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Impact
Impact of financial liberalization of financial
on agricultural growth: a case liberalization
study of Pakistan
191
Qazi Muhammad Adnan Hye
Institute of Business Management, Karachi, Pakistan, and
Shahida Wizarat
Economics Department, Institute of Business Management,
Karachi, Pakistan

Abstract
Purpose – The purpose of this paper is to develop a financial liberalization index (FLI) and evaluate its
impact on agricultural growth.
Design/methodology/approach – The study uses the autoregressive distributed lag approach to
determine the long run and short coefficients.
Findings – The empirical results show that FLI affects agricultural growth positively in the short and
the long run; but real interest rate positively affects agricultural growth in the short run and negatively
in the long run.
Originality/value – While previous research focuses on overall economic growth, this paper
evaluates the impact of financial liberalization on the agricultural sector.
Keywords Pakistan, Agriculture, Economic growth, Economic policy
Paper type Research paper

1. Introduction
Agriculture has played a crucial role in the Pakistan economy and will continue do so.
The reason is that agricultural contributes 20.4 percent to the gross domestic product
(GDP) and employs 44 percent of the labor force. More than two-thirds of the population
lives in rural areas and continues to rotate around agriculture and connected
activities[1]. The subdivision of this sector includes major crops, minor crops, livestock,
fishing and forestry. Availability and access to financial resources is one of the key
elements for agricultural development. It is important for the Pakistan economy to
undertake financial liberalization in order to expand banking in the rural areas.
Robinson (1997) and Mwega (2002) explain that Indonesia and Kenya have promoted
financial institutions to meet rural lending requirements.
In Pakistan, agricultural credit requirement is classified into farm and non-farm.
Farm credit requirements are classified into short, medium- and long term. Farmers
require short-term credit for the purchase of new varieties of seeds, water, fertilizers and
power. Medium and long-term credit is required for land improvement, clearance of
jungles, leveling, layout, terracing, soil improvement, embankments, land formation,
watercourse improvement alignment, lining, silt clearance, constriction of modules and China Agricultural Economic Review
Vol. 3 No. 2, 2011
culverts; wells (tube-wells, lifts pumps, deep turbines and implements); farm power pp. 191-209
q Emerald Group Publishing Limited
1756-137X
JEL classification – G20, Q1 DOI 10.1108/17561371111131317
CAER (bullocks, tractors, trailers, thrashers and other agricultural machinery and equipment);
3,2 arboriculture; orchards and fencing. Non-farm agricultural sector has also required
credit for short, medium and long terms. Short-term credit is required for feeding of
livestock and poultry and to meet veterinary expenditures. Medium- and long-term
credit is needed to purchase live stock, poultry, sheds, tools and implements and for
financing expenditures on electrical installations, drinking water tanks for animals,
192 processing of livestock products, labor charges, etc. In the forestry sector, only medium-
and long-term credit is needed for the purchase of seedlings, labour charges, apiculture
and sericulture. For the fishery sector, short-term credit is required to purchase salt,
ice and to pay cold storage charges and curing expenses, while long-term credit is needed
to purchase nets and twins, trawlers, boats, engines and fishyards. Other purposes for
which agricultural credit is required include storage, transportation, and marketing,
packing and processing. The short-term credit needs of these are for storage,
transportation hire charges, packing material, etc. The long-term needs of these sectors
are for construction of godowns, bins and silos, purchase of trucks, bullock-carts,
transport machinery, country-boats, fork lifts, etc. and purchase of processing
machinery for use at the farm (State Bank of Pakistan, 1962, 2005a, b; Government of
Pakistan, 2008).
On the basis of the above credit requirements, the development of the agricultural
sector suffers from the absence of a strong financial system. Therefore, Pakistan has
adopted financial liberalization policies to strength the financial system. This study
evaluates the association between financial liberalization policies and agricultural
growth. In the empirical literature, number of studies examines the relationship between
the financial liberalization and growth on the aggregate level, but in this paper we
evaluate the impact of financial liberalization on the sectoral level, i.e. the agricultural
sector. Empirical literature on financial liberalization and growth indicate both positive
and negative results. Goldsmith (1969) and McKinnon (1973) and Shaw (1973) recognized
positive correlation between economic growth and indicators of financial development[2].
Fry (1988) stated that financial liberalization increases the supply and allocation of funds
for investment. Levine et al. (2000) found financial intermediation having a positive
impact on economic growth in the sample of 74 countries. La Porta et al. (2002) examined
the ownership structure of banks in 92 countries and found that higher government
ownership of banks resulted in lower per capita GDP growth even when initial financial
intermediation development had a positive and significant effect. Nair (2004) suggested a
significant negative impact of financial liberalization index (FLI) on the household saving
rate. Mattoo et al. (2006) examined openness in financial services having a positive and
significant effect on economic growth in a sample of 59 countries. Ang and Mckibbin
(2007) reported financial liberalization through removal of financial repression having a
favorable effect in stimulating financial sector development in Malaysia.
On the other hand, some studies report that financial liberalization is the cause of
financial crises in many developed and developing countries. Specially, the Mexican
financial crises (1994-1995), the Asian crises (1997-1998) and the crises of Brazil, Russia and
many Latin American countries (1998-1999). Arestis and Demetriades (1999) examined
financial liberalization in developing countries with weak institutions causing financial
destabilization. Arphasil (2001) examined East Asian Crisis (1997-1998) due to interest rate
and capital account liberalization, as financial liberalization leads to a credit boom, mostly
short-term borrowing from abroad. Such a boom leads to an unstable foundation,
ultimately causing financial fragility or crises. Wade (2001) claimed that it is dangerous to Impact
liberalize capital account when the banks have little experience of international market and of financial
non-banks also borrow abroad. It is doubly dangerous when the financial sector is based
on bank borrowing than equity finance and when the exchange rate is pegged. liberalization
Singh et al. (2003) disagreed with the perception of donors/creditors that
the fundamental causes of the Asian crisis were the imperfect systems of corporate
governance and a poor competitive environment in the affected countries. Rather, the 193
available evidence suggested that the crisis was the result of precipitous capital account
liberalization. Tornell et al. (2004) empirically proved that financial liberalization
increased incidence of financial crises. Mete (2007) stated that financial liberalization
rendered the Turkish economy vulnerable to currency crises. Behrman et al. (2009) found
that increases in financial liberalization was associated with bank crises and other
domestic and external shocks, and that higher schooling inequality reduces the impetus
for liberalization brought on by bank crises in Latin America.
The remaining part of the paper is organized as follows: Session 2 discusses financial
liberalization policies in Pakistan; an overview, while Section 3 presents methodology.
Section 4 contains the results and discussion; the final Section 5 gives conclusions and
policy recommendations.

