Marmara Üniversitesi

İngilizce İktisat Bölümü

Marmara University

Department of Economics

What Do We Know about Marmara University

Mehmet Ali SOYTAŞ

January, 2005

Working Paper No: 2005/1 Suggested Citation: Özerkek, Y., 2005, “The Link between Trade Balance and Growth: Panel Data Evidence for the Emerging Market Countries,” Marmara University, Department of Economics, Göztepe Campus, Istanbul, Independent Research Paper No: IRP200503 © Yasemin ÖZERKEK, 2005

The Link between Trade Balance and Growth: Panel

Data Evidence for the Emerging Market Countries

Yasemin ÖZERKEK

June 2005

Independent Research Paper No: IRP200503

1

The Link between Trade Balance and Growth: Panel Data Evidence for the Emerging Market Countries

Yasemin ÖZERKEK*

June 2005

Working Paper No: 200503

ABSTRACT An issue having a recent surge of interest in economics is the link between trade deficit and growth performance. A few studies have attempted to investigate the influence of growth performance on trade balance. However, to our knowledge, there is no such an empirical analysis exploring the issue the other way around. To this end, this paper aims to investigate the linkage between trade deficit and growth performance of emerging market countries providing empirical evidence of the estimated impact of trade balance on growth rates. The empirical results show that controlling for one period lag of GDP growth rate, a deteriorating trade balance is associated with an increasing rate of economic growth in the emerging market economies for the period 1970-2002. JEL Code: C23, F43, O57 Keywords: Trade balance, economic growth. *) Marmara University, Department of Economics.

1. Introduction

An issue having particular concern in economics is the sustainability of trade deficits.

Trade deficits are basically the result of more imports than exports for an economy in a

certain period. Underlying reasons can be very complex varying country by country and

period by period. Hong (2001) suggests that it is usually difficult to identify the causes from

the effects because many factors interact simultaneously. Views have also diverged regarding

the effects of the trade deficits on economies (Hong, 2001).

Zhang and Wan (2004) point out that the factors responsible for movements in the

trade balance fall into two groups. “Some alter the trade balance permanently and thus

determine the level of ‘structural’ trade balance. Others have their effects last only for a

limited period of time. Accordingly, part of the trade balance movements can be seen as

transitional dynamics between different levels of ‘structural trade balance’ and the rest are

cyclical fluctuations that will be corrected over time.” (p.14) They suggest that interpreting

trade balance movements within such a framework is important for macroeconomic policy

formulation since these two types of movements require policy responses of distinct nature.

A variety of studies have addressed the issues as to whether higher trade openness

helps to improve economic growth (Lee et al., 2004), income effects on the trade balance

(Kim, 1996), and the impact of trade liberalization on trade deficits and current accounts of

developing countries (Paulino and Thirlwall, 2002). While these questions have received a

great deal of attention in the literature, the link between trade deficit and growth performance

has not been dwelled on much. A few studies have attempted to investigate the influence of

growth performance on trade balance, but to our knowledge, there is no such an empirical

analysis exploring the issue the other way around. To this end, this paper aims to investigate

the linkage between trade deficit and growth performance of emerging market countries,

providing empirical evidence of the estimated impact of trade balance on growth rates.

3

The rest of the paper is organized as follows. Section 2 briefly reviews literature on

the empirical investigation of the trade balance and growth performance, i.e. the relation from

growth to trade balance. Section 3 describes the data, delineates the conceptual framework of

the model, and presents the empirical results assessing the role of trade balance on growth

performance of emerging market countries over the period 1970-2002. Some concluding

remarks are offered in Section 4.

2. Literature Review

A variety of studies has addressed the issue of economic growth, generally using

either cross-country or panel data approach. Among these, some studies have attempted to

explain the impact of economic growth on trade balance.

UNCTAD (1999) presents the results of some econometric exercises designed to

estimate the relation between economic growth and the trade balance in developing countries

and the effect thereon of trade liberalization. The model is specified by the ratio of trade

balance (TB) to GDP as the dependent variable, and the explanatory variables, growth rate

(GROWTH), the purchasing power of exports (PPX) of developing countries and the growth

rate of industrial countries (GRIND). Liberalization (LIB) is used as a dummy variable being

expected to capture the joint effects of currency appreciations and instability resulting from

capital account liberalization as well as the impact of import liberalization. The countries in

the study are Argentina, Brazil, Chile, Colombia, Mexico, Indonesia, Malaysia, Philippines,

Thailand, Venezuela, Republic of Korea, Ghana, Kenya, Morocco, Tunisia, and Uganda. The

regression equations are obtained on the basis of panel data estimation techniques using the

information for the 16 countries over 26 years i.e. from 1970 to 1995.

