vulnerabilities of developing countries to ......economic characteristics of countries. mercantilist...

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International Journal of Management (IJM) Volume 11, Issue 8, August 2020, pp. 646-659, Article ID: IJM_11_08_059

Available online at http://www.iaeme.com/IJM/issues.asp?JType=IJM&VType=11&IType=8

ISSN Print: 0976-6502 and ISSN Online: 0976-6510

DOI: 10.34218/IJM.11.8.2020.059

© IAEME Publication Scopus Indexed

VULNERABILITIES OF DEVELOPING

COUNTRIES TO FOREIGN EXCHANGE

RESERVES AND REMITTANCES: A CASE

STUDY OF PAKISTAN ECONOMY

Ishtiaq Ahmad

Assistant Professor, Department of Economics

The Islamia University of Bahawalpur, Pakistan

Ali Azam

Assistant Professor, Department of Economics

The Islamia University of Bahawalpur, Pakistan

Khawaja Asif Mehmood*

Lecturer School of Economics

Bahauddin Zakariya University Multan, Pakistan

Muhammad Zahir Faridi

Professor School of Economics


Muhammad Aurmaghan

PhD Scholar School of Economics


* Corresponding Author

ABSTRACT

Pakistan is found vulnerable to foreign exchange reserves’ crises which require

investigation. This study hypothesizes vital role of exporting underutilized surplus

labour for such vulnerabilities. In view of limited available evidence which lacks

recent developments in data and empirical methodologies this study attempts to

contribute by investigating the role of remittances in demand for foreign exchange

reserves. Annual timeseries data from 1980 to 2016 is employed. Chow breakpoint test

and dynamic OLS (DOLS) is applied to explore structural break and long run

relationship. Structural break is the core characteristic of the data and cointegration

among the variables is only established in the presence of structural break. Sensitivity

of parameters to direction of relationship and statistical significance is also observed

Vulnerabilities of Developing Countries to Foreign Exchange Reserves and Remittances:

A Case Study of Pakistan Economy


in alternative modelling. Robust evidence in case of remittance is concluded. It is

suggested that underutilized surplus human resources could play a vital role for

vulnerabilities of foreign exchange reserves.

JEL Classifications: F24; F41; C82; C82; C51; and O11

Key words: Remittances; International Reserves; Structural Break; Chow Breakpoint

Test, Dynamic OLS; and Economic Development

Cite this Article: Ishtiaq Ahmad, Ali Azam, Khawaja Asif Mehmood, Muhammad

Zahir Faridi and Muhammad Aurmaghan, Vulnerabilities of Developing Countries to

Foreign Exchange Reserves and Remittances: A Case Study of Pakistan Economy,

International Journal of Management, 11(8), 2020, pp. 646-659.

http://www.iaeme.com/IJM/issues.asp?JType=IJM&VType=11&IType=8

1. INTRODUCTION

Pakistan came into being in 1947 and since independence its economy is striving hard to

survive on global map. Average growth rate of the economy is five percent which could be

termed satisfactory. However, an important issue to be faced by the economy is volatility in

economic performance. From 1947 to 2019 there are about seven decades and the economy is

constantly facing decade vise ups and down. Decades of sixties and eighties along with early

six years of twenty first century could be termed as high growth era while remaining time was

showing lower pace of growth. The volatility could be observed in all the spheres of

economic environment. In decades of high growth, it looks that the economy is in a position

to take off on the path of development. But on account of some internal or external shocks the

economy again fell into the eras of low economic growth. Inception of Bangladesh and

increased inequality in seventies, end of Afghan war and internal political crises in nineties

and increased level of terrorism and oil price shock after two thousand six are some of the

highlighted events which affected economic performance of the country adversely. It points

out that in presence of volatility the average level of five percent growth is unable to place the

economy on development trajectory. Pakistan economy is found to be vulnerable to the

internal or external shocks.