2. Financial liberalization policies in Pakistan: an overview

First, we discuss financial liberalization reforms undertaken by the Government of
Pakistan (GOP) in order to improve the efficiency of the financial sector and enable it to
compete at the global level. The aim of these reforms was to improve the efficiency of
financial markets, formulate market based and relatively more efficient monetary and
credit policies and strengthen the capital and market-based financial institutions. The
liberalization process of the financial sector started from the late 1980s, but this study
considers the Islamization process as a form of financial development. Reforms which
were directed to financial market strengthening, institutional development and macro
economic stability are discussed below.

Islamization
Pakistan started the process of Islamization in 1980. The system of Zakat was introduced
and registration of Modarabah companies was started in June 1980. Small business
finance corporations started interest-free operations and Investment Corporation of
Pakistan (ICP) revised its investor schemes on the basis of profit and loss. In 1984, banks
were allowed to provide finances under Islamic modes on interest-free (limited to
six months) basis. Islamization Commission was formed in 1991 in order to ensure
elimination of interest (riba). In 2001, the State Bank of Pakistan (SBP) (2001) adopted a
three-pronged strategy to establish Islamic banking in parallel with conventional
banking. This strategy authorized the setting up of full-fledged Islamic commercial
banks, establishment of subsidiaries by commercial banks to undertake Shariah
compliant banking business and establishment of branches dealing exclusively in
Islamic financial products. Meezan Bank Limited was given the first Islamic commercial
banking license. Shariah Board was established in the SBP in 2003. Institute of
Chartered Accounts of Pakistan’s finalized the accounting standard of Mudaraba and
Ijara in 2004. While the accounting standards for Musharikas are nearing completion.
CAER Privatization of financial institutions
3,2 In order to improve the efficiency of the banking sector and make it more competitive, the
1974 Act of Nationalized Commercial Banks was modified. Privatization of national
commercial banks was started in 1991. First, Muslim Commercial Bank and Allied Bank
Limited were partially privatized. Habib Credit and Exchange Bank was also privatized
and management transferred in 1996. Partially, privatized commercial banks were
194 completely privatized in 1997. In 2002, United Bank Limited was offered for privation.
The cabinet approved the proposal for restructuring of Industrial Development Bank of
Pakistan in 2003. In 2003, ICP was privatized. The government successfully offloaded
23.2 percent shares of the National Bank of Pakistan in 2004-2005.

