This report is submitted for the partial fulfillment of the requirements for the degree of Masters in Business

Administration

Empirical relationship between Financial Development and Trade liberalization: In case of

Pakistan

Submitted By

NAME: NAZAR ALI

MBA-IV ROLL NO 914135

Submitted to

Irfan Lal

Department of Business Administration

Federal Urdu University of Arts, Science and Technology, Molvi Abdul Haq Campus, Karachi

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Department of Business Administration

Federal Urdu University of Arts Science and Technology

This is to certify that Master's Thesis of

Nazar Ali

has met the thesis requirements of

Federal Urdu University of Arts Science and Technology

Abdul Haq Campus, Karachi 2011.

Signature of Author . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Department of Business Administration May 2011

Certified by . . . . . . . . . . . . . . . . . . . . . Irfan Lal

Thesis Supervisor

Accepted by. . . . . . . . . . . . . . . . . . . . . . . . . . . . Sulaiman D. Mohammad

Professor and Dean Department Business Administration

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ACKNOWLEDGEMENT

First I would like to thank Almighty Allah for giving me the

tendency with which I carried out this report. It is by His blessing

that I had an opportunity to able to write this report.

I would like to gratefully acknowledge the enthusiastic supervision

of Irfan Lal during this work. I am grateful to all my friends, for

being the surrogate family during the many years I stayed there

and for their continued moral support there after.

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Table of Content

Chapter#1:

Abstract--------------------------------------------------------5

Introduction------------------------------------------------- 5-21

Current Scenario------------------------------------------ 21-23

Scope Of Study----------------------------------------- 23-25

Chapter#2:

Literature Review---------------------------------------- 25-28

Chapter#3:

Objective------------------------------------------------------28-29

Research1Model----------------------------------------------29-31

Data Source---------------------------------------------------31

Hypothesis----------------------------------------------------31

Chapter#4:

Research Methodology------------------------------------32

Results-----------------------------------------------------32-33

Chapter#5:

Suggestion/Recommendation/Policy------------------33-34

Chapter#6:

References-----------------------------------------------35-38

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Abstract

The main purpose of this research is to find out empirical relation ship among financial development money supply, import and export. For this purpose we use ordinary Least Square (OLS) techniques and take data the time period 1982 to 2010. Result shows money supply and export positively related with financial development while import has negative relationship with financial development.

Key words: FD, Import, Export, M2, OLS (ordinary Least Square)

INTRODUCATION:

Long-term sustainable economic growth depends on the ability to raise the rates of accumulation of physical and human capital, to use the resulting productive assets more efficiently, and to ensure the access of the whole population to these assets. Financial intermediation supports this investment process by mobilizing household and foreign savings for investment by firms; ensuring that these funds are allocated to the most productive use; and spreading risk and providing liquidity so that firms can operate the new capacity efficiently. Financial development thus involves the establishment and expansion of institutions, instruments and markets that support this investment and growth process. Historically the role of banks and non-bank financial intermediaries ranging from pension funds to stock markets, has been to translate household savings into enterprise investment, monitor investments and allocate funds, and to price and spread risk. Yet financial intermediation has strong externalities in this context, which are generally positive (such as information and liquidity provision) but can also be negative in the systemic financial crises which are endemic to market systems. The

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financial development and economic growth has a long run relationship. The subject matter of investigation is focused on cross-sectional difference among variables under investigation and their relative influence on higher (lower) economic growth. The time-series analysis, the subject matter of investigation center around the growth over a time period. The proposition that the change in time warrants a change in variables under investigation may show a positive (negative) influence in the process of financial Development across time period, contributing a positive (negative) change in economic growth or vice versa. The economists proceed in this line to investigate financial development-economic growth nexus (FE) and provide mixed evidence. The panel data analysis based on a theoretical foundation that takes care-of the combined influence of cross-sectional and time-series specifications in empirical testing. Especially the study of FE nexus has to accommodate the existing economic structure and state’s contribution in cross-sectional as well as time-series dimensions and this model may provide a meaningful explanation of FE nexus in the Indian context.

The theoretical argument for linking financial development to growth is that a well-developed financial system performs several critical functions to enhance the efficiency of intermediation by reducing information, transaction, and monitoring costs. A modern financial system promotes investment by identifying and funding good business opportunities, mobilizes savings, monitors the performance of managers, enables the trading, hedging, and diversification of risk, and facilitates the exchange of goods and services. These functions result in a more efficient allocation of resources, in a more rapid accumulation of physical and human capital, and in faster technological progress, which in turn feed economic growth. Most of the literature has mainly focused on the role of macroeconomic stability, inequality, income and wealth, institutional development, ethnic and religious diversity and financial market imperfections. Financial development, however,

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should be thought of as a broader concept that also includes financial innovations that occur outside the banking system. Because of the lack of data regarding non-bank financial innovation in developing countries like Pakistan, the level of financial intermediation effectively measures the degree of financial development by the banking system.

