t - j + | t k DlnTTt - k + | t l DlnYt - l + n t
j=0

k=0

(10)

l=0

In the above equations, the firstt-difference operators are denoted by and t represents residual terms.
Keeping in view of the sensitivity of F-statistic with lag order selection, the suitable lag length of the
first-differenced regression is selected on the basis of the minimum value of akaike information criterion
(AIC) since the inappropriate lag length selection may lead to misleading results. Pesaran et al. (2001)
suggested an F-test to evaluate the joint significance of the coefficients of lagged level variables. For
example, the null hypothesis for cointegration between the variables is H0: aTT = aTB = aY = aYF = 0,
while the rejection of null hypothesis for cointegration is Ha: aTT aTB aY aYF 0. Pesaran et al.
(2001) generated two asymptotic critical values, that is, upper critical bound (UCB) and lower critical
bound (LCB), that are used to determine the existence of cointegration between the series without
knowing the order of integration. The LCB is used to test cointegration if all the series are integrated at
I(0); otherwise, we use UCB. Our computed F-statistics are FTB(TB/TT, Y, YF), FTT(TT/TB, Y, YF),
FY(Y/TB, TT, YF) and FYF(YF/Y, TB, TT) for equations (7)(10), respectively. In the ARDL bound
testing approach, the existence of a long-run relationship between the variables is calculated in the basis
of F-statistic. If the F-statistic falls outside the UCB, then there is cointegration between the series or if
our calculated F-statistic falls within LCB, then there is no cointegration. Similarly, the decision
regarding cointegration is inconclusive if calculated F-statistic falls between LCB and UCB. In such
scenario, an error correction method is adopted which is an easy and suitable way to examine cointegration
between the variables. Here, we have used critical bounds generated by Narayan (2005) to test
cointegration rather than those generated by Pesaran et al. (2001) and Turner (2006).

The VECM Granger Causality

After determining the long-run relationship among the variables, we use the Granger causality test to
assess the causality between the variables. In case the cointegration exists between the series, the VECM
can be developed as follows:

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Afza et al.

RS
V R V R
V R
V
RS
V
SSB 11, m B 12, m B 13, m B 14, m WWW
SSD ln TTtWWW SSSb 1WWW SSSB 11, 1 B 12, 1 B 13, 1 B 14, 1 WWW SSSD ln TTt - 1 WWW
SSB B B B WW
SSD ln TB WW SSb WW SSB B B B WW SSD ln TB WW
tW
t - 1W
SS 2WW + SS 21, 1 22, 1 23, 1 24, 1 WW # SS
SS 21, m 22, m 23, m 24, m WW
SS
W
W
=
+
...
+
SSB 31, m B 32, m B 33, m B 34, m WW
SSD ln Yt WW SSb 3WW SSB 31, 1 B 32, 1 B 33, 1 B 34, 1 WW SSD ln Yt - 1 WW
WW SS WW SS
WW SS
WW
SS
SS
W
SB 41, m B 42, m B 43, m B 44, m WW
SD ln YFtW Sb 4W SB 41, 1 B 42, 1 B 43, 1 B 44, 1 W SD ln YFt - 1W
X T X T
X T
X
T
T
X

(11)
VW RS VW
RS
R
V
S
W
ln
TT
D
g
n
t - 1W
SS
S 1W
SS 1tWW
SSD ln TB WWW SSSg WWW
S W
1
2
t
WW + SS WW # (ECM ) + SSn 2tWW
# SSS
SS WW
t-1
SSD ln Yt - 1 WWW SSSg 3WWW
SSn 3tWW
SS
W S W
SSn WW
D ln YFt W Sg 4W
4t
T X
T
X T X
It is mentioned in the VECM model that the difference operator is represented by (1 L) and ECMt1
denotes the lagged error correction term, generated from the long-run association. The statistical
significance of estimate of the lagged error term, that is, the negative sign of ECTt1 confirms the existence
of the long-run causal relation using the t-statistic. However, the short-run causality is identified by the
joint |2 statistical significance of the estimates of first-difference lagged independent variables. For
example, the significance of a22,i 06i suggests that the terms of trade Granger causes trade balance and
causality runs from trade balance to terms of trade can be indicated by the significance of b22,i 06i. The
same inference can be drawn for rest of causality hypotheses. Finally, we use Wald or F-test to test
the joint significance of estimates of lagged terms of independent variables and error correction term.