Interest rate deregulation

Interest rate was deregulated in March 1995 with the removal of caps on maximum
lending rates of banks and non-bank financial institutions (NBFIs) (for trade-related
mode of financing). In October 1995, the caps on project financing were also removed.
Minimum financing restriction on trade and project-related lending rates were removed
in July 1997. Therefore, banks and financial institutions have determined lending rates
according to the demand and supply conditions in the market.

Credit control
System of credit ceilings was abolished from February 1, 1992, and replaced by a
relatively flexible control through the fixing of credit deposit ratio (CDR) in each quarter.
System of CDR was also abolished on September 30, 1995 and replaced by a
market-based mechanism.

Removal of entry barriers

The government liberalized the entry of private and foreign banks in order to gain
efficiency and enhance competition within the financial sector. First, appropriate
amendments were made in the Banking Act 1974 to provide legal cover to these actions.
Private sector was allowed to start banking companies. A number of non-bank financial
entities were allowed to operate and mergers were also encouraged, in order to reduce
inefficiencies. Bank branches (1997-2001) were fully liberalized, which allowed private
banks to grow faster and increase their market shares.

Prudential regulations
In order to strengthen the governance and credit system the SBP introduced prudential
regulation in 1994, which covered various aspects of operations of commercial banks.
In 2002, SBP introduce separate prudent regulations for microfinance institutions (MFIs),
since MFI’s nature and activities are different from commercial banks. Other prudent
regulations on banking operation were issued in 2004 that covered corporate/commercial
banking, small and medium enterprises, financing and consumer financing. In 2003,
various rules and regulations were advocated for NBFIs, which covered leasing, investment
banks, housing finance companies, discount houses and venture capital companies. In
response to the growing demand for microfinance, the policies were designed in January
2000, to expedite the process of microfinance sector development. Ministry of Finance and
the SBP worked with the support of the Asian Development Bank. Amendments regarding
microfinance activities were made in the finance bill, which included change in the
definition of the poor, enhancement in the powers of the SBP in the removal of Board of Impact
Directors (BODs), granting permission and allowing surplus funds in marketable securities. of financial
In 2000, different amendments were made in the Insurance Act 1958. For the development
of the insurance sector, there were separate rules and regulations issued by the Ministry of liberalization
Commerce in 2002. To shape the insurance sector in accordance with the Islamic mode,
Ministry of Commerce issued rules and regulation for the establishment of Takaful
insurance in 2005. Owing to expansion of the agricultural sector, its credit requirements also 195
increased. Keeping in view the requirement of agri-credit, the SBP designed prudent
regulation for agri-financing, which was effected in 2005.This enabled banks to introduce
new financial schemes for agric-development such as farm development credit for input
purchase, agri-machinery, equipments, livestock and cooperative farming. With regard to
consumer financing, small- and medium-enterprise financing and corporate/commercial
banking prudent regulation were issued by the SBP in 2009.

Payment reforms
A comprehensive package of exchange and payment reforms was announced in 1991.
Resident Pakistanis were allowed to hold foreign currency accounts in Pakistani banks.
Companies were allowed to remit profits without specific approval of the SBP. The
government also abolished ceiling on payment of royalty and technical fee to non-residents.

External account liberalization

In 1994, Pak Rupee was made convertible. A dual exchange rate system was adopted in
1998. This was replaced by a market-based exchange rate system given a narrow band
in 1999. The unofficial cap on the exchange rate was finally removed on July 21, 2000 to
make it purely market based.