Despite severe challenges, the economy has shown resilience in the outgoing year. Growth in Gross Domestic Product (GDP) for 2009‐10, on an inflation‐adjusted basis, has been recorded at a provisional 4.1%. This compares with GDP growth of 1.2% (revised) in the previous year. For the outgoing year, the Agriculture sector grew an estimated 2%, against a target of 3.8%, and previous year’s growth rate of 4%. While the Crops sub‐sector declined 0.4% over the previous year, Livestock posted a healthy rise of 4.1%. The performance of the Agriculture sector was boosted by the weakening of the El Nino phenomenon, after late winter rains. Industrial output expanded by 4.9%, with Large Scale Manufacturing (LSM) posting a 4.4% rate of growth. The Services sector grew 4.6%, as compared to 1.6% in 2008‐09. Overall, the Commodity Producing Sectors are estimated to have expanded at a 3.6% pace, which represents a significant turnaround from the economic growth rates of the previous two fiscal years.

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A Contribution analysisFor 2009‐10, sect oral contribution to growth was as follows: Services contributed 59% to overall growth in the economy for the year, followed by Industry (30%), and Agriculture (11%). In terms of individual sectors, Manufacturing accounted for 23% of the outgoing year’s overall growth, followed by Wholesale & Retail Trade (21%), and Social & Community Services (19%). Table 1.2 compares the structure of contribution to overall GDP growth for 2009‐10, with the previous Five years. Growth in Agriculture contributed 11% to headline GDP growth for the year, with Industry Accounting for 30%. What stands out from the Table is the consistently high contribution to recent Growth, averaging 62% for the past six years, accounted for by the Services sector. In 2009‐10, the share of services in headline growth was roughly in line with its average, at 59%.

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Another important point to note is the consistently declining contribution of Manufacturing to the headline growth rate. From 30% in 2004‐05, the manufacturing sector’s share in growth has declined to 23% for the outgoing year.

In terms of contribution by expenditure (i.e. the composition of GDP growth), consumption expenditure continued to account for a dominant share in growth, accounting for 96% of GDP growth in 2009‐10. The large weight of private consumption expenditure in GDP was reflected in its share of 81% in the growth for the outgoing year, with general government consumption expenditure accounting for the balance 15%.

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Reflecting the marginal decline in gross fixed investment for the year of ‐0.6%, the share of total investment was a nominal 1% in GDP growth. Adjusting for the assumed contribution of Changes in stocks category, the contribution of gross fixed capital formation (GFCF) was ‐1%. Finally, reflecting the sharp reduction in the external current account deficit, which is projected to decline to less than 2.8

Percent of GDP for 2009‐10 from 5.7 percent the previous year, share of Net Exports was 4%. The stronger pace of economic growth in 2009‐10 has occurred on the back of several favorable, developments, which have included:Developing countries attach great importance to financial sector development and deepening in the pursuit of their poverty reduction goal. By mobilizing savings, facilitating payments and trade of goods and services, and promoting efficient allocation of resources, the financial sector is seen as playing a critical role in

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facilitating economic growth and, directly through broadening access to finance and indirectly through growth, contributing to poverty reduction. Supporting financial sector development has also been a key priority of development assistance in the past several decades. ADB reaffirms financial sector development as one of its core areas of operations in the coming years in support of inclusive and environmentally sustainable growth, regional integration, and poverty eradication in Asia and the Pacific. However, economists’ views on the role of finance in economic development have not always been unanimous. Economists have also debated on the nature of the growth-poverty nexus: whether and to what extent economic growth leads to poverty reduction. Further, there were questions over whether financial sector development can bring direct benefits to the poor. The last 2 decades, however, have seen the emergence of a consensus on the vital importance of financial sector development in facilitating growth and supporting poverty reduction, and this has been backed up by a large body of empirical studies providing evidence of the causal linkages from financial sector development to economic growth and poverty reduction. The main purpose of this paper is to review the literature on the linkages between finance, growth, and poverty reduction, with a view to improving understanding of the rationale for development assistance to support financial sector development in developing countries. One of the important lessons learned from the recent global financial crisis and indeed from many crisis episodes in the past is that the financial sector needs to be adequately regulated and cannot be left entirely to the hands of market forces.

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The impact of financial development on economic growth

According to McKinnon (1973) liberalization of financial markets allows financial deepening which reflects an increasing use of financial intermediation by savers and investors and the monetization of the economy, and allows efficient flow of resources among people and institutions over time. This encourages savings and reduces constraint on capital accumulation and improves allocative efficiency of investment by transferring capital from less productive to more productive sectors. The efficiency as well as the level of investment is thus expected to rise with the financial development that liberalization promotes. These benefits include a decrease in firms’ in self-investment at low and even negative rates of return, allocation of credit by capital markets rather than by public authorities and commercial banks, a shift away from capital-intensive investments due to the higher cost of capital reflecting its scarcity, the lengthening of financial maturities, and the