4

The equations are estimated alternatively as a random-effects and a fixed-effects

model. The Hausman test supports the random-effects model, implying that the intercepts are

uncorrelated with the explanatory variables. UNCTAD (1999) notes that all the structural

parameters have the expected signs and pass the significance test at the 1 per cent level. The

results specify a significant negative relation between GROWTH and TB/GDP, suggesting

that speeding up of growth in developing countries adds to trade deficits. The results imply

that better terms of trade and faster growth in industrial countries improve the trade balance,

while liberalization worsens it significantly. A striking result is the strong impact of growth in

industrial countries on trade balances (UNCTAD, 1999).

Based on the same data, incorporating the variables denoting the interaction of

liberalization with the variable for growth and terms of trade in developing countries, and for

growth in industrial countries, show that the overall impact of liberalization on the trade

balance varies with the values of GROWTH, PPX and GRIND, and may be positive or

negative depending on the particular configuration of these variables. UNCTAD (1999) notes

that growth in a liberalized developing economy is associated with greater trade deficits than

in a non-liberalized economy. On the other hand, increases in the purchasing power of

exports continue to improve the trade balance in a liberalized economy, but less than

before liberalization. The results in UNCTAD (1999) show that faster growth in industrial

countries improves the trade balance in a liberalized developing economy more than in a non-

liberalized economy.

Parikh and Stirbu (2004) analyze the impact of growth on trade balance and current

account to examine whether higher economic growth due to liberalization leads to adverse

effects on balance of trade in 42 developing countries of Asia, Africa, and Latin America over

the period 1970-1999. In their analysis, trade balance is normalized by GDP to take into

5

consideration different sizes of countries, and allowed control variables such as terms of

trade, advanced countries’ growth rates, liberalization, and debt related variables.

Parikh and Stirbu (2004) use both panel data and country-by-country data to measure

the impact of liberalization on domestic economic growth measured in PPP terms from the

data available in Heston, Summers and Aten (2001) study. Regional panel for three regions

and country by country analysis suggest that liberalization promotes growth but growth itself

has negative effect on trade balance for a large majority of countries. Trade deficits tend to

rise with economic growth in Asian economies while there is no such evidence for either

Latin American or African economies (Parikh and Stirbu, 2004).

They provide some tentative conclusion on the evidence that balance of trade and

economic growth are negatively related for a large number of developing countries and the

evidence supports the hypothesis that faster growth with liberalization could create balance of

trade problems. They do not find a great deal of evidence on current account balances being

affected by economic growth. Parikh and Stirbu (2004) point out that liberalization worsens

trade deficits while growth, current account, and investment rate are all encouraged by

liberalization. They conclude that trade balance obviously deteriorates with liberalization and

economic growth and hence countries would have difficulty in reaching potential or planned

growth in the subsequent periods after liberalization. They argue that deterioration in trade

balance could have impact on economic growth in subsequent periods (Parikh and Stirbu,

2004).

Parikh (2004) uses panel data of 42 countries (both time-series and cross-section

dimension) to estimate the effect of trade liberalization and growth on trade balance while

controlling for other factors such as income terms of trade. He estimates a dynamic model

using Generalized Method of Moments, with trade balance or current account to GDP in

percentages as the dependent variable, and liberalization, growth in real GDP, terms of trade,

6

and interactions of liberalization with purchasing and of liberalization with the growth rate in

real GDP in developing countries and developed countries. Equations The major findings of

his study are that trade liberalization promotes growth in most cases, the growth itself has a

negative impact on trade balance, and this in turn could have negative impacts on growth

through deterioration in trade balance and adverse terms of trade. Parikh (2004) argues that

trade liberalization could constrain growth through adverse impact on balance of payments.