Stock market reforms

The stock market plays an important role in the economy by mobilizing domestic
resources and channeling them to productive investment. This implies that it must have
a significant relationship with the economy. Of the three stock exchanges in Pakistan
(Karachi, Lahore and Islamabad), Karachi dominates the other markets in the country.
The Karachi Stock Exchange (KSE) was established soon after independence in 1947.
The other exchanges in Pakistan, the Lahore Stock Exchange and the Islamabad Stock
Exchange (ISE) were established in 1974 and 1997, respectively. KSE was declared the
best performing stock market of the world in 2002 by Business Week, US news magazine.
In order to improve the efficiency of the stock markets, the following steps have been
taken by policy makers. The KSE 100 index came into existence in November 1991. The
Corporate Law Authority was suspended in 1991 and the Securities and Exchange
Commission of Pakistan was established. The KSE was linked with international
investors through Reuters. Like many international markets a general manager of the
KSE was appointed. To facilitate electronic transfer of stocks and manage large
volumes, the Central Depository Company of Pakistan (CDC) was established in
September 1997 in collaboration with International Finance Corporation, Citibank, other
leading commercial banks and development finance institutions (DFIs). The CDC
registers and maintains the transfer of securities in the form of an electronic book entry.
It transfers the ownership of securities without any physical movement. In 2003, trading
in futures contracts was started[3]. From August 2005, the Security and Exchange
CAER Corporation of Pakistan started phasing out this trade by replacing it with a facility
3,2 called continuous funding system and by encouraging investors to use futures trading.

Credit ratings of NBFIs

Effective April 20, 1995, all NBFI were required to have themselves credit rated by an
SBP approved rating agency. The same will be applicable to all commercial banks from
196 June 2000. From 1997, all banks were required to maintain not less than 8 percent general
reserve of their risk weighted.

Downsizing and restructuring

Public sector banks and DFIs were asked to prepare action plans for restructuring and
downsizing of their organizations in order to reduce financial intermediation cost.
Accordingly, through various incentive schemes from 1997 to 1999, work force of these
institutions was reduced from 99,954 to 81,079, while 815 loss-making branches were closed.

Establishment of Corporate and Industrial Restructuring Corporation

The Corporate and Industrial Restructuring Corporation was established in 2000 to
promote revitalization of the economy by reviving sick industrial units. It will take
over the non-performing loans (NPLs) of national commercial banks and DFIs.

Non-performing loans
In 1992, classification of outstanding loans was done as doubtful and loss loans. In 1996,
the financial sector was on the verge of collapse with about one-third of banking assets
stuck in the form of NPLs. Liquidity problems had begun to emerge as disintermediation
spread and banking losses increased. Most cases of loan defaults remained unresolved
because of ineffective judicial system. Establishment of banking courts (1997)
implemented new loan recovery laws and incentive schemes from loan defaulters. SBP
introduced two separate incentive schemes to provide opportunity to loan defaulters to
pay their dues and regularize the remaining amounts.

Debt-management reforms
The aim of debt-management reforms was to reduce the segmentation in government
debt market, rationalize the cost of raising long-term government debt, establish a
market-based rate of return structure for government securities and pave the way for
implementation of monetary policy through instruments of indirect monetary control.
A securities department was set up in the SBP to launch an auction system for public
debt and develop a secondary market for government securities in 1990. In the same
year, auction system for treasury bills, national saving schemes (special saving
certificates and special saving accounts) and registered and bearer were introduced.
To mobilize foreign exchange, the bearer instruments such as five-year Foreign
Currency Bearer Certificates (FEBCs) and US Dollar Bearer Certificates, etc. were issued
in January 1992. Three-year FEBCs denominated in US dollar and pound sterling were
introduced in February 1998 and discontinued in December 2000. The outstanding stock
of these certificates was reported in domestic debt, because of the Pak rupee
counterpart implications for the budget. In December 2000, the government issued
three-five- and ten-year Pakistan Investment Bounds, first effectively extending the
yield curve to ten years which was further increased to 20 years.
Cash reserve requirement Impact
All scheduled banks are required under Section 36(1) of the SBP Act, 1956 to maintain a of financial
balance-return fee with the SBP equivalent to 5 percent of their demand and time deposit
liabilities. But through the reform period (1991-1997), cash reserve requirement (CRR) liberalization
remained more or less constant at 5 percent. In 1997, banks were advised to maintain with
the SBP an average balance of 5 percent of total time and demand deposit liabilities in
Pakistan worked out on weekly basis. The amount of balance at the close of business on 197
any day should not be less than 4 percent of the total demand and time liabilities in
Pakistan. For the NBFIs, an additional 1 percent CRR of original 15 percent (1996)
statutory liquidity requirement for banks was to be maintained. SBP raised the CRR for
banks, together with further increasing its policy rate by 50 bps to 9.5 percent in July 2006.
In 2008, SBP reduced the CRR by 400 bps to 5 percent of time and demand liabilities.

Open market operations

Open market operations were introduced in order to effectively control monetary policy.
Major developments in this area include removal of ceiling on the maximum lending
rates of banks and NBFIs for trade-related modes of financing in 1995. However, this
process could not continue, and caps on minimum lending rates of banks and NBFIs for
trade and project-related modes of financing were removed.