The vulnerability of developing countries like Pakistan is more obvious to the external

shocks of global business cycles, oil prices, financial crises, and exchange rate instabilities.

These vulnerabilities are easily observable in presence of optimal level relating to foreign

exchange reserves. Optimal level of reserves was treated differently in Pakistan before start of

twenty first century and it was believed that three months import bills were sufficient as an

optimal level. But afterwards this level was increased up to seven months import bill.

Historically it could be observed that in different points of time Pakistan was even unable to

sustain the optimal level of foreign exchange reserves and was constrained to go to IMF for

survival. From Figure 1 it is crystal clear that in different years (1980, 1989, 1991, 1996,

1998, 2001, 2007, 2013 and 2018) Pakistan economy is found to be vulnerable in terms of

foreign exchange reserves. What are the factors behind foreign exchange reserves’

vulnerability? Which factors are helpful to control the vulnerability? And which factors are

responsible to aggravate the vulnerability? These questions are vital for developing economies

like Pakistan.

Ishtiaq Ahmad, Ali Azam, Khawaja Asif Mehmood, Muhammad Zahir Faridi and Muhammad Aurmaghan


1980 1985 1990 1995 2000 2005 2010 2015

RESMG

Figure 1 Foreign Exchange Reserves in Pakistan 1980 to 2018

Most of the research exploring the factors affecting exchange reserves’ vulnerability

relates to developing and emerging economies. In case of developed World, the issue is not

that of vulnerability of foreign exchange reserves but the issue is that of exploring the optimal

level of foreign reserves in perspective of cost and benefit analysis. In either case theory

behind research exploring the factors affecting foreign exchange reserves is the demand for

international reserves. Two main determinants of demand for international reserves are the

monetary factors and macroeconomic factors (Benecka & Komarek, 2018). Most of the

research in developing countries on demand for international reserves takes into consideration

balance of payments’ variability, exchange rates, trade openness, financial openness, imports,

imports’ elasticity, growth rates, currency crisis and exchange rate regimes as major

determinants of international reserves. Very limited evidence is available for remittances as a

determinant of demand for reserves. This study attempts to explore the determinants of

demand for reserves and specifically hypothesizes that remittances could play a vital role for

controlling the vulnerability of foreign exchange reserves.

Most of the developing countries are abundant in human resources. Pakistan is also rich in

human resources. Population in Pakistan is about 213 million which is sixth largest in the

World. Population growth rate is 2.4 percent which is worrying. Labour force is ninth largest

in the World. Labour force participation rate is nearly 31 percent. Labour productivity growth

rate is lowest in the South Asian region. On the whole Pakistan is rich in labour but labour

development is poor. Respectable apex courts in view of alarming state of demography in

Pakistan in a Sue Moto case considers it a serious human rights’ issue and constitutes a task

force to suggest suitable solution of demographic problem. Although population is a problem

and to control population is necessary for development but existing population is the resource.

In economics full and efficient use of resources is the guaranty for economic growth. Hence,

solution of demographic problems is two directional; in one wary it is necessary to focus the

measures for controlling the population and in other way it is required to use existing human

resources efficiently. In this perspective basic target is full and efficient utilization of human

resources. Indigenously enhanced employment opportunities in nonfarm sectors and

externally projected export of human resources to rest of the World will be helpful for

resolving problems of existing human resources. Under this approach most important factor is

the skill development. Active vocational training centers in Pakistan and energetic embassies

in the World, for absorption of Pakistani workforce could easily achieve these targets at least

cost. In these circumstances this study suggests that unemployed and underemployed labour




force in Pakistan could be utilized for resolving the balance of payments’ crises by exporting

the human resources.

It is hypothesized in this study that remittances could play a positive role for foreign

exchange reserves’ crises in Pakistan. Contributions of this study is to extend the literature on

this topic, focusing on country specific factors instead of cross-country evidence or

comparative study for competing models, utilizing latest data and analyzing the data with

most suitable techniques for estimation. This study includes five sections in the followings;

introduction, survey of literature, data and methodology, results and conclusions.