Elimination of fragmented and inefficient curb markets (Balassa, 1993). Development of the financial system facilitates portfolio diversification for savers reducing risk, and offers more choices to investors increasing returns. Another important function of financial system is to collect and process information on (productivity-enhancing) investment projects in a cost effective manner, which reduces cost of investment for individual investors (King & Levine, 1993b). The productive capacity of the economy is determined by the quality as well as by the quantity of investment and capacity utilization is as important as the installed capacity. Easing credit constraint, particularly working capital, is expected to improve the efficiency of resource allocation and thereby reduce the gap between actual and potential output. This

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new model is not clear about what institutional forms should in fact replace the previous system, which was clearly inefficient but did directly support strategic investment and growth objectives. In fact, financial systems serve five broad functions. First, they produce information ex ante about possible investments. Second, they mobilize and pool savings and allocate capital. Third, they monitor investments and exert corporate governance after providing finance. Fourth, they facilitate the trading, diversification and management of risk. Fifth, they ease the exchange of goods and services. While all financial systems provide these financial functions, and each of these functions can be expected to have an impact on economic growth, there are large differences in how well they are provided. There are three basic characteristics of financial systems that are now regarded as capturing the impact of these five functions on economic growth: (i) the level of financial intermediation; (ii) the efficiency of financial intermediation; and (iii) the composition of financial intermediation. First, the level of financial intermediation: the size of financial systems relative to an economy is important for each of the functions listed above. A larger financial system allows the exploitation of economies of scale, as there are significant fixed costs in the operation of financial intermediaries. As more individuals join financial intermediaries, the latter can produce better information with positive implications (an externalities) for growth, a channel emphasized in some of the earlier theoretical models of the finance- growth literature (e.g. Greenwood & Jovanovic, 1990: Bencivenga & Smith (1991). A larger financial system can also ease credit constraints: the greater the ability of firms to borrow, the more likely that profitable investment opportunities will not be by-passed because of credit rationing.

A large financial system should also be more effective at allocating capital and monitoring the use of funds as there are significant economies of scale in this function. Greater availability of financing can also increase the resilience of the economy to

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external shocks, helping to smooth consumption and investment patterns. More generally, a financial system plays an important function in transforming and reallocating risk in an economy. Besides cross-sectional risk diversification, a larger financial system may improve intertemporal risk sharing (Allen & Gale, 1997). By expanding a financial system to more individuals there will be a better allocation of risks, which can in turn boost investment activity in both physical and human capital, leading to higher growth rates.

Econometrics analysis is heavily used to find out the empirical evidence between financial development and economic growth. Financial development is required, which affects significantly and strongly correlated with social infrastructure, gross physical capital formation and growth. The merits of bank based v/s market based financial system have long debate over the history of many decades but there is no consensus at empirical as well as theoretical level of this debate. Analysis shows that the superiority of one type of financial model over the other. The banks based financial system and market based financial system and recommended an overall financial service that can be important to support economic activity. The complementarities between bank based financial system and market based financial system. The theoretical debate about the financial structure cumulative into four views of different economists such as bank based financial system, market based financial system, the law and finance and the financial service. However, “it is very difficult to draw broad conclusions about bank-based and market-based financial systems from only four countries”. They argue that the empirical appraisal of the role of financial structure should be based on wide dataset that include wide-ranging national experiences.

Financial development and trade openness policies reduce inefficiency in the production process and positively influence

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economic growth. This argument is strengthened by the fact that growth rates in countries with trade openness and financial policies outperform those with restrictive financial and trade policies. The existence of a correlation between financial development and economic growth has been documented in a number of empirical studies starting with (Fatih Yucel , Goldsmith. Financial development increases the macroeconomic instability, thereby having a negative effect on economic growth.

Financial development follows economic development. Economic growth causes financial institutions to change and develop and financial as well as credit markets to grow. Financial development is thus demand-driven. In this view, the lack of financial development is simply a manifestation of the lack of demand for financial system. The demand for kinds of financial services rises thus will be met by financial sector, as the real sectors of the economy grow. Therefore financial development follows economic growth. Financial development is a determinant of economic growth. The line of causation runs from financial development to real development, where financial development, of course, are only one among the many growth-inducing factors, some of them necessary and some of them sufficient. In this point, services provided by the financial system are base for economic growth. As the Financial system develops then quantity and quality of investment, thus, will be one of special determinant of economic growth. Financial development may at least occasionally and in the short run-turn out to be an impediment to economic growth. As in hypothesis third, the line of causation runs from financial development to real development, but the focus lies on potentially destabilizing effects of financial overtrading and crises rather than on the smooth functioning of the financial system. This view conceives the financial system as inherently unstable.