Composition of the FLI

In Pakistan, a number of financial policies were used in the process of financial
liberalization. These policies were used in this study to develop a FLI by using the
principal components method. FLI indicates the level of financial liberalization at a
specific time period. Bandiera et al. (2000) constructed an FLI by using eight financial
liberalization components for eight developing countries. These components are:
(1) interest rates;
(2) pro-competition measures;
(3) reserve requirements;
(4) directed credit;
(5) banks’ ownership;
(6) prudential regulations;
(7) stock markets; and
(8) international financial liberalization.

Laeven (2003) included six components of financial liberalization (excluding stocks and
external sector) while developing an FLI for 13 developing countries. Nair (2004)
constructed financial liberation index by using six components of financial liberalization
(interest rate liberalization, reduction in reserve requirements, pro-competition measures,
increased prudential regulation, stock market development and international
financial liberalization). Shrestha and Chowdhury (2006) developed FLI for Nepal by
using eight components of financial liberalization (interest rate liberalization,
removal of entry barriers, reduction in reserve requirements, easing credit controls,
introduction of Prudential Regulations, stock market reform, privatization of state-owned
CAER banks and external account liberalization). Ahmed (2007) constructed FLI for Botswana
3,2 by using five financial liberalization indicators:
(1) interest rate liberalization;
(2) exchange rate liberalization;
(3) reduction in reserve requirement;
198 (4) authorization of new banks and privatization of banks; and
(5) securities markets.

This study uses 11 major components of financial liberalization for the construction of
the FLI for Pakistan. The financial liberalization policy components contain:
(1) Islamization;
(2) interest rate deregulation;
(3) credit controls;
(4) stock market reforms;
(5) prudential regulations;
(6) privatization of financial institutions;
(7) removal of entry barriers;
(8) non-performing loans;
(9) external account liberalization;
(10) debt-management reforms;
(11) open-market operations.

The FLI was constructed by using the methodology followed by Bandiera et al. (2000).
In order to derive the FLI, we have created a 0-1 dummy variable, with “1” representing
the liberalized regime and “0” representing the non-liberalized regimes. (For details, see
the Appendix Table AI.)
The composition of the FLI is as follows:

FLI t ¼ 41 IS þ 42 IR þ 43 CC þ 44 SMR þ 45 PR þ 46 P þ 47 EB þ 48 NPL

þ 49 EAC þ 410 DMR þ 411 OM ð1Þ

where v
s is the weight of the financial liberalization component that is calculated by using
the principal component method. The first principal component explains variations
(85 percent of total variance) better than any other linear combination of policy variables
(Appendix Table AII). So, it is the best measures of financial liberalization in this case.
The first principal component is computed as a linear combination of the 11 measures of
financial liberalization with weights given by the first eigenvector. We use these weights
to construct a financial liberalization policy index, denoted as FLI. The index is calculated
by substituting the weights of policy variable in the equation (1) and multiplied with the
respected value (Appendix Table AIII). The index is calculated by adding the values of all
11 policy components for the respective year.
In Figure 1, FLI shows that 1990-1996 was the time period when most liberalization
measures were taken by the policy makers in Pakistan.
 3.5 Impact
3.0
of financial
liberalization
2.5
Index values

2.0
199
1.5

1.0

0.5
Figure 1.
0.0 Financial
1975 1980 1985 1990 1995 2000 2005
liberalization index
Years

3. Methodology
This study uses annual time series data for the period of 1971-2007. GDP and gross fixed
capital formation are measured in millions of rupees. Labor force is in millions of
numbers. The real interest rate (RIRt) is defined as nominal deposit rate (rt) minus the
inflation rate ðpt Þ½RIRt ¼ r t 2 pt
. The data are taken from the Hand Book of Statistics
on Pakistan’s Economy, Statistical Bulletin published by the SBP and various issue of the
Pakistan Economic Survey. For the construction of the FLI, the information was
gathered by using the financial liberalization assessment 1990-2000 and the Annual
Financial Assessment of the SBP.
To check the impact of financial liberalization on agricultural growth in Pakistan, the
relationship is modeled by using the RIR and composite financial policy index as
determinants of total factor productivity. Employing a Cobb-Douglas function, we can
specify:
Y A ¼ dK bA LaA ð2Þ
where YA is agricultural GDP, d is the residual containing the impact of the RIR and the
composite FLI, etc. KA is capital, LA is labor and a and b are partial elasticities.
Decomposing the residual, we rewrite the equation as follows:
LnðY A Þt ¼ b0 þ b1 FLI t þ b2 RIRt þ b3 LnðK A Þt þ b4 LnðLA Þt þ m1t ð3Þ
where Ln(YA)t, Ln(KA)t and Ln(LA)t are natural logarithm of GDP, gross fixed capital
formation and labor force in agricultural sector. RIRt is the real interest rate and FLIt is
the FLI and mt is the error term.

