The role of CO2 emissions, exchange rate and foreign direct investment on trade balance in Pakistan : an ARDL approach

Abstract

The external sector stability and economic development hinges upon international trade, especially in developing countries like Pakistan. Despite its strategic significance, Pakistan has faced continuous trade deficits for decades and has worried about the foreign exchange reserves, external debt build-up and long-term economic performance. This study focuses on the effects of CO2 emissions, exchange rate fluctuations and foreign direct investment (FDI) on Pakistan's trade balance for the time period 1970-2024. The theoretical framework of the study is based in the theory of international trade and the Marshall-Lerner rule. Annual time-series data from World Bank's World Development Indicators (WDI) database are used. The bounds testing method of the Auto-regressive Distributed Lag (ARDL) is used to examine the short run dynamics and longer run relationships between the variables. External balance of goods and services in percentage of GDP is measured as trade balance. The results of the ARDL bounds test confirm the presence of a long-run relationship between trade balance, CO2 emissions, exchange rate and FDI. The long run analysis shows that there is a positive and significant relationship between the CO2 emissions and trade balance, indicating that Pakistan's export performance is still significantly related to carbon-intensive industrial production. It is observed that the depreciation of exchange rate has negative impact on trade balance in long run, which reflects Pakistan's structural dependency on using energy, machinery and raw materials from outside the country. In the long run, FDI inflows are shown to have a negative impact on trade balance, perhaps because of the import of capital goods and machinery used in the foreign investment activity. The error correction model confirms an adjustment mechanism that is relatively stable and in which about 28.5% of short-run disequilibrium is corrected each year. The serial correlation, heteroskedasticity and non-normality tests are satisfied by all the diagnostic tests and the CUSUM stability tests indicate stability of the parameters over the sample period. The results reveal that the control of carbon-intensive production and exchange rate policy and the share of foreign investment in the total investment portfolio are key determinants for improving the performance of the external sector of the economy in Pakistan.