3. Trade Balance and Growth

Contrary to the studies analyzing the influence of growth on trade balance, this

section approaches the question in a slightly novel fashion asking whether trade balances of

emerging market economies have any impact on their observed rates of economic growth. To

cast a light on the issue, this paper develops an empirical model using a dynamic panel data

approach.

3.1 Data

This study uses the latest available data from World Development Indicators (2004)

on annual GDP growth rates (%) and trade balances (% of GDP) of 20 emerging market

countries to examine the relationship between trade balance and growth for the period 1970-

2002. The list of countries in the study is provided in Appendix 1.1

Figure 1 and 2 illustrate the relationship between average growth rates and the average

trade balance (% of GDP) for two sub-periods, i.e. 1970-1989 and 1990-2002.2 In Appendix 2

1 Singapore, Czech Republic, Russia, Poland, and Taiwan are excluded because of data unavailability. 2 Trade balance (% of GDP) is calculated by subtracting imports of goods and services (% of GDP) from exports of goods and services (% of GDP). Different sizes of countries are taken into account by using trade balance to GDP (TB/GDP) ratios in percentage terms.

7

-20 -10 0

1

2

3

4

5

6

7

8

9

average TB/GDP

ave

rag

e G

GD

P

ARG

BRA

CHL

CHN

COL

EGY

HKG

HUN

IND

IDN

ISR

PRK

MYS

MEX

PER

PHL

ZAF

THA

TUR

VEN

1970-89

Figure 1 Average GDP Growth Rate v. Average TB/GDP

-10 0 10

0

1

2

3

4

5

6

7

8

9

10

average TB/GDP

ave

rag

e G

GD

P

ARGBRA

CHL

CHN

COL

EGYHKG

HUN

INDIDNISR

PRK MYS

MEXPERPHL

ZAF

THA

TUR

VEN

1990-2002

Figure 2 Average GDP Growth Rate v. Average TB/GDP

8

are reported the complete list of the data for averages. While Figure 1 does not configure a

significant relationship between average growth rates and average trade balance (% of GDP),

Figure 2 suggests a negative relationship between the two, with Israel and Egypt being

outliers particularly in the period 1970-1989. The reason underlying these far values from

most others in the set of data can be attributed to these countries’ taking advantage of foreign

aid in financing their trade deficit. Excluding Israel and Egypt from the regressions does not

change the significance of estimates, implying that even easy financing cannot change the

negative relationship between trade balance and growth.

The data from World Development Indicator (2004) reveal that while trade accounts

of many emerging market countries worsens during the 1970s, there is a notable recovery

during the 1980s. One of the most striking stylized facts emerging from the data is the relative

deterioration in trade balances in most of the emerging market countries in the 1990s

compared to the 1980s. UNCTAD (1999) argues that declines in the terms of trade, losses of

purchasing power of exports, and liberalization of trade and of capital accounts have all

contributed to the worsening of trade balances of developing countries during this period.

3.2 Empirical Methodology

For a country, having a trade deficit implies that this country is not producing as much

as it consumes. Accordingly, one might expect that faster growth in imports in relation to

exports could have serious implications for balance of trade and this in itself could constrain

economic growth in some of the developing economies. On this respect, Parikh and Stirbu

(2004) argue that it appears that trade contributes to improvement in real income and per

capita growth, however, if trade is not combined with adequate policies to balance imports

against exports, it could generate the balance of trade and balance of payments deficits

leading to deterioration in the growth of real incomes.

9

To fathom the relation between trade balance and growth performance of the emerging

market economies, a model is specified by annual GDP growth (in %), GGDP, as the

dependent variable, and the trade balance (% of GDP) (TB/GDP) and one period lag of GDP

growth (annual %)( GGDP_1) of emerging market countries as explanatory variables.

Employing a dynamic panel data approach, this analysis aims at looking for any

change in the pattern of relationship between trade balance (% of GDP) and GDP growth

rates of 18 emerging market countries over 33 years, i.e. 1970 to 2002.3 By including one

period lag of GDP growth rate as a control variable, it is intended to capture its trend effect on

GDP growth in order to see the impact of trade balance on GDP growth in a macroeconomic

framework.

The panel data sets used in this paper have several observations, collected over time

for a number of countries. They share properties with both time series data and cross-sectional

data sets. Both cross-country and time variation specifics are used in an attempt to explain the

link between trade balances on economic growth in emerging market countries. In other

words, the equation is estimated alternatively as a random-effects and fixed-effects model.