2. LITERATURE SURVEY

Scholarly literature on demand for international reserves describes different approaches in

different times. In line with the Keynesian demand for money approach initially it is observed

that there are three basic motives for reserve’s hoarding; transaction, precautionary, and

speculative [ (Heller, 1968), (Olivera, 1969), (Claassen, 1974), (Officer, 1976), (Reddy,

2002), and (Prabheesh, Malathy, & Madhumathi, 2009)]. Transaction motive helps

indigenous financial system to play its role in international transactions. Precautionary motive

helps central banks in times of balance of payments’ crises. Speculative motive highlights the

cost of holding foreign exchange reserves. Inventory management approach to explore

optimal level of foreign exchange reserves tries to balance the costs- opportunity versus

adjustment costs [ (Miller & Orr, 1966) (Frenkel & Jovanovic, 1981), (Jung C. , 1995)]

Mercantilist approach (bullionism) to international reserves holding was also popular in

theory [ (Dooley, Forkerts-Landau, & Garber, 2004) (Aizenman & Lee, 2007) (Ghosh & Kim,

2008) (Ghosh, Ostry, & Tsangarides, 2017)]. Vulnerability approach specifically takes into

consideration reserves as a safety shield against currency crises [ (Krugman, 1979), and

(Obstfeld, 1996)]. In another approach different types of measures were considered for

capturing the vulnerability of the economies to international reserves [(Bussiere and Mulder,

2000), and (IMF, 2016)]. In monetary approach demand for reserves was explored in easing

out monetary policies [(Aizenman, 2010), and (Aizenman, Chinn, & Ito, 2010]). These

motives make it easy to conclude that foreign exchange reserves are of vital importance in the

background of international trade relations and no nation is able to meet all its demands from

necessities to luxuries.

However, countries’ reserves needs are different on account of their income level [

(Cheung & Ito, 2009), and (Moore & Glean, 2016)]. Higher income countries hoard reserves

in view of cost and benefit analysis (speculative motive). Middle income countries’ reserves

requirement is based on deterrent principle (precautionary motive). Lower income countries

are constrained to maintain a certain level of reserves keeping in view vulnerability to pay for

import bills (transaction motive and precautionary motive). Moore and Glean (2016) explores

reserve adequacy and elaborates that foreign exchange reserves’ holding is sensitive to

economic characteristics of countries. Mercantilist and precautionary motives are only

supported partially with non-linearity in case of G-20 countries (Wu & Lee, 2018). In

Economic and Monetary Union of european countries which comprises of developed nations,

the demand for foreign exchange reserves is found to be lower. It is also observed that with

the increase in number of members in union the demand is lower (Hansen & King, 2011).

Cheung and Ito (2009) concludes that demand of foreign exchange reserves for developed

economies is lesser than that of developing economies. Fear of capital mobility is found to be

robust motive for increased demand of international reserves (Steiner, 2013). Precautionary

motive for emerging and developing coutries is endorsed by Bussiere, Cheng, Chinn, and

Lisack (2015). Aizenman and Hutchison (2012) describes that before than financial crisis

2007 emerging countries in fear of reserves’ losses allow market forces to work and currency



to depriciate. Delatte and Fouquau (2011) confirms that need of emerging countries is

increased and this evidence is found robust in presence of nonlinearity. Precautionary motive

behid increased exchange reserves by emerging countries after financial crisis is confirmed by

Joyce and Razo-Garcia (2011). Increased level of foreign exchange reserves in form of U.S.