The financial development and trade openness policies reduce the distortions in the production process and positively influence

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GDP growth. This argument is empirically proved because the countries with highly developed financial sector and open trade policies have shown greater GDP growth rate as compare to the countries who have restrictive financial and trade policies. The studies(Rao Muhammad Atif , Abida Jadoon, Khalid Zaman1, Aisha Ismail, Rabia Seemab, 1980 to 2009) concludes that the trade liberalization and financial development both have significant and positive relationship with growth. further added that financial liberalizations can contribute to economic growth in a country in the financial markets encourages the small savers to pool funds and it can encourage saving by providing a wider range of saving drives. As financial Development increases the saving rate therefore it leads to efficient allocation of capital , financial sector development redirect the credit from slow growing /less efficient sector of fast growing/efficient sector, trade liberalizations can improve indigenous technology which will lead to more efficient production function, and hence productivity will rise. the relationship between GDP growth and trade openness by emphasizing that the trade liberalizations may offer a greater access to capital goods. Openness reduces the hindrances to international trade and such countries can experience competitively higher GDP growth rate. It is commonly believed that an open trade regime is imperative for economic development.

The nexus between finance growth and poverty ensures that an efficient financial system certainly encourage investment by identifying and funding adequate business opportunities, mobilizing savings, diversifying and reducing risks, facilitating exchange of goods and services, and so forth. The system certainly helps enhancing optimal allocation of resources and hence, contributes to economic growth in the development process. It is, however, hypothesized, that finance-growth nexus could have considerable effect on poverty reduction. India, the second most populated country of above 1.3 billion, has emerged

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as one of the fastest growing economies and ten most emerging industrialized nations in the world. With the GDP growth of 7.5 % per annum, India stands second after China. Its current per capita GDP is about US$ 1154 and is recognized as fourth largest economy in terms of PPP. The country is now very popular for its rapidly growing consumer market and financial market and has developed as one of the largest cost competitiveness technical workforce nation with large pool of skilled manpower like manager, engineer, etc. Its comparative advantage in the world market has drastically changed because of various factors like high economic growth, financial sectors development and changing technology. On the contrary, India is also low performer in various other aspects like poverty alleviation, regional disparities, public delivery, accountability and infrastructural deficiency.

The relationship between the stock market development and economic growth provided empirical evidence on the major theoretical debates about the linkages between stock markets and long-run economic growth using data on 41 countries from 1976 to 1993. Their result showed that stock market liquidity is positively and significantly correlated to current and future rates of economic growth, capital accumulation, and productivity improvements, even after controlling for economic, political and other factors. The main question is: Does Euronext stock market affects European countries’ economic growth? According to what has been found in the literature, we can answer by positive correlation between financial stock market and economic growth measures by GDP and FDI (Ake Boubakari ) measure stock market development along various dimensions: aggregate stock market capitalization to GDP and the number of listed firms , domestic turnover and value traded (liquidity), integration with world capital markets, and the standard deviation of monthly stock returns (volatility). The results provide a strong and significant relationship between stock market development and economic

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growth. Numerous studies have been analyzing the role of stock markets in economic growth; most of them have focused on individual stock market, and some on merged market. The financial stock market facilitates higher investments and the allocation of capital, and indirectly the economic growth. Sometimes investors avoid investing directly to the companies because they cannot easily withdraw their money whenever they want. But through the financial stock market, they can buy and sell stocks quickly with more independence. stock markets development along with different magnitude and have suggested strong statistically significant relationship between initial stock market development and subsequent economic growth. An efficient stock market contributes to attract more investment by financing productive projects that lead to economic growth, mobilize domestic savings, allocate capital proficiency, reduce risk by diversifying, and facilitate exchange of goods and services. Stock market liquidity is still a reliable indicator of future long-term growth the financial system has a significant role and provides an important contribution to economic growth.

Even though a growing body of work reflects the close relationship between financial development and economic growth it is possible to encounter especially empirical researches (Erdal Güryay evidencing all possibilities as positive, negative, no association or negligible relationships. In this respect, the main aim of this study is to determine the relationship between financial development and economic growth in Northern Cyprus by conducting empirical analysis. The first, testing the relationship between economic growth and financial development, frequently adopts a single measure of financial development and tests the hypothesis on a number of countries.Although it is common to consider cross-country regression to judge the growth effects of financial development, it is also important to study individual-country evidence at least at a simple level. For this purpose, out of several indicators of financial development, DEP, which is the ratio of’ deposits’ to’GDP’ and LOA, which is the ratio of’ loans’ to’GDP’ are seems most

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appropriate since they have been used widely as a prime indicator of financial development and data for it are relatively more Plentiful. The fundamental question in the relevant empirical literature is: does financial development or trade causes economic growth or is financial development or increase in trade an engine of growth for an economy? One crucial factor that has begun to receive considerable attention more recently is the role of financial market and banking sector in the development of growth process. The nexus between economic growth and financial development has been conducted on number of divergent lines. After the extensive studies in this field, it is now well recognized that financial development is a crucial factor for economic growth as it is a necessary condition for achieving a high rate of economic growth and has a strong positive relationship with economic growth. Financial development and trade openness these two factors are identified as macroeconomic variables as being highly correlated with economic growth performance across countries in the empirical growth literature (Beck, 2002). The other empirical studies in the literature also searched the channels based on the relationship between financial development and trade openness affecting economic growth. 7) Incorporates financial sector into the Heckscher-Ohlin trade model and show that financial sector development gives countries a comparative advantage in industries that rely more on external financing. Additionally, Baldwin (1989) points out that financial markets are a source of comparative advantage financial sector follows rather than leads the development of the real sector due to the fact that the specialization of countries in particular industries would create a demand for a well-developed financial sector and secondly, tests the direction of causality between these three variables based on the supply-leading, the Demand-following and trade-led hypotheses for the Indian economy.