The estimators in the random effects model are the generalized least squares estimators,

combining the within and between country estimators using the corresponding residual

variance as weights (Parikh, 2004). These two techniques have been developed to handle

systematic tendency of individual specific components to be higher for some units than for

others. The random effect estimator is used if the individual specific component is assumed to

be random with respect to the explanatory variables, while the fixed effects estimator is used

if the individual specific component is not independent with respect to the explanatory

variables (Dewan and Hussein, 2001). 4

3 Israel and Egypt are excluded from the analysis for the reason given before. 4 While fixed effects regression is used to control for omitted variables that differ between cases but are constant over time, allowing using the changes in the variables over time to estimate the effects of the independent variables on the dependent variable, and is the main technique used for analysis of panel data, random effects

10

The following equation is estimated using the panel data encompassing two sub-

periods, i.e. 1970-1989 and 1990-2000, and 18 emerging market countries.

1 2 3( ) ( / ) ( _1) (1)

i 1,2,...18 and t 1,2,..33

it it it itGGDP TB GDP GGDP

3.3 Regression Results

For the whole period, empirical results indicate a significant negative relationship

between trade balance (TB/GDP) and economic growth (GGDP) (Table 1). As is seen in

Table 1, fixed effects model gives highly significant estimates for TB/GDP and GGDP for the

period 1970-2002.

When the overall 1970-2002 time period is split into the sub-periods 1970-1989, and

1990-2002, these periods yield different results. The main findings of fixed-effect model

suggest that trade deficit has a positive effect on economic growth in the period 1990-2002

while there is no such evidence in the earlier period 1970-1989. However, one lag of GDP

growth rate turns out to be insignificant in this case. On the other hand, whereas random-

effects model gives positive and insignificant estimates for TB/GDP for the earlier period, the

relationship between TB/GDP and GGDP turns into negative and significant at 5% level, with

the estimate for GGDP_1 also being strongly significant, in the period 1990-2002. This result

may suggest that these emerging market countries were more homogenous in the earlier

period.

regression is used when some omitted variables may be constant over time but vary between cases, and others may be fixed between cases but vary over time (Princeton University Library, 2004).

11

These empirical results may also imply that the significant negative relationship

between TB/GDP and GGDP over the period 1990-2002 dominates, and thereby generates a

significant negative linkage among these variables for the whole period as well.

The negative relationship between trade balance and growth exposed by empirical

results may be an unexpected result given the reasons before. However, “the trade balance, or

the related concept of the current account, can be seen in two ways: either as equal to the

difference between exports and imports of goods and services; or, as approximately equal to

the difference between national savings and national investment. While a worsening of the

trade balance is traditionally considered as a sign of competitiveness loss for the country, it

may actually signal a strong economy where national investment is growing faster than

national savings. In this sense, a worsening of the trade balance may be good new about the

economy.”5

As is well known, existence of trade deficit implies an insufficient production level in

relation to the overall consumption in a country. Having addressed the negative link between

the trade balance (% of GDP) and GDP growth, the objective of the second part of the

empirical exercise is to investigate the same link by using the 3-year moving average of trade

balance (% of GDP) values instead of annual rates to see whether the significant negative

relationship is still applicable. Empirical results show that the estimated coefficient for

TB/GDP turns out to be positive but insignificant for both random and fixed effect models,

5 http://pages.stern.nyu.edu/~nroubini/bci/InternationalTrade.html

Table 1 The Relation between Trade Balance and Growth: Summary of Regression Results

Independent variable

1970-1989 1990-2002

1970-2002

Fixed effect Random effect Fixed effect Random effect Fixed effect Random effect

TB/GDP

***.0275365 (-0.48)

***.0098136 (0.20)

*.3857345(-5.81)

**.1250705 (-2.38)

*.1381858 (-3.32)

***.0521834 (-1.45)

GGDP_1

*.2260532 (4.03)

*.4187867 (8.28)

***.034486(0.50)

*.3357892(5.55)

*.2253101 (5.34)

*.3929433 (10.17)

Constant

-

2.75654 (7.94) -

2.699329(7.14)

-

2.717504 (10.61)