T-bonds by the emerging economies is investigated by Jung and Pyun (2016) which indicates

endogenous role of capital mobility in the model. Vulnerability of developing countries in

perspective of exchange rate sensitivity for Algeria’s foreign exchange reserves is highlighted

by Kashif, Thiyagarajan, and Sridharan (2017). China’s case of increased level of

international reserves also fall strongly in the ambit of precautionary motive for the reserves

(Schroder, 2017). Turkey is also an emerging country where precautionary need of foreign

exchange reserves is found by Ozyildirim and Yaman (2005). In case of India too it is found

that capital account variations are more responsible for boosted reserves (Praheeesh, Malathy,

& Madhumati, 2007). Enhanced demand for foreign exchange reserves by the devolping

countries is taken as exception and explored by Pina (2015). It is found that cost of holding

extra reserves is pledged by the inflationary process. Rodrik (2006) suggests developing

countries to shorten foreign debts for hoarding optimum level of reserves because cost of

excessed reserves is high. In South African countries it is found by Sanusi, Meyer, and

Hassan (2019) that transaction and precautionary motives for holding reserves are more

important than speculative motives.

In view of differentiated needs of foreign exchange reserves on account of income status

of the countries it is also necessary to differentiate determinants of the international reserves.

Level of reserves itself is an important determinant of demand for reserves in developing

countries (Bussiere et al., 2015). As the level of reserves fluctuate among developing nations

its determinants also differentiate (Sula, 2011). Now the determinants of foreign exchange

reserves for developing countries are discussed. Aizenman and Marion (2004) highlights

international trade, political scenario and exchange rate as the core determinants of

developing countries. Exchange rate, imports to GDP ratio, and interest rate are found

important determinants of demand for reserves in case of India (Praheeesh et al., 2007). Dash

and Narayanan (2011) found a longrun relatioship among reserves, exchange rate and

imports. Non-linearity is also found to play the role of intervening variable as a determinant

of foreign exchange reserves (Delatte & Fouquau, 2011). International Monetary Fund quotas

play an inverse role as a determinant of foreign exchange reserves (Joyce & Razo-Garcia,

2011). Interest rate, volatility of exports, exchange rate regime, financial openness, currency

crisis, trade openness, population and GDP growth are used by Sula (2011). Important

findings of the study is that quantile regression is of importance in the estimation of model.

Level of reserves is also found to be a good determinant of foreign exchange reserves.

Exchange rates and economic growth are the main determinants of international reserves for

Algeria (Kashif et al., 2017). Interest rate is found to be an important factor for reserves’

demand in case of developing countries (Pina, 2017), (Edwards, 1985) . Determinants of

foreign exchange reserves in South African countries are observed to be exports, imports,

exchange rates and inflation (Sanusi et al., 2019).

It is observed that role of remittances is not considered in the studies related to developing

countries. The only studies which consider this role are Elbadawi (1990) and Khan and

Ahmed (2005). Elbadawi (1990) is the pioneering study but theoretical and empirical

development during 1990 to 2019 could not be ignored in the estimation. However, this study

inspired by the idea of exporting the surplus labour for reserves’ crises, develops the

hypothesis that remittances are vital to the vulnerability of developing countries. This study

specifically contributes by considering recent developments in theory and empirics. Khan and

Ahmad (2005) is the classic study on this topic from Pakistan. The major difference of this

study with Khan and Ahmad (2005) is that of structural development, data and estimation.




Financial crises and nine eleven incidence introduces a structural break in public policy for

foreign exchange reserves which increases the optimal level of reserves in the start of twenty

first century. This study utilizes structural break and employ annual data instead of quarterly

data because now constraints of timeseries data have been removed. Along with this dynamic

OLS (DOLS) technique is used in this study instead of simple timeseries econometrics. In this

way this study attempts to contribute significantly in the research exploring the role of

remittance as determinant of demand for international reserves.

3. DATA, MODEL AND METHODOLOGY

This study utilizes time series data for analysis. A big structural change was occurred in 1971

when Bangladesh was separated from Pakistan. In 1982 pegged exchange rate policy was

changed. On this basis this study selects time from 1980 to 2016. Data is available up to 2018

but to measure volatility of balance of payments the standard deviation of five years is used,

hence, volatility data is available up to 2016. Variables of the model, definitions, and sources

are explained in Table 3.1.