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Economic Growth during 2009-2010 of India

Financial sector had gone under large transformation in many countries of the world. Deregulation, privatization and openness had brought revolution in this sector. This resulted in many findings related to importance of financial sector developments in prompting the economic development of a nation. It is true that a

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well-developed, efficient, organized and viable financial system is a necessary condition for the economic development in any economy. The financial sector occupied a crucial place in performing the development activities and acted as a catalyst to economic growth. Countries with developed banking sector and dynamic stock markets grew faster over the period compared with the countries had lagged financial system(Sofia Anwar).The effects of technological changes had expanded firm’s financial demand and these changes had increased requirements for financial intermediaries. Financial Intermediaries allocated funds to those projects where the marginal productivity of capital was maximum, thus financial sector caused the economic growth by increasing the productivity of capital. Development of the banking sector and the stock market were highly correlated with the economic development and both sectors exerted an important impact on development of a country (Ghulam Shabi). Further, the financial sector played a very important role in mobilizing and better utilization of saving . Financial sector utilized these resources to increase capital formation through the provision of a wide range of financial tools to meet different requirements of borrowers and lenders. The financial sector of Pakistan also witnessed revolutionary changes. A broad based program of reforms was launched since 1990s but the pace of these reforms increased manifold since 2000. The banking sector in Pakistan had been transformed from a sluggish state- owned sector to a dynamic private sector. The State Bank of Pakistan took a number of steps to further enhance the pace of this transformation process of the development of financial sector in the country.

CURRENT SENIRO

Economic Growth in PakistanPakistan’s economy is facing numerous challenges, including twin deficits - current account deficit and fiscal deficit - as well as stagnant exports, tax revenues and almost a halted privatization process. Inflation is another big challenge for the upcoming economic managers and

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improving the supply side coupled with better management can reduce woes on this front. Pakistan is an agricultural country as 75% of its population relies on agriculture. Remaining 25% are workers, industrialists, government officials etc. Currently government is trying to improve the system of tax collection. As far as local industry’s production is concern, it is struggling due to several reasons. The main reason behind it is current energy crisis in Pakistan. Due to this crisis local products are very expensive. This created a big gap for countries like China who are capable of taking full advantage of this gap. Due to the increase in prices inflation rate is increasing. This results in the form of currency devaluation. One would say that, currency devaluation would result in increase the export and exporter would earn more revenue. There is another threat to its economy that is ‘terrorism’. It is preventing foreign investors from investing in Pakistan which is slowing down the economy’s growth. This threat is also affecting one more area which is ‘tourism’. Pakistan has a lot of potential in tourism department but, it is lagging behind due to this threat. This threat is not limited to Pakistan. It has struck its neighboring country Afghanistan. Afghanistan has no infrastructure. There is a lot of development going on in there. This is a very good opportunity for Pakistan’s economy.

1. Trade Gape The amount by which the value of a country's visible imports exceeds that of visible exports; an unfavorable balance of trade

2. Budget A budget is generally a list of all planned expenses and revenues. It is a plan for saving and spending.

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Quality budget

i. Revenue surplusii It should be balancediii. It should create environment for growth and

developmentiv. The budget should conciliate for macroeconomics

fundamental.v. As for as budget should be possible.

3. Low Tax In Pakistan agriculture has been given a lot of benefits including tax remittance. So 75% of the population does not pay tax. From remaining 25% majority has monthly income less than applicable to tax payment. So government has very little collection of revenue in order to cater the problems of its population. Direct tax of our country is 10% but it should be 15%-16%.

Low Productivity

There are 45 million people are workforce out of 45 million people only 15% is in agriculture but it should be 23% percent this low rate of use work force is called low productivity.

5. Low Participation Rate 35% people are not playing role in economy and women participation rate is minimum. The reason of minimum participation of women is

Higher population of children Custom and tradition does not allow to work The dependency of single person

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Scope of study

The goals of financial structure analysis and development assessment for a country are to (a) assess the current provision of financial services, (b) analyze the factors behind missing or underdeveloped services and markets, and (c) identify the obstacles to the efficient and effective provision of a broad range of financial services. The dimensions along which service provision must be assessed include the range, scale (depth) and reach (breadth or penetration), and the cost and quality of financial services provided to the economy. At a high level of abstraction, those services are usually classified as including the following:

• Making payments

• Mobilizing savings

• Allocating capital funds

• Monitoring users of funds

• Transforming risk

Thus, the ideal financial system will provide, for example, reliable and inexpensive money transfer within the country, reaching remote areas and poor households. There will be remunerative deposit facilities and other investment opportunities offering liquidity and a reasonable risk-return tradeoff. Entrepreneurs will have access to a range of sources for funds for their working- and fixed-capital formation; affordable mortgage and consumer finance will be available to households. The credit renewal decisions of banks and the market signals coming from organized markets in traded securities will help ensure that good use continues to be made of inevitable funds. Insurance intermediaries and the portfolio possibilities offered by liquid

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securities markets will help maximize the risk pooling and the shifting of risk at a Reasonable price to entities that are able and willing to absorb it.