Unit root and co-integration

The Phillips and Perron (1988) unit root test determines time series properties. Phillips
and Perron (PP) test proposes an alternative (nonparametric) method for controlling
serial correlation when testing unit root of time series data. The PP method estimates
the non-augmented Dickey-Fuller equation (4). The test detects the presence of a unit
root in a series, say Xt by estimating:
DX t ¼ a þ rX t21 þ 1t ð4Þ
CAER The PP test estimate the modified t-value associated with the estimated coefficient of r
so that serial correlation does not affect the asymptotic distribution of the test statistic.
3,2 The PP test is based on the following statistic:

1=2
~tr ¼ t r g0 Tð f 0 2 g0 Þðseðr~ÞÞ
2 1=2
ð5Þ
f0 2f s
200 0

where r~ is the estimate, and tr the t-ratio of, seðr~Þ is the coefficient standard error, and s
is the standard error of the test regression. In addition, g0 is a consistent estimate of the
error variance in equation (5) was calculated as:
ðT 2 kÞs 2
g0 ¼ ð6Þ
T
where k is the number of regressors and T is tabulated value. The remaining term, f0,
is an estimator of the residual spectrum at frequency zero. The series is stationary if r
is negative and significant.

Co-integration
The traditional approach is criticized for ignoring the problems caused by the presence
of unit root variables in the data generating process. However, both unit root and
co-integration have important implications for the specification and estimation of
dynamic models.
Co-integration is a convenient approach to estimate the long-run parameters in a
relationship with unit root. This is a different method of modeling dynamic
relationships. It provides a direct test of economic theory and enables utilization of the
estimated long-run parameters into the estimation of short-run disequilibrium
relationships. It estimates the long-run parameters derived by imposing restrictions
and using the test to check for theoretical validity. Thus, co-integration regressions
show the long run or equilibrium relationships between economic variables. This work
used the autoregressive distributed lag (ARDL) model to determine the long- and
short-run relationship between the variables.