Foreign exchange reserves measure demand for foreign exchange reserves in a buffer

stock perspective which is the dependent variable. Its relationships with the independent

variables as observed in the survey of literature above are discussed here on the basis of

theory. However, exceptions are also observed but this study follow the generalized

theoretical expectations. Real GDP per capita measures the size of the economy which is

positively related with demand for foreign exchange reserves. Money market rate is included

to measure the cost of holding excess reserves and is negatively related with demand for

international reserves. Trade openness and financial openness are also theorized to be in

positive relationship with demand for the reserves. In case of market-based exchange rate

system the demand for foreign reserves is higher which highlight positive sign. Balance of

payments’ variability is positively related with demand for international reserves. In post

structural break era exchange rate policy targeted the foreign exchange reserves three-fold

higher than pre structural break era which points out a negative sign.

3.1. Model

This study follows (Sula, 2011) for modelling demand for reserves where developing World

is the context of the study. Dynamic OLS (DOLS) methodology is followed in line with

(Schroder, 2017). Following generalized equation is the base for all the models analyzed in

this study:

Yt = a + b Xit + ut

Y is the dependent variable and X represents independent variables where i is the number

of variables and t denotes observations in time. Error term is u while a and b are the

parameters of the model.

4. RESULTS AND DISCUSSION

In this section of the study results are discussed. Ratio scale variables of the models are

graphed from 1980 to 2016 in Fig 2 for evaluating structural break if any. Structural breaks

are observed around 2001 and 2002 respectively in graphs for international reserves and

balance of payments’ variability. Remittances’ graph is U-shaped with lowest point at about

2000. Upward and downward trends are observed correspondingly for graphs relating to GDP

and trade openness. The graph of money market rate is observed to be highly volatile but with

no trend.



Table 1 Variables of the Model: Definition and Sources

Variables Abbreviation Definition Source

Natural logarithm

of foreign

exchange reserves

Lnresmg Total reserves minus gold

(current US$)

World Development Indicators

(WDI), World Bank

Logarithm of Real

GDP per capita Lnrgdp

GDP per capita (constant 2010

US$) WDI

Money Market

Rate Mmr

Money market rate in

percentage

International Financial Statistics

(IFS), IMF

Trade Openness To Trade as percentage of GDP WDI

Financial

Openness Fo

Financial Openness: A binary

dummy variable that codify the

tabulation of restrictions on

cross-border financial

transactions reported in the

IMF's Annual Report on

Exchange Arrangements and

Exchange Restrictions. Values

1-4 ranges from full control to

full openness

The Chinn-Ito Index (Chinn &

Ito, 2006)

http://web.pdx.edu/~ito/Chinn-

Ito_website.htm

Exchange Rate

Regime Cpeg

A Dummy variable measuring

‘pegged and crawling peg’ with

1 and 0 otherwise. As per

available data 15 classifications

of exchange rate regimes are

mentioned. In this paper

authors measure it as dummy

variable.

Balance Payments

Variability Lnbopv

Standard deviation calculated

from five years data of balance

of payments in US$

IFS

Remittances Lnrem Personal remittances, received

(current US$) WDI

Structural Break Posb

A dummy variable measuring

post structural break (2001) era

by ‘1’ otherwise ‘0’

Constructed by authors

Source: Prepared by authors

This information lead analysis to point out structural break between 2000 to 2003. In

recent past it depicts that during this time period a big event which affects international

relationships specifically in economic sphere is nine-eleven. It is concluded that data to be

used in this study shows a structural break in 2001. Structural break is defined to be a point

where variables of the model significantly deviates from past behavior. In case of structural

break in time series data it is suggested that special care should have been taken in analysis to

avoid spuriousness.