Results and Discussions

The descriptive statistics and correlation matrix are reported in Table 1. The results showed that all the
series are normally distributed which is indicated by the statistics of JarqueBera normality test. This
implies that series have zero mean with constant variance. The correlation analysis reported indicates
that terms of trade and domestic income are positively correlated with trade balance. A negative correlation is also found between foreign income and trade balance. There exists a positive correlation from
Table 1. Descriptive Statistics and Correlation Matrix
Variables
Mean
Median
Maximum
Minimum
Std. Dev.
Skewness
Kurtosis
JarqueBera
Probability
ln TBt
ln TTt
ln Yt
ln YFt

ln TBt
0.3762
0.2854
0.2875
1.2147
0.4259
0.4366
1.9444
3.2061
0.2012
1.0000
0.5468
0.1905
0.0924

ln Yt

ln YFt

9.2811
9.5861
11.1736
7.3246
0.8507
0.3713
2.9323
0.9502
0.6218

ln TTt

10.0588
10.1545
10.4692
9.5491
0.2881
0.3562
1.9040
2.9191
0.2323

6.1125
6.2083
6.5212
5.6029
0.2880
0.3572
1.9035
2.9260
0.2315

1.0000
0.2799
0.1869

1.0000
0.1630

1.0000

Source: Authors own.

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Global Business Review 17(4)

domestic and foreign incomes to terms of trade. Finally, foreign income is positively correlated with
domestic income.
The long-run relationship among the variables has been examined using the ARDL cointegration framework with bound testing approach. However, the condition for utilizing this approach is that if the variables
are integrated either at I(0) or I(1) or I(0)/I(1). Therefore, to ensure this condition that none of the variables
is stationary at I(2) or beyond this level, we have applied augmented DickeyFuller (ADF) unit root test by
Dickey and Fuller (1979), Dickey and Fuller generalized least-squares (DF-GLS) unit root test by Elliot,
Rothenberg and Stock (1996) and NgPerron unit root test by Ng and Perron (2001). These unit root tests
determine that all the variables have unit root problem at their level form but were found to be integrated at
I(1).7 However, Baum (2004) pointed out that unit root analysis by ADF, DF-GLS and PhillipsPerron
(PP) unit root tests may provide biased results due to structural break that might occur in the series.
In order to resolve this issue, we have also obtained two structural break unit root tests such as Zivot
and Andrews (1992) unit root test which provides information about one structural break and Clemente
MontanesReyes (1998) de-trended structural break unit root test that contains information about two
structural breakpoints in the series. Moreover, ClementeMontanesReyes unit root test administers
information about two possible structural breakpoints in the series through (i) an additive outliers (AO)
model that seeks out an abrupt change in the mean of the series and (ii) an innovational outliers (IO)
model that directs gradual shifts in the mean of the series. As a result, the AO model is more consistent
for series having sudden structural changes when compared with gradual shifts.
The results reported in Table 2 show that trade balance, terms of trade, domestic income and foreign
income are found to be non-stationary at their level. The variables are stationary at first-differenced
form. This implies that the series are integrated at I(1). The unique level of integration of the variables
leads us to apply the ARDL bounds testing approach to test cointegration among trade balance, terms of
trade, domestic income and foreign income in the case of Pakistan over the period of 1978Q12012Q4.
After confirming that all the series are integrated at I(1), the model is now ready for the analysis of
cointegration relationship between the series using the ARDL bounds testing approach. The selection
of an appropriate lag length of the variables using AIC and Schwarzs Bayesian criterion criteria is a
necessary step before the ARDL bounds test is applied (Tiwari & Shahbaz, 2013). It is described by
Ltkepohl (2006) that AIC lag length criteria provide efficient and consistent results to capture dynamic
relation between the variables. Therefore, using the AIC criteria, the optimal lag length of the variables
is mentioned in the second column of Table 3 along with the results of the cointegration test. In order to
determine whether cointegration between the variables exists or not, we have to compare our calculated
F-statistic by following null hypothesis, that is, no cointegration with critical bounds such as LCB and
UCB. The results reveal that there are two cointegrating vectors. This represents the cointegration
relationship at 1 and 5 per cent significance levels when terms of trade and trade balance are treated as
Table 2. ZivotAndrews Structural Break Trended Unit Root Test
At Level

At First Difference

Variable

t-statistic

Time Break

ln TBt
ln TTt
ln Yt
ln YFt

4.099 (2)
4.367 (0)
3.582 (1)
3.586 (1)

1981
2003
1993
1993

t-statistic
7.973 (0)*
7.868 (2)*
5.663 (0)**
5.659 (0)*

Time Break
1980
1977
1982
1982

Source: Authors own.