ARDL model
In economic research, the determination of a long-run relationship between the variables is
important. Econometrics literature offers a variety of co-integration testing techniques, the
pioneering work of Engle and Granger (1987)[4], Phillips and Hansen (1990), Johansen’s
(1991, 1995) multivariate tests, Gregory and Hansen’s (1996) tests with unknown timing
break, error correction model (ECM) test (Bannerjee et al., 1998), and so on.
But this research employs a testing procedure for co-integration proposed by
Pesaran et al. (2001). It is generally known as bounds testing procedure or ARDL
procedure. It has some econometric advantages in comparison with other co-integration
procedures. First, endogeneity problems and inability to test hypotheses on the
estimated coefficients in the long run associated with the Engle Granger method are
avoided. Second, the long- and short-run parameters of the model are estimated
simultaneously. Third, all variables are assumed to be endogenous. Fourth, the
econometric methodology is relieved the burden of pre-testing of unit roots, it is
applicable when the underlying variables are I(0), I(1), or fractionally integrated.
 The ARDL procedure involves investigating the existence of a long-run relationship Impact
in the form of the unrestricted ECM as follow:
X k X
k X
k of financial
DLnðY A Þt ¼b0 þ b1 DLnðY A Þt2j þ b2 DFLI t2j þ b3 DRIRt2j liberalization
j¼1 j¼0 j¼0
X
k X
k ð7Þ
þ b4 DLnðK A Þt2j þ b5 DLnðLA Þt¼0 þ v
1 LnðY ÞA t21
j¼0 j¼0 201
þ v
2 FLI t21 þ v
3 RIRt21 þ v
4 LnðK A Þt21 þ v
5 LnðLA Þt21 þ m1t
The terms with summation signs in equation (7) represent the error correction dynamic
while the second part (term with v
s) corresponding to the long-run relationship. The
F-tests are used for testing the existence of a long-run relationship. The H0 defined by
kH 0 : v
1 ¼ v
2 ¼ v
3 ¼ v
4 ¼ v
5 ¼ 0l, is tested against the alternative,
kH 0 : v
1 – v
2 – v
3 – v
4 – v
5 – 0l. However, the asymptotic distribution of this
F-statistic is nonstandard, regardless of weather the variables are I(0) or I(1). The decision
rule of long-run relationship is as follows. If the computed F-statistic lies above the upper
bound [I(1)], then the H0 can be rejected at a conventional level of significance, say 1, 5 or
10 percent suggesting a co-integrating relationship among the variables. On the other
hand, if the computed F-statistic lies below the lower bound [I(0)], the H0 cannot be rejected
indicating no co-integration in the relationships. Critical value of the lower and upper
bound are derived from Turner (2006) response surface, according to the sample size.
However, conclusive inference cannot be made when the test statistic falls within the lower
and upper bounds. In this case, the time series properties must be known before any
conclusion can be drawn (Pesaran et al., 2001). When a long-run relationship exists, the
F-test indicates which variable should be normalized. If a long-run relationship exists
(co-integration) among the variables, the following long-run model is estimated:
Xk X k Xk
LnðY A Þt ¼b0 þ f1j LnðY A Þt2j þ b1j FLI t2j þ b2i RIRt2j
j¼1 j¼0 j¼0
ð8Þ
X
k X
k
þ b3i LnðK A Þt2j þ b4i LnðLA Þt2j þ ht
j¼0 j¼0
The orders of lags in the ARDL model are selected by minimizing the Schwarz Bayesian
criterion (SBC) and Akaike information criterion (AIC). The ARDL specification of the
short-run dynamics can be derived by constructing an ECM of the following form:
X k X
k X
k
DLnðY A Þt ¼b0 þ f1j DLnðY A Þt2j þ b1j DFLI t2j þ b 2i DRIRt2j
j¼1 j¼0 j¼0
ð9Þ
X
k X
k
þ b3i DLnðK A Þt2j þ b4i DLnðLA Þt2j þ lECM t21 þ y t
j¼0 j¼0
where ECMt2 1 is the error correction term, defined as:
Xk Xk X
k
ECM t ¼LnðY A Þt 2 b0 2 f1j LnðY A Þt2j 2 b1j FLI t2j 2 b2i RIRt2j
j¼1 j¼0 j¼0
X
k X
k ð10Þ
2 b3i LnðK A Þt2j 2 b4i LnðLA Þt2j
j¼0 j¼0
CAER All coefficients of the short-run equation are coefficients relating to the short-run
3,2 dynamics of the models convergence to equilibrium and l represent the speed of
adjustment for short-run discrepancy to the long-run equilibrium.

4. Results and discussions

202 Table I represents the result of PP unit root test for five variables, agricultural sector
GDP [Ln(YA)], labor force in the agricultural sector [Ln(LA)], gross fixed capital
formation in the agricultural sector [Ln(KA)], RIR and FLI. The PP test statistics suggests
that all the variables are integrated of order one, i.e. I(1). Therefore, the hypothesis that
the time series property contains an autoregressive unit root is accepted in all the cases.
The next step is to examine the long-run relationship among the variables as
suggested by Pesaran and Shin (1999). The optimal lag order selected by minimizing the
AIC and SBC. The calculated F-statistics for the cointegration test is displayed in Table II.
The critical value is reported in the same table which is derived from the Turner (2006)
response surface (according to the sample size). The calculated F-statistics ( ¼ 8.49)
is higher than the upper bound critical value at 1 percent level of significance. This
verifies the robustness of a long-run co-integration relationship among the variables.
Table III shows the result of long-run coefficients and optimum ARDL agricultural
growth model which was selected on the basis of AIC and SBC.
According to empirical results, the FLI, capital and labor positively (statistically
significant) determine agricultural growth in the long run. On the other hand, the RIR
negatively effects (at 10 percent level of significance) agricultural growth in the long run.
The FLI is positively and significantly associated with agricultural growth in the long
run. The coefficient of FLI is 0.29, which shows that a unit increase in the FLI increases
AGDP by Rs 1.34 million in the long run[5], while the RIR is negatively correlated with
agricultural growth. Therefore, one unit increase in the RIR decreases agricultural GDP

PP unit root test

Regressors Level First difference

Ln(YA) 2 2.04 25.06 *

Ln(LA) 2 0.22 27.35 *
Ln(KA) 2 2.19 26.03 *
RIR 2 3.14 25.08 *
FLI 0.64 22.37 *
Table I.
Unit root test results Note: Significant at: *1 percent level