R-square 0.0515 0.1643 0.1838 0.0687 0.0898 0.1658

Number of

observations

360

360 234

234

594 594

Number of

countries

18

18 18 18

18 18

* : significant at 1%; ** at 5%; *** insignificant Note: Bracketed terms under the coefficients are t-statistics and z-statistics for fixed effect and random effect models, respectively.

while between effects model provides a negative and significant estimate for avTB/GDP

(Table 2).6

Also reported in this section are country-by-country regressions. The estimated

coefficient on the trade balance is negative for 13 out of 18 countries. Five of these 13 cases

yield significant results, suggesting that GDP growth rates tend to decline as the trade balance

surplus gets larger while controlling for one period lag of GDP growth rate (Table 3). Table 4

summarizes the empirical results and demonstrates the direction of the relation between trade

balance and growth for the emerging market economies. One of the most striking stylized

facts consistent with the empirical results reported in Table 1 is that there is no country that

has a positive significant relationship between its trade balance (%of GDP) and growth rates

(Table 4).

6 Regression with between effects is the model used to control for omitted variables that change over time but are constant between cases. It allows using the variation between cases to estimate the effect of the omitted independent variables on dependent variable. Running between effects regression is equivalent to taking the mean of each variable for each case across time and running a regression on the collapsed dataset of means. As this results in loss of information, between effects are not used much in practice (Princeton University Library, 2004).

14

Table 2 The Relation between Three-year Moving Average of Trade Balance and Growth: Summary of Regression Results for the Period 1970-2002

Independent Variable

Fixed effect

Between effects

Random effect

avTB/GDP

***.0537246 (1.03)

**-.0294699 (-2.36 )

***.0620684 (1.45)

GGDP_1

*.2713646 (6.38)

*1.033234 (62.90)

***.4046758 (10.21)

Constant

-

*-.2431364 (-3.02)

*2.553335 (9.84)

R-square 0.0703 0.9963 0.1586

Number of observations

558

558

558

Number of countries

18

18

18

* : significant at 1%; ** at 5%; *** insignificant

Note: Bracketed terms under the coefficients are t-statistics and z-statistics for fixed effect and between effects, and random effect models, respectively.

1

Table 3. The Relation between Trade Balance and Growth: Results of Country Level Regressions

Country Number of observations

Constant TB/GDP GGDP_1 R-square

Argentina

33

3.509396

(3.21)

*-1.165165

(-3.93)

****-.1853333

(-1.02)

0.3630

Brazil

33

1.99872

(1.97)

****-.1113373

(-0.39 )

*.4991369

(2.99)

0.2893

Chile

33

2.549661

(2.13)

****.356764

(1.29)

**.3991637

(2.28 )

0.1587

China

33

-.0294699

(3.08)

**** -.035692

(-0.10)

**-.0294699

(2.14)

0.1530

Colombia

33

2.064221

(2.78)

**** .1215289

(1.17)

* .446339

(2.82)

0.2423

Hong Kong,China

33

4.040727

(2.35)

**** .2308961

(1.18)

*** .2151732

(1.24)

0.0854

Hungary

33

1.205482

(1.53)

**** -.0264421

(-0.14)

* .4470233

(2.78)

0.2067

India

33

4.635277

(3.35)

**** - .3664336

(-0.56)

**** -.564201

(-0.31)

0.0151

Indonesia

33

5.239114

(3.45)

**** -.271704

(-1.49)

*** .2919327

(1.71)

0.1834

Republic of Korea

33

7.084353

(4.77)

**** -.0629896

(-0.50)

**** .0220846

(0.12)

0.0101

Malaysia

33

7.827919

(4.40)

*** -.1882722

(-1.96)

**** -.0256118

(-0.13)

0.1411

Mexico

33

3.537817

(3.84)

** -.5207999

(-2.67)

*** .0794193

(0.44)

0.2733

Peru

33

1.750792

(1.63)

**** .0867694

(0.33)

*** .3758991

(1.98)

0.1245

2

Country

Number of observations

Constant TB/GDP GGDP_1 R-

square

Philippines

33

1.950738

(2.39)

**** .1305874

(0.87)

* .5684052

(3.50)

0.2914

S. Africa

33

2.987098

(2.53)

**** -.2534713

(-1.21)

**** .0821573

(0.41)

0.0898

Thailand

33

5.060623

(3.75)

** -.3931452

(-2.46)