Note: * and ** represent significance at 1% and 10% levels, respectively. The lag order is shown in parenthesis.

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Afza et al.
Table 3. The Results of ARDL Cointegration Test
Bounds Testing to Cointegration
Estimated Models

Optimal Lag Length

FTB(TB/TT, Y, YF)
FTT(TT/TB, Y, YF)
FY(Y/TB, TT, YF)
FYF(YF/TB, TT, Y)

2, 2, 2, 2
2, 2, 1, 2
2, 2, 2, 1
2, 2, 2, 1

Diagnostic Tests
F-statistics

| 2NORMAL

| 2ARCH

| 2RESET

7.308*
7.3836**
1.2917
0.9466

2.7823
0.4410
0.9897
0.4973

[1]: 0.2974
[1]: 0.2411
[1]: 0.0965
[1]: 2.4996

[1]: 2.1921
[1]: 0.0416
[1]: 0.2098
[3]: 1.8647

Critical Values (T = 40)#

Significant Level
1% level
5% level
10% level

Lower Bounds I(0)

Upper Bounds I(1)

6.053
4.450
3.740

7.458
5.560
4.780

Source: Authors own.

Note: The asterisks * and ** denote significance at 1%, 5% and 10% levels. The optimal lag length is determined by AIC. [] is
the order of diagnostic tests. # denote that critical values are collected from Narayan (2005).

response variables. The results reported in Table 3 show that a long-run relationship among trade balance,
terms of trade, domestic income and foreign income exists in the case of Pakistan.
It is also noticed that the presence of structural break in the time series makes long-run relations
biased, weak and unreliable. To avoid this issue, we have applied GregoryHansen (1996) structural
break cointegration test that does not only remove this deficiency of the ARDL bounds testing approach
to cointegration but also ensure the robustness of long-run relationship among trade balance, terms of
trade, domestic income and foreign income. The GregoryHansen cointegration test is powerful over
residual-based cointegration tests and adjusts the presence of one structural break in the series. The
results are reported in Table 4. The results show that cointegration relationship exists among trade
balance, terms of trade, domestic income and foreign income after allowing structural breaks in 1981 and
2003 which was investigated by applying fully modified ordinary least-square (FMOLS) approach. This
approach indicated the statistical significance of the dummy variable for structural break in trade sectors
of Pakistan. The structural breaks in trade reforms include competitiveness, concentration of exports and
openness for agricultural in 1980s and implementation of national export policy in 2002. The empirical
evidence indicated that there is a cointegration relationship between the variables as trade balance and
terms of trade are used as forcing variables including dummy variable. This implies that a long-run
relationship exists between the variables and long-run results are robust.
Table 4. GregoryHansen Structural Break Cointegration Test
Model
Break period
ADF test
Prob. values

TTB(TB/TT, Y, YF)

TTT(TT/TB, Y, YF)

1981
4.7119**
0.0000

2003
4.8279**
0.0033

TY(Y/TB, TT, YF)

1993
3.3579
0.0014

TYF(YF/TB, TT, Y)
1993
3.7297
0.0005

Source: Authors own.

Note: * shows significance at 1% level. The ADF statistics show the GregoryHansen tests of cointegration
with an endogenous break in the intercept. Critical values for the ADF test at 1%, 5% and 10% are
5.13, 4.61 and 4.34, respectively. The results of other alternative tests such as Zt and Za are
available upon request from authors.