The scope of financial structure analysis and of development assessment is fairly extensive—as illustrated in the above list—and those structural issues cannot be simply broken into self-contained segments corresponding to existing institutional arrangements.

Structural and development issues arise across the entire spectrum of financial markets and intermediaries, including banking, insurance, securities markets, and non bank intermediation. They often demand consideration of factors for which well-adapted and standardized quantification is not readily available. Therefore, the challenge is to translate those wide-ranging and somewhat abstract concepts into a concrete and practical assessment methodology.

LITERTURE REVIEW

The paper examines the causality relations between financial development, import export and economic growth (GDP) of pakistan. financial development and economic growth and trade openness to the Turkish economy in the period from 1989M1-2007M11 Although the Turkish economy downturn was due to the major crises (in 1994 and 2001) significant improvements have been appearing in the Turkish economy after crises and earthquakes due to the applied economic policies. These policies have positive effect on financial system and trade. It means that economic policies that affect financial development and trade openness will have positive impact on GDP. Turkish financial and banking regulations have been overhauled since 1990s, partly in response to the crisis. Improvements of financial system have a

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positive effect on GDP. The economy shows that economic policies objective at financial development and trade openness have a statistically significant impact on economic growth and also this policies reduce inefficiency in the production process and positively influence economic growth. Financial development follows economic development. Economic growth causes financial institutions to change and develop and financial as well as credit markets to grow. Financial development is thus demand-driven.

The trade liberalization and financial development both have positive relationship with economic growth. Financial liberalizations can contribute to economic growth in a country in the financial markets encourages the small savers to save his funds and it can encourage saving by providing a spread range of saving drives. As financial Development increases the saving rate therefore it leads to efficient allocation of capital , financial sector development redirect the credit from slow growing /less efficient sector of fast growing/efficient sector, trade liberalizations can improve originating technology which will lead to more to increase production function, and increase the productivity. The relationship between GDP growth and trade openness by emphasizing that the trade liberalizations may offer a greater access to capital goods. Openness reduces the difficulties to international trade and such countries can experience competitively higher GDP growth rate. Trade openness and financial development both increases economic growth by almost 0.453% and 1.657% respectively. It is manifest that economic growth is sensitive to changes both trade and financial liberalization policies

Economic growth is very responsible for financial development and both have substantial contribution to poverty reduction in the economy. The study of Mr. Rudra P. Pradhan is show India, the second most populated country of above 1.3 billion, has emerged as one of the fastest growing economies and ten most emerging

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industrialized nations in the world. With the GDP growth of 7.5 % per annum, India stands second after China. Its current per capita GDP is about US$ 1154 and is recognized as fourth largest economy in terms of PPP. The country is now very popular for its rapidly growing consumer market and financial market and has developed as one of the largest cost competitiveness technical workforce nation with large pool of skilled manpower like manager, engineer, etc.

It detects the unidirectional causality from poverty reduction to economic growth, economic growth to finance development, economic growth to poverty reduction, and financial development to poverty reduction. It also finds no causality between finance development and economic growth and poverty reduction to finance development. To conclude, an enhanced economic growth is very responsible for financial development and both have substantial contribution to poverty reduction in the economy.

Ake Boubakari explored bi-directional causality test between financial development and economic growth they found that the financial stock market affects economic growth. stock market liquidity is positively and significantly correlated to current and future rates of economic growth, capital accumulation, and productivity improvements, even after controlling for economic, political and other factors. Stock market development along various dimensions: aggregate stock market capitalization to GDP and the number of listed firms (size), domestic turnover and value traded (liquidity), integration with world capital markets, and the standard deviation of monthly stock returns (volatility).The literature makes a modest contribution on the role of stock market development on economic growth in some Euronext countries for the period from 1995:Q1 – 2008:Q4. The results of the study suggest that the stock market growth and economic growth have long-run relationship. The causality has been observed only in the countries where the stock market in

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significantly active and highly liquid. More precisely, the causality runs from stock market proxies to economic growth shows a significant relation between market capitalization, total trade value and turnover ratio on the GDP and FDI. The funds raised by the corporate from the financial markets during the study period thus played an important role for the appreciable growth registered by the Euronext countries economy.

This literature emphasis that possible co-integration and the direction of causality between financial development, international trade and economic growth in India. And data collect from 1965-2004 period have been used a possible co-integration and the direction of causality between financial development, international trade and economic growth in India using annual data that covers the period 1965-2004. There is long run equilibrium relationship

between financial development, international trade and real

income growth in the case of India. Growth in real income leads to

growth in international trade sector, namely exports and imports.