**** .1174282

(0.55)

0.3734

Turkey

33

1.495634

(1.00)

* -.873128

(-2.87)

**** -.1056291

(-0.65)

0.2428

Venezuela

33

2.895778

(2.40)

**** -.1846143

(-1.50)

**** -.0731164

(-0.35)

0.0715

* : significant at 1%; ** at 5%; ***at 10 %; **** insignificant

Table 4 Classification of Emerging Market Countries According to the Movements

of the Trade Balance and GDP Growth Rates in the Period 1970-2002

significant insignificant

negative

positive * significant at 1%, ** significant at 5%, *** significant at 10%

*Argentina

*Turkey

**Mexico **Thailand ***Malaysia

Brazil China Hungary India Indonesia Rep. of Korea S.Africa Venezuela

Chile Colombia Hong Kong Peru Philippines

3

4. Concluding Remarks

This paper has explored the link between trade balance (% of GDP) and economic

growth. The empirical results show that controlling for one period lag of GDP growth rate, a

deteriorating trade balance is associated with a decreasing rate of economic growth in the

emerging market economies for the period 1970-2002.

Increasing imports (% of GDP) implies an increase in the entry of foreign resources

into the country. Hence, the likely influence of trade balances on growth can be explained by

the effects coming from demand side. As is noted before, the trade balance can be viewed in

two ways: either as equal to the difference between exports and imports of goods and

services; or, as approximately equal to the difference between national savings and national

investment. At the same time as a deterioration of trade balance is usually regarded as a signal

of competitiveness loss for the country, it may essentially signal an economy where national

investment is growing faster than national savings. In this respect, a worsening of the trade

balance may be viewed as good news.7

An alternative explanation may be provided by referring to endogenous growth

theories. Recent developments in growth theory points to the importance of technical change

as the driving force behind growth performance. The transfer of the technology developed by

advanced countries to the others through imported goods may give rise to the enhancement of

growth rates of these countries.

7 http://pages.stern.nyu.edu/~nroubini/bci/InternationalTrade.html

4

Appendix 1 List of Countries Country Code

Argentina ARG

Brazil BRA

Chile CHL

China CHN

Colombia COL

Egypt EGY

Hong Kong, China HGK

Hungary HUN

India

IND

Indonesia IDN

Israel ISR

Republic of Korea PRK

Malaysia MYS

Mexico MEX

Peru PER

Philippines PHL

S.Africa ZAF

Thailand THA

Turkey TUR

Venezuela VEN

5

Appendix 2 1970-1989 Country average GGDP average TB/GDP ARG 1.100991 1.792354 BRA 5.730511 0.14545 CHL 3.434555 -0.2708 CHN 8.595 -0.35406 COL 4.60677 0.769832 EGY 6.08447 -12.3188 HKG 8.308056 5.421115 HUN 3.196654 -1.33864 IND 4.409932 -1.46391 IDN 7.097659 3.175663 ISR 4.733529 -20.4081 PRK 8.043368 -2.76345 MYS 6.801162 3.32532 MEX 4.363508 1.062492 PER 2.140787 -1.28753 PHL 3.901379 -1.8203 ZAF 2.837165 3.159396 THA 7.402037 -3.26482 TUR 4.3885 -3.49333VEN 1.900352 3.867438 Average 4.953819 -1.30324 Source: Calculated by the author from the data of World Development Indicators (2004). 1990-2002 Country average GGDP average TB/GDP ARG 2.239967011 0.634577 BRA 1.976923077 -0.36725 CHL 5.704130923 0.662439 CHN 9.276923077 2.568874 COL 2.659043204 -1.27484 EGY 4.280998978 -6.52877 HKG 3.884747035 3.190061 HUN 0.975280719 -1.80077 IND 5.434138568 -0.88621 IDN 4.642968672 3.821843 ISR 4.592491974 -11.2283 PRK 6.234301129 1.057005 MYS 6.567687713 7.642825 MEX 3.140353292 -1.77844 PER 3.098726229 -2.91007 PHL 3.167911469 -4.88763 ZAF 1.780909945 2.894475 THA 5.004052602 0.926609 TUR 3.57765397 -3.34559 VEN 1.6580918 6.942966 Average 3.994865069 -0.23331Source: Calculated by the author from the data of World Development Indicators (2004).

6

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