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Table 5 reports the results of long- and short-run analyses. The results reveal that commodity terms of
trade have a positive impact on trade balance in Pakistan. All else same, a 1 per cent increase in terms
of trade leads trade balance by 0.2795 per cent.8 It is statically significant at 1 per cent level of significance.
This validates the HLM effect which reveals that an increase in terms of trade improves trade balance
in the case of Pakistan. These findings are consistent with Wong (2006) for Malaysia, Zortuk (2008) for
Turkey but contradictory with Wong (2009) for Hong Kong. The positive impact of domestic income on
trade balance shows the presence of absorption theory. Theory of absorption discloses that an increase in
domestic income raises the demand for money and that would subsequently increase exports that will
improve in trade balance. Keeping other things constant, a 1 per cent increase in per capita income adds
in trade balance by 0.1229 per cent. Shahbaz, Awan and Ahmad (2011) also indicated a positive effect
of income on trade balance but it is statistically insignificant. This may be due to the use of different
proxies for terms of trade and data span as well as data frequency.9 A positive and statistically significant
relationship is found from foreign income to trade balance in the case of Pakistan. This shows that an
increase in income of world will raise demand for Pakistani products which in result improves trade
balance of the country. A 1 per cent increase in world income is linked with 0.1094 per cent improvement

Table 5. Long- and Short-run Results

Dependent Variable = ln TBt
Long-run Analysis
Variables
Constant
ln TTt
ln Yt
ln YFt

Coefficient
21.7047
0.2795
0.1229
0.1094

Std. Error
4.7792
0.0758
0.0421
0.0618

t-statistic
4.5414*
3.6832*
2.9213*
1.7685***

Prob. Values
0.0001
0.0008
0.0061
0.0857

Short-run Analysis
Variables

Coefficient

t-statistic

Coefficient

t-statistic

Constant
Dln TTt
Dln Yt
Dln YFt
ECMt1
R2
F-statistic
DurbinWatson

0.0773
0.4751
0.4926
0.1169
0.4575
0.5092
8.5615*
1.7245

0.0309
0.0839
0.7427
0.0748
0.1047

2.4948**
5.6617*
0.6632
1.5621
4.3674*

0.0178
0.0000
0.5118
0.1278
0.0001

Short-run Diagnostic Tests

Test
| 2NORMAL
| 2SERIAL
| 2ARCH
| 2WHITE
| 2REMSAY

F-statistic

Prob. Values

0.4073
0.6846
0.1583
0.4056
0.0619

0.8157
0.5117
0.6930
0.9080
0.8050

Source: Authors own.

Note: * and ** show significance at 1% and 5% levels, respectively.

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Afza et al.

in trade balance, all else same. This finding is same as that of Shahbaz et al. (2011) but coefficients are
different due to differences in data frequencies and time spans.
The short-run results are shown in Table 5. Our results indicate that terms of trade improve trade
balance and it is statistically significant at 1 per cent level. The impact of national income (foreign
income) has a positive (negative) impact on trade balance but insignificant. The results show the significance of lagged error term, that is, ECMt1 while estimate has a negative sign. The statiscally significant
lagged error terms verify our established cointegration relationship among terms of trade, domestic
income, foreign income and trade balance in the case of Pakistan. The coefficient of ECMt1 is 0.4575
and it is significant at 1 per cent level. We note that changes in terms of trade are modified by 45.75 per
cent in each quarter. This implies that convergence would take more than 2 years to range the stable path
of equilibrium which is an indication of very fast and significant adjustment process for Pakistan in any
shock to trade balance equation.
The model is also tested for sensitivity analysis by using stability test of cumulative sum of recursive
residuals (CUSUM) and the CUSUM of square (CUSUMSQ) suggested by Brown, Durbin and Evans
(1975). Hansen argued that misspecification of model may provide biased results that further lead to
misinterpretation of results. The CUSUM and CUSUMsq tests are applied as diagnostic tests in order
to ensure the adherence of parameters. Further, Brown et al. (1975) suggested that these tests provide
help in analyzing the possible changes in parameters. The expected value of recursive residual is zero
which leads us to accept that null hypothesis of parameter constancy is correct, otherwise not.
The plots of both CUSUM and CUSUMsq are shown in Figures 1 and 2 at 5 per cent level of significance. The results indicate that plots of both tests are within critical bounds at 5 per cent level of
significance. Table 5 shows the results of diagnostic tests. The results signify that the short-run model
successfully passes all the tests of normality, serial correlation, autoregressive conditional heteroskedasticity, white heteroskedasticity and functioning form of the model. It is also evident that normality
of residual term is proved by JarqueBera estimates, and no serial correlation is observed during short

Figure 1. Plot of Cumulative Sum of Recursive Residuals

Source: Authors own.
Note: The straight lines represent critical bounds at 5 per cent significance level.