To further analyze the structural break the residual stability test is conducted on OLS

estimation of the variables mentioned above with international reserves as dependent variable.

The CUSUM graph with five percent significance level is presented in Fig 3. It could be

observed that residuals deviate a little from mean up to 2001 and thereafter residuals deviate

significantly which also points out structural break in the data.




0

5

10

15

20

25

30

35

40

1980 1985 1990 1995 2000 2005 2010 2015

RESE LNRGDP MMR

LNBOPV REMG TO

Figure 2 Plots Representing Variables of the Models

The graphical analysis which pointing out the structural break is not sufficient to conclude

that structural break should be included in the analysis phase of the study. It is also necessary

to confirm the structural break through statistical procedures. Chow break point test is readily

available for this purpose which is represented in Table 2. It is clear from the estimates

mentioned in the table that null hypothesis of no break at 2001 could be rejected. Hence, it is

concluded statistically significantly that structural break is existed in the data on 2001.

-20

-15

-10

-5

0

5

10

15

20

86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16

CUSUM 5% Significance

Figure 3 Plot Representing Stability of OLS estimation of the Variables of the models

Table 2 Chow Breakpoint Test for Structural Break

Null Hypothesis: No breaks at 2001

Regressors: lnrgdp; mmr; lnbopv; remg; and to

Statistics Estimate Prob

F-Statistic 7.5623 0.0002

Log Likelihood Ratio 33.2120 0.0000

Wald Statistic 37.8114 0.0000

Source: Authors’ Calculations



In time series data starting point of the analysis is stationarity testing and cointegration. In

this study stationary tests are not utilized because in dynamic OLS estimation the integration

orders of variables of the model are not of importance for exploring cointegration among the

variables of the model. The DOLS estimation is reliable and poses statistically high level of

precision in any case whether the variables in the model are stationary at level or at first

difference or at both. Another advantage of DOLS estimation is its ability to deal with the

problem of endogeneity.

This study attempts to find out determinants of international reserves for Pakistan

economy. In developing countries like Pakistan, a certain limitation of research is that of data

availability and most of the important determinants could not be included in the analysis.

Currency crisis is an important determinant of international reserves but this study is

restricted to include it in analysis on the basis of data limitations. In cointegration analysis as

the number of variables is increased chance of long-run relationship is restricted. This is why

all the variables of the model could not be included simultaneously. Endogeneity arises as a

major consequence when important variables are not part of the analysis. Keeping in view

such problems this study specifically considers DOLS estimation for analysis (Stock &

Watson, 1993).

Six models are estimated in analysis. In model-1 major determinants of international

reserves in the light of literature survey are used. Then variables of financial opennes,

exchange rate regime, balance of payments’ variability and remittances are added separately

in model-2 to model-5 respectively. Afterward in model-6 dummy variable for structural

break is added in model-5. In model-6 structural break is utilized for analyzing main

hypothesis of the study that remittances may play a vital role for international reserves in

Pakistan economy.

There are two mainstreams for determinants of international reserves; monetary aspect of

the economy and macroeconomic environment of the economy. In model 1 both these two

aspects are included. Money market rate captures the opportunity cost of the reserves. Real

GDP along with trade openness are respectively the size of economy and trade regime in the

country. Signs of real GDP and trade openness are as per expectations and are also

statistically significant. Sign of money market should have been negative but results show a

positive sign but this relationship is not backed by statistical significance. Jarque-Berra

statistic is sufficient to believe that residuals are normally distributed because null hypothesis

of normality could not be rejected. Variables of the model are not found to be cointegrated in

the background of Engle-Granger tau-statisitcs whereby hypthesis of no cointegration could

not be rejected. In view of these facts about model-1 it could be concluded that there is no

long run relationship among the variables of the model. Thereafter model-1 is estimated with

dummy variable of structural break that is post structural break period. It is found out that

even the model is cointegrated but most of the variables of the model are insignificant.