Thus, there is unidirectional causation that runs from real income

growth to international trade growth. On the other hand,

bidirectional causality has been obtained between real income

growth and financial development measures, namely M2 and

domestic credits. The trade-led growth (TLG) hypothesis fails to

produce conclusive findings. The new trade theory has

contributed to the theoretical relationship between exports and

growth regarding effects on technical efficiency. Show that

expansion of international trade increases growth by increasing

the number of specialized production inputs.

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The study evaluates the role of financial sector in sustainable

economic development of Pakistan. The main objectives of the

study are to analyze the long run relationship between financial

sector development and sustainable economic development and

also to determine the direction of causality between financial

sector indicators and sustainable economic development. A stable

co integration relationship is found among the variables and Error

Correction coefficient is also found statistically significant. It

indicates that there is a stable long run relationship between

financial sector and economic development. Short run results

indicate that the lagged values of external debt to exports ratio

with direct relationship are accumulating the external debt to

exports ratio.

Objective

The main objective of this research is to examine the empirical

relationship among the financial development, money supply,

import, export.

Is financial development and explained by import export and

money supply? This research examine to trade liberalization

increase financial development and economic growth of Pakistan.

Model

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FD=α+β1M2+β2Imp+ β3Exp+ µ

Dependent variable

FD= Financial Development =money supply/GDP

Independent Variable

M2=Money supplyImp=ImportExp=Exportµ= error term

Data of research

Years GDP M2 M2/GDP Export Import TL

1982 30725972228 1.32233E+11 4.303606702 3419646277 6721839747 3419646278

1983 28691890865 1.59882E+11 5.572361918 3448628398 6607694676 3448628398

1984 31151825048 1.67312E+11 5.370866707 3246343733 7355744359 3246343733

1985 31144920867 1.91985E+11 6.164250692 3796228356 7090127077 3796228356

1986 31899072715 2.22842E+11 6.985855106 4414017834 7200329462 4414017834

1987 33351526336 2.59396E+11 7.777644039 5227069419 7570955417 5227069419

1988 38472741071 2.79378E+11 7.2616999 5576987106 8623660011 5576987106

1989 40171021120 3.00054E+11 7.46941431 6216942715 9112947789 6216942715

1990 40010425587 3.34991E+11 8.372600268 77254439991020536673

4 7725444000

1991 45451961234 3.98453E+11 8.766466599 84427385011099745878

5 8442738501

1992 48635242274 5.15202E+11 10.59318461 83943051171239996106

6 8394305117

1993 51478354558 6.08626E+11 11.82294977 84497781211201866135

4 8449778121

1994 51894795658 7.14348E+11 13.76531097 1.0132E+101188475929

7 10132269179

1995 60636071684 8.12998E+11 13.40782767 1.0703E+101418529507

8 10703072794

30

1996 63320170084 9.76155E+11 15.41617779 1.0041E+101562252917

5 10040500611

1997 62433340468 1.17053E+12 18.74839615 1.0252E+101340845110

0 10252214044

1998 62191955814 1.26252E+12 20.30039068 96686905141209500000

0 9668690514

1999 62973855719 1.31699E+12 20.91326607 99401787871166600000

0 9940178787

2000 73952374970 1.31699E+12 17.80860994 1.06E+101214800000

0 10600274820

2001 72309738921 1.65013E+12 22.82024558 1.1008E+101207100000

0 11007713544

2002 72306820396 1.928E+12 26.66408216 1.3918E+101266900000

0 13917671163

2003 83244801093 2.26616E+12 27.22288203 1.535E+101527200000

0 15350078166

2004 97977766198 2.73105E+12 27.87421173 1.7196E+102202600000

0 17195686994

2005 1.096E+11 3.18252E+12 29.03754562 1.9422E+102928120000

0 19422312204

2006 1.275E+11 3.64705E+12 28.6042902 2.0315E+103511448000

0 20315335573

2007 1.43171E+11 4.35769E+12 30.43688625 2.1064E+103758610000

0 21063909786

2008 1.63892E+11 0 2.0805E+104793300000

0 20805429029

2009 1.6199E+11 0 3500800000

0 0.216112137

EVIEWS RESULTS

Dependent Variable: M2_GDP

Method: Least Squares

Date: 04/12/11 Time: 18:40

Sample (adjusted): 1982 2007

Included observations: 26 after adjustments

Variable Coefficient Std. Error t-Statistic Prob.

31

M2 7.05E-12 1.09E-12 6.492825 0.01

IMPORT -8.76E-10 1.07E-10 -8.14792 0.03

EXPORT 1.33E-09 2.15E-10 6.184149 0.2

C 6.130825 1.197605 5.119238 0.1

R-squared 0.974564 Mean dependent var 15.5185

Adjusted R-squared 0.971096 S.D. dependent var 8.796311

S.E. of regression 1.495488 Akaike info criterion 3.78342

Sum squared resid 49.20264 Schwarz criterion 3.976974

Log likelihood -45.18446 F-statistic 280.973

Durbin-Watson stat 2.93343 Prob(F-statistic) 0

Data sources

32

The data were taken from the IFS (International Financial Statistics), the WDI (World Development Indicators) and the Economic Survey of Pakistan (2010-2011) for the period 1980-2009.