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Global Business Review 17(4)

Figure 2. Plot of Cumulative Sum of Squares of Recursive Residuals

Source: Authors own.
Note: The straight lines represent critical bounds at 5 per cent significance level.

span of time. Similarly, no evidence of autoregressive conditional heteroskedasticity is found and same
inference can be seen for white heteroskedasticity. The functional form of the short-run model is well
justified and is confirmed by the estimates of Ramsey regression equation specification error (RESET)
test. The stability and sensitivity analysis show that the ARDL and short-run results are stable and
reliable for policy purpose regarding trade balance in the case of Pakistan.
The long-run and short-run analyses just show the impact of independent variables on dependent
variables and ignore the cause and effect of the variables (direction of causal relationship between
the variables). This is solved by applying the VECM Granger causality approach. Table 6 reports the
empirical findings of the VECM Granger causality framework. In the long run, we find that the feedback effect exists between trade balance and terms of trade. Domestic and foreign incomes Granger
cause trade balance. Terms of trade is Granger caused by domestic and foreign incomes. In shortrun causality analysis, trade balance Granger causes terms of trade and in result, terms of trade Granger
cause trade balance. The unidirectional causality is found to be running from foreign income to trade
balance. Foreign income is Granger caused by terms of trade and trade balance in Pakistan.
In an economic literature, it is argued that the Granger causality approaches, such as VECM Granger
causality test, possess some limitations, that is, the causality test does not acquire the relative strength of
causal relation between the variable beyond the specified time limit. This weakens the reliability of
causality results by the VECM Granger approach. However, the innovative accounting approach (IAA)
provides solution to this problem. The IAA is a combination of variance decomposition method (VDM)
and impulse response function (IRF). The variance decomposition approach determines the response of
the dependent actor to shocks stemming from independent actors. Therefore, we applied the IRF and
VDM. The IRF is an alternative to VDM. Table 7 shows the results of VDM, while the IRF graph is
shown in Figure 3. The variance decomposition approach indicates the magnitude of the predicted error
variance for a series accounted for by innovations from each of the independent variable over different
time horizons beyond the selected time period.

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8.4948*
[0.0013]
0.1160
[0.8908]
3.5974**
[0.0394]

Dln TBt1

0.6694
[0.5192]
6.2084*
[0.0053]
0.1025
[0.9028]

1.0827
[0.3524]
0.8074
[0.4561]

161786*
[0.0000]

Dln Yt1

Dln TTt1

4.8410**
[0.0156]
0.4382
[0.6495]
0.0838
[0.9197]

0.6522*
[4.7747]
0.3649*
[3.3012]

ECTt1

Long Run

6.8840*
[0.0013]

17.1158*
[0.0000]

Dln TTt1,
ECTt1

19.0913*
[0.0000]
5.4644*
[0.0044]

Dln Yt1,
ECTt1

14.5403*
[0.0000]
4.4847**
[0.0108]

Dln YFt1,
ECTt1

Joint Long- and Short-run Causality

Dln TBt1,
ECTt1

Direction of Causality

Dln YFt1

Source: Authors own.

Note: *, ** and *** show significance at 1%, 5% and 10% levels, respectively.

Dln YFt

Dln Yt

Dln TTt

Dln TBt

Dependent Variable

Short Run

Table 6. The VECM Granger Causality Analysis

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Table 7. Variance Decomposition Method

Period

S.E.

ln TBt

Variance Decomposition of ln TBt

1
0.1275
100.0000
2
0.1562
86.2587
3
0.1601
85.1947
4
0.1686
77.9464
5
0.1849
66.2377
6
0.2010
58.5778
7
0.2127
55.6391
8
0.2203
55.0003
9
0.2252
54.9118
10
0.2288
54.6859
11
0.2321
54.2032
12
0.2352
53.5989
13
0.2381
53.0654
14
0.2406
52.6955
15
0.2425
52.4641
Variance Decomposition of ln TTt
1
0.1783
41.9810
2
0.2702
29.7024
3
0.3235
28.1993
4
0.3612
28.7108
5
0.3881
29.1961
6
0.4077
29.4297
7
0.4228
29.4519
8
0.4351
29.3658
9
0.4451
29.2535
10
0.4533
29.1398
11
0.4598
29.0137
12
0.4650
28.8621
13
0.4691
28.6857
14
0.4724
28.4949
15
0.4751
28.3009
Variance Decomposition of ln Yt
1
0.0191
2.3693
2
0.0297
3.1383
3
0.0372
3.1168
4
0.0431
3.2345
5
0.0479
3.6161
6
0.0522
4.3280
7
0.0557
5.3500
8
0.0587
6.5435
9
0.0612
7.7374
10
0.0634
8.8163
11
0.0653
9.7434
12
0.0671
10.5343
13
0.0687
11.2206
14
0.0702
11.8268
15
0.2667
22.3959