Results of model-1 after structural break are mentioned in appendix.

In model-2 financial openness is included as additional variable and then the model-2 is

estimated with DOLS. As per results shown in Table 3 variables of the basic model-1 pose the

same signs and statistical significance again as mentioned in model-1 above. The additional

variable of the financial openness is now found to be in positive relationship with

international reserves. This sign is as per expectation because as a developing economy is

open to financial horizon then more is the chance to capital flight which cause danger to

reserves and demand for international reserves increase. However, financial openness is found

to be statistically insignificant. The model-2 is also not cointegrated. The model could not be

estimated in presence of structural break on account of singular matrix.




Table 3 DOLS Regression Estimates

Dependent Variable: lnresmg

Variables Model 1 Model

2 Model 3

Model

4

Model

5 Model 6

Lnrgdp 4.429* 3.702* 4.351* 5.228* 3.819* 3.793***

Lmr 0.181 0.142 0.144 0.264 0.216** 0.198***

To -0.358* -

0.426*

-

0.224***

-

0.361* -0.232* -0.311**

Fo 2.027

Cpeg 0.913***

Lnbopv -0.253

Lnrem -0.099 -

0.551***

Posb 0.435

C 2.319 12.165 -2.224 -2.405 3.459 16.454

Observations 34 34 34 34 34 34

Jarque-Bera 1.307 0.644 0.613 1.211 1.029 0.180

Cointegration Test

Engel-Granger tau-Statistic -2.468 -2.585 -2.665 -2.471 -2.176

Hansen Lc Statistic 0.070

*, ** & *** shows significance at 1, 5 & 10 percent level respectively

1. Hansen (1992)

Source: Authors’ Calculation

Model-3 takes into consideration exchange rate regime of the economy as additional

variable which is dummy in nature. Results in Table 3 shows that basic model’s behavior is

still intact. Sign of crawling peg is positive. This sign is also in line with expectations because

more reserves are required to keep exchange rate at fixed level or at crawling fixed level. This

variable is significant at ten percent level. The model is not found to be cointegrated. When

the model is estimated in presence of structural break then cointegration is observed.

However, the variable of structural break is observed significant and all other variables are

found insignificant. Results in presence of structural break are presented in appendix.

In next model that is model-4 the variable of balance of payments’ variability is analyzed

as additional variable. Behavior of basic model could again be observed the same as earlier.

The sign of balance of payments’ variability is found to be negative which is in contrast to the

expectation. Evidence about cointegration among the variables of the model is not proved in

Engle-Granger tau statistic. However, when the model-4 is estimated in presence of structural

break then cointegration is proved. But all variables except structural break and balance of

payments’ variability are not statistically significant as shown in results mentioned in

appendix.

Lastly hypothesized variable of this study that is remittances is added in model-5. Basic

model’s variables are again posing the same results as mentioned in all the earlier models.

The sign of remittances is in line with the theory and is negative and this variable is also

statistically significant. The model is also not found to be cointegrated as shown by the Engle-

Granger tau statistic.

Thereafter, when structural break is added with remittances as shown in model-6 then all

variables of the model except structural break are found to be statistically significant. Positive

sign of post structural break era is representative of the fact that demand for reserves after

break is higher than the demand for reserves before structural break. Significance level of

trade openness is five percent while that of real GDP, money market and remittances is ten

percent. Now the Hansen Lc statistic also points out that variables of model are cointegrated.

Only worrying element is the sign of money market which is now also statistically significant.

Developing countries like Pakistan time and again face foreign exchange reserve’s crises. In

these circumstances cost of reserves holding is lesser in relation to the costs incurred on



account of currency depreciation. This might be the reason that sign of money market is

positive in case of Pakistan economy.