Hypothesis

Ho: Null hypothesis

Financial Development insignificantly impact on trade liberalization

H1: Alternative Hypothesis

Financial development significantly impact on trade liberalization

Research Methodology:

ORDINARY LEAST SQUARES (OLS)

33

In statistics and econometrics, ordinary least squares

(OLS) or linear least squares is a method for estimating the

unknown parameters in a linear regression model. This method

minimizes the sum of squared vertical distances between the

observed responses in the dataset, and the responses predicted

by the linear approximation. The resulting estimator can be

expressed by a simple formula, especially in the case of a single

repressor on the right-hand side.

The OLS estimator is consistent when the regressors

are exogenous and there is no multicollinearity, and optimal in

the class of linear unbiased estimators when

the errors are homoscedastic and serially uncorrelated. OLS can

be derived as a maximum likelihood estimator under the

assumption that the errors are normally distributed, however the

method has good statistical properties for a much broader class of

distributions (except for efficiency).

Multicollinearity

Multicollinearity is a statistical phenomenon in which two or more

predictor variables in a multiple regression model are highly

34

correlated. In this situation the coefficient estimates may change

erratically in response to small changes in the model or the data.

Multicollinearity does not reduce the predictive power or reliability

of the model as a whole, at least within the sample data

themselves; it only affects calculations regarding individual

predictors. That is, a multiple regression model with correlated

predictors can indicate how well the entire bundle of predictors

predicts the outcome variable, but it may not give valid results

about any individual predictor, or about which predictors are

redundant with respect to others.

Autocorrelation

Autocorrelation is the cross-correlation of a signal with itself.

Informally, it is the similarity between observations as a function

of the time separation between them. It is a mathematical tool for

finding repeating patterns, such as the presence of a periodic

signal which has been buried under noise, or identifying the

missing fundamental frequency in a signal implied by its harmonic

frequencies. It is often used in signal processing for analyzing

functions or series of values, such as time domain signals.

35

Heteroscedastic

In statistics, a sequence of random variables is heteroscedastic,

or heteroskedastic, if the random variables have different

variances. The term means "differing variance" and comes from

the Greek "hetero" ('different') and "skedasis" ('dispersion'). In

contrast, a sequence of random variables is called homoscedastic

if it has constant variance.

Suppose there is a sequence of random variables {Yt}t=1n and a

sequence of vectors of random variables, {Xt}t=1n. In dealing

with conditional expectations of Yt given Xt, the sequence

{Yt}t=1n is said to be heteroskedastic if the conditional variance

of Yt given Xt, changes with t. Some authors refer to this as

conditional heteroscedasticity to emphasize the fact that it is the

sequence of conditional variance that changes and not the

unconditional variance. In fact it is possible to observe conditional

heteroscedasticity even when dealing with a sequence of

36

unconditional homoscedastic random variables, however, the

opposite does not hold.

When using some statistical techniques, such as ordinary least

squares (OLS), a number of assumptions are typically made. One

of these is that the error term has a constant variance. This might

not be true even if the error term is assumed to be drawn from

identical distributions.

Result of the Model

FD and M2

1% increase in M2 leads to 7.05% increase in FD

t = 6.4 significant p = 0.1

FD and Import

1% increase in import leads to 8.76% decrease in FD

T= 1.07 p=0.3

FD and Export

1% increase in Export leads to 1.33% increase in FD

P=0.1 is less then R=0.97

Over all models is significant F value 280.973 D value of the model.

37

We check following diagrammatic test:

Multicollinearity:

Individual t values correlation among independent variable and

find low correlation while overall R2 is greater 0.97.in this model

there is no any Multicollinearity.

Auto correlation:

Durbin Watson value is 2.9 that show the no Auto correlation in our model.

Conclusion:

In this research M2 and export positively increase FD by 7.05 and 1.33% and import decline FD by 8.76%.our result an empirical significant .FD significant impact on economy growth that declining import we should increase in export to increase financial development. The analysis demonstrates that in the long-run, trade openness Trade Liberalization, Financial Development and Economic Growth: Evidence from Pakistan (1980-2009 35Journal of International Academic Research (2010) Vol.10, No.2. 31 August 2010 and financial development both increases economic growth by almost 0.453% and 1.657% respectively. While in the short-run, the results indicate directional causality between trade openness (TOP) to Granger-caused economic growth (GDP) and M2 Granger-caused GDP. It is manifest that economic growth is sensitive to changes both trade and financial liberalization policies. Therefore, the government should realize effective macro-economic policies along with momentous improvements in

38

the structure and functioning systems of governance for stabilizing economic growth along with trade and financial liberalization reforms. Based on the above findings we can derive some important policy implication.• If policy-makers want to promote growth, then attention should

be focused on long run policies, for example, the creation of

modern financial

Institutions, in the banking sector and the stock markets.

• The financial markets affect the cost of external finance to the

firm and,

Therefore, their effects should be materialize through facilitating

the

Investment process.

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