ln TTt

ln Yt

ln YFt

0.0000
0.3969
1.2152
8.1303
19.7662
28.3183
32.3480
33.7218
34.1771
34.5006
34.8863
35.3037
35.6542
35.8732
35.9705

0.0000
1.2284
1.2512
1.8452
2.2046
2.1639
1.9725
1.8441
1.8066
1.8031
1.7956
1.7804
1.7673
1.7632
1.7677

0.0000
12.1158
12.3387
12.0779
11.7913
10.9399
10.0402
9.4336
9.1043
9.0102
9.1148
9.3167
9.5129
9.6679
9.7976

58.0189
65.2860
65.6518
64.1752
62.6072
61.4196
60.5425
59.7933
59.0387
58.2397
57.4286
56.6581
55.9637
55.3545
54.8229

0.0000
0.2465
0.2811
0.6121
1.2806
2.1380
3.0846
4.0662
5.0600
6.0532
7.0251
7.9488
8.8008
9.5680
10.2482

0.0000
4.7648
5.8677
6.5017
6.9159
7.0125
6.9208
6.7745
6.6476
6.5671
6.5324
6.5308
6.5496
6.5824
6.6278

4.3456
8.5308
11.3966
14.6770
18.5024
22.1656
25.1300
27.2892
28.8031
29.8859
30.6955
31.3173
31.7886
32.1275
68.3167

93.2850
87.1981
84.3643
81.2431
76.9010
72.0632
67.4920
63.5186
60.1407
57.2269
54.6512
52.3426
50.2770
48.4482
0.9108

0.0000
1.1327
1.1221
0.8452
0.9802
1.4431
2.0278
2.6485
3.3187
4.0707
4.9097
5.8056
6.7135
7.5973
2.9001

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Afza et al.
Period

S.E.

ln TBt

Variance Decomposition of ln YFt

1
0.0195
2
0.0308
3
0.0379
4
0.0417
5
0.0438
6
0.0451
7
0.0462
8
0.0474
9
0.0486
10
0.0498
11
0.0508
12
0.0517
13
0.0524
14
0.0531
15
0.0538

0.1174
1.1424
3.7166
7.69536
11.1668
13.0787
13.7400
13.7794
13.6448
13.5888
13.6736
13.8279
13.9615
14.0342
14.0535

ln TTt

ln Yt

ln YFt

6.3734
21.2148
27.2338
27.7798
26.4743
25.1818
24.1542
23.3561
22.8615
22.5890
22.3720
22.1331
21.8806
21.6435
21.4430

0.5540
0.2233
0.1550
0.1909
0.2991
0.3588
0.3470
0.3552
0.4432
0.5930
0.7672
0.9502
1.1448
1.3579
1.5905

92.9550
77.4193
68.8945
64.3338
62.0596
61.3805
61.7586
62.5092
63.0502
63.2290
63.1870
63.0887
63.0129
62.9643
62.9128

Source: Authors own.

Table 7 reports the empirical evidence regarding VDM and results reveal that innovative shocks
of terms of trade, domestic income and foreign income contribute to trade balance by 35.97, 1.76 and
9.79 per cent and rest is explained by innovative shock of trade balance itself. Trade balance is explained
by 52.46 per cent of its own shocks. The response of terms of trade due to shocks in trade balance
is 28.30 per cent. The contribution of domestic income and foreign income to explain trade balance is
10.24 and 6.62 per cent, respectively.
Trade balance contributes to economic growth by 22.39 per cent. Domestic income is 68.31 per cent
contributed by terms of trade. Foreign income contributes to domestic income by 2.90 per cent.
Trade balance, terms of trade and domestic income contribute to foreign income by 14.05, 21.44 and
1.59 per cent, respectively. Overall results show that the feedback effect exists between trade balance and
terms of trade. Trade balance and terms of trade cause domestic income. Foreign income is caused by
terms of trade.
The IMF traces the time path of the impacts of shocks of independent variables on the dependent
variables in a VAR system. The IMF is an alternative to VDM showing how long independent variable
reacts to shock stemming in the dependent variables. We can see the magnitude of the response of
trade balance to its own shock, those of terms of trade, domestic income and foreign income. Trade
balance responds positively due to forecast error stemming in terms of trade. The response in domestic
income is inverted U-shaped and foreign income responds positively after third time horizon due to
forecast error stemming in terms of trade. The response in terms of trade, domestic income and foreign
income is fluctuating due to forecast error stemming in trade balance. The contribution of domestic
income to trade balance, terms of trade and foreign income is positive. Trade balance and terms of trade
respond positively but response of foreign income in domestic income is minimal and fluctuating.