It could be perused that in absence of structural break long run relationship is not observed

in any of the models investigating determinants of international reserves. When structural

break is added in the models then all the models are showing a long run relationship among

the variables. Nevertheless, the only models which are proved on the basis of relatively strong

statistical and theoretical grounds are the models with remittances as additional variable. Still,

it is not proved that the model-6 is reliable and is showing a high level of precision.

Reliability and precision could be established after the diagnostic testing which is shown in

Table 4. It is obvious from the results that hypotheses of no serial correlation, no

heteroscedasticity, and model is correctly specified could not be rejected. Therefore, results of

the model could not be termed as spurious.

Table 4 Diagnostic Tests for DOLS Models

Model 6

Breusch-Godfrey Serial Correlation LM Test

F-Statistic 0.622

Obs*R-squared 1.675

Breusch-Pagan-Godfrey Heteroscedasticity Test

F-Statistic 1.469

Obs*R-squared 23.571

Ramsey RESET Test

t-Statistic 0.043

F-Statistic 0.002

*, ** & *** shows significance at 1, 5 & 10 percent level respectively


5. CONCLUSIONS AND POLICY IMPLICATION

In this study demand for reserves is modelled for its determinants in Pakistan economy as a

case study of developing countries. It is hypothesized that existing population could be treated

as a resource which is in surplus and underutilized. In case that labour is exported positively

then remittances could play a vital role for prevention of vulnerabilities of the foreign

exchange reserves against internal and external shocks to the economy. This study exploits

DOLS methodology on time series data from 1980 to 2016. Structural break is also observed

in the data which leads the analysis in two directions that is analysis in presence of structural

break and in absence of it.

Results and discussions above guide this study to conclude that in absence of structural

break long run relationship is not observed among the variables of the model. When structural

break is included in the models then evidence of long run relationship among variables is

witnessed significantly. This fact leads this study to point out that structural break is an

important factor in the model exploring demand for international reserves.

In presence of structural break, it is found that behavior of the determinants in observed

models is not stable. Discrepancies of the determinants with hypothesized relationships is the

obvious analysis, however, such discrepancies could be termed as exceptions to the

expectations which are also observed in survey of literature.

When the effect of remittances on demand for reserves is concerned it is concluded that

long run relationship is only found in presence of structural break. No discrepancy is observed

in behavior of the determinants of the model before and after the inclusion of structural break.

On this basis it is concluded that size of the economy and money market rate cause the

demand for foreign exchange reserves to increase whereas trade openness and remittance




affects the demand for foreign exchange reserves to decline. The structural break is even

effectively observed in the data but its robustness in the model is not found to be effective.

6. POLICY IMPLICATIONS

On the basis of results, it is suggested in this study that underutilized surplus labour in

Pakistan economy could play its role effectively for vulnerabilities of foreign exchange

reserves. Even this study claims only the positive role of human resources’ utilization in the

context of exporting the labour. But efficient utilization of human resource could also play its

role for vulnerabilities of foreign exchange reserves in indigenous context as suggested by

Lewis development model when implemented in perspective of export promotion strategy.

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APPENDIX A

Table A.1 DOLS Regression Estimates in Presence of Structural Breaks

Dependent Variable: lnresmg

Variables Model 1 Model 2 Model 3 Model 4

lnrgdp -0.4490 - -1.5737 0.6764

mmr 0.0964 - 0.1264 0.2040

to -0.1093 - -0.094 -0.1219

fo -

cpeg - 0.3371

lnbopv - -0.5534

lnrem -

posb 2.2740* - 2.4367* 2.6798

C 26.5481 - 32.8790 21.5270

Observations 34 - 34 34

Jarque-Bera 0.1632 - 0.4740 0.6071

Cointegration Test

Engel-Granger tau-Statistic -

Hansen Lc Statistic 0.0539 - 0.0778 0.05966

*, ** & *** shows significance at 1, 5 & 10 percent level respectively 1. Hansen (1992)


vulnerabilities of developing countries to ......economic characteristics of countries. mercantilist...

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