Concluding Remarks and Policy Recommendations

This article explored the validation of HLM effect by incorporating domestic income and foreign income
in trade balance function in case of Pakistan. We have employed the ARDL bounds testing to investigate

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Figure 3. Impulse Response Function

Source: Authors own.

the long-run relationship between the variables. We find that trade balance, terms of trade, domestic
income and foreign income are cointegrated for long-run relationship. Moreover, improvement in terms
of trade improves trade balance which validates the HLM effect in Pakistan. Domestic income improves
trade balance. Foreign income is positively linked with trade balance. The causality analysis by IAA
reveals that terms of trade causes trade balance and trade balance leads terms of trade. Domestic income
is cause of trade balance, whereas terms of trade causes foreign income.
The results of this study suggest that Pakistan has the capability to benefit from the improved terms
of trade if foreign investment is attracted. However, in the past, the conventional way of dealing with
deteriorating terms of trade has been the currency devaluation that has not been successful and balance
of trade remained fragile to external shocks due to weak price elasticity of demand for Pakistani exports.

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Afza et al.

This orthodox policy must be replaced by paying attention towards the new policy to increase foreign
investment. It does not only improves balance of payment and growth but also improves terms of trade
as a rebound in the long run. Due to increase in the foreign investment, the exports flourish both in terms
of volume and composition. The analysis also suggests that if the investment is diverted more towards
the production of such goods and services that cover larger part of countrys imports, it would guarantee
higher outcomes of improved terms of trade.
We are aware about the limitations of our study. For instance, this article indicates the partial impact
of income terms of trade on trade balance in Pakistan. To capture the complete impact of terms of trade
on trade balance, commodity terms of trade should also be considered for empirical analysis (we have
used income terms of trade). Few studies have investigated the impact of currency devaluation on trade
balance (Shahbaz, Awan & Ahmad, 2011, Shahbaz, Jalil & Islam, 2012a) and domestic output (Shahbaz,
Islam & Aamir, 2012b). The Marshal Learner Condition was also empirically investigated (Aftab &
Aurangzeb, 2002; Aftab & Khan, 2008). Such studies could not provide any help to policymakers in
designing a comprehensive trade policy for the removal of trade deficit. This shows the importance of
further comprehensive research investigating the impact of currency devaluation and terms of trade
(income terms of trade and commodity terms of trade) on trade balance, exports, imports and domestic
output using time-varying cointegration, time-varying Granger causality and time-varying long-run
estimates. The time-varying cointegration, causality and long-run estimates provide efficient empirical
evidence due to their high explanatory powers.
Acknowledgement
The authors/author is/are grateful to the anonymous referees of the journal for their extremely useful suggestions to
improve the quality of the article. Usual disclaimers apply.

Notes
1. The condition states that the trade balance in terms of elasticities of demand and supply improves with the
depreciation of exchange rate.
2. Otto finds two important results. First, a strong support for an HLM effect is present. Second, his findings
implied by the structural vector autoregression model are consistent with those reported by Mendoza (1995)
based on simulation of a specific dynamic stochastic equilibrium model for a small open economy.
3. It is defined as export price divided by import price.
4. It is defined as export price multiplied by export volume and divided by import price.
5. We have used a quadratic match-sum method to convert annual data into quarter frequency for GDP series.
6. If the value falls within the bound limits.
7. Results are available upon request from authors.
8. Shahbaz et al. (2012) reported the negative impact of change in income terms of trade on trade balance in Pakistan.
9. Shahbaz et al. (2011) utilized the quarterly data to investigate the impact of terms of trade on trade balance in
Pakistan.

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