F-statistic 8.49
Critical value (%) Lower bound I(0) Upper bound I(1)

1 5.14 6.87
5 3.57 4.92
10 2.92 4.11
Table II.
Bounds test for long-run Notes: Critical values derived from the Turner (2006) response surface; unrestricted intercept and no
relationship trend (k ¼ 4)
 Impact
Dependent variable Ln(YA)
Regressors Coefficients t-ratio p-value of financial
Ln(LA) 1.27 1.71 0.09
liberalization
Ln(KA) 0.40 4.47 0.00
RIR 20.015 2 1.67 0.10
FLI 0.29 5.99 0.00 203
Constant 4.96 3.44 0.00
R2 0.99
R-bar2 0.99 Table III.
F-stat. ( p-value) 5,360.0 (0.00) Long-run coefficients of
DW-statistic 2.2491 agricultural growth model

by Rs 1.02 million[6] in the long run. The other determinants, labor and capital are
positively linked to agricultural growth according to growth theory.
For short-run analysis this study has also used the AIC and SBC in order to select the
ARDL-based ECM. The regression results are given in Table IV, the estimated value of
error correction term [ECM(2 1)] is 2 0.24 which is statistically significant, suggesting
that ECM tends to cause agricultural growth to converge monotonically to its long-run
equilibrium path in relation to changes in the exogenous variables.
The results in Table IV also suggest that the FLI, RIR and capital positively and
significantly impact on agricultural GDP, but there is no evidence of the impact of labor
force in the short span of time.
The diagnostic test results (Table V) indicate that the model is well specified. None
of the statistics shown in the table are significant.

Dependent variable DLn(YA)

Regressors Coefficients t-ratio p-value

DLn(LA) 0.29 1.42 0.16

DLn(KA) 0.096 2.68 0.01
D(RIR) 0.004 2.14 0.04
D(FLI) 0.069 3.19 0.003
ECM (21) 2 0.24 2 3.39 0.002
Constant 1.18 2.92 0.007
R2 0.52
R-bar2 0.44 Table IV.
F-stat. 6.22 (0.00) Short-run coefficients of
DW-statistic 2.2491 agricultural growth model

Test statistics LM version F version

A: serial correlation – 0.58 (0.45)

B: functional form – 1.43 (0.24)
C: normality 0.53 (0.76) – Table V.
D: heteroscedasticity – 4.03 (0.05) Results of diagnostic test
CAER 5. Conclusion and policy recommendation
3,2 This paper investigated the impact of financial liberalization on agricultural growth for
the Pakistan economy by applying the semi-log function over the period 1971-2007.
We have attempted to construct an FLI for Pakistan for the first time. The study used the
PP unit root in order to determine the order of integration and ARDL technique for long-
and short-run coefficients. Empirical results show that agriculture growth is positively
204 related to the FLI in the long run and short run. But the RIR has a negative effect in the
long run and positive effect in the short run.
While financial liberalization has had a positive impact on agricultural growth in the
short and the long run. This may be on account of removal of credit rationing and other
aspects of liberalization that had a positive impact on agricultural output growth. But the
finding that one unit increase in the RIR reduces agricultural growth by over Rs 1 million
is very worrying. The analysis brings to the fore the tremendous loss of agricultural
output on account of IMF’s stabilization policies during the 1990s and again from 2008
onwards on account of tight monetary policy to fight inflation. And the impact on supply
shortage emanating from reduction in agricultural output growth (with constant
demand for agricultural output) on increasing prices of agricultural products is a
paradox, which has not been addressed by the policy makers in Pakistan. In fact,
in Pakistan over the last few years prices of agricultural commodities have skyrocketed,
especially those related with basic food items. Is a tight monetary policy, through
constraining output, enhancing the very prices it is supposed to be curtailing? The SBP
and the GOP need to address this paradox and try to make financial liberalization
consistent with agricultural output growth.

Notes
1. See Pakistan Economic Survey 2007-2008.
2. But these studies fail to explain the direction of causality between financial development and
economic growth.
3. Siddiqi (2008) argues that when prices are decreasing, financiers refuse to clear the payments
causing brokers to default. The financier has incentive to withdraw from the falling market
causing further fall in prices.
4. The classical approach of residual-based cointegration tests
5. The FLI is in the level form but agricultural GDP is in the natural logarithmic form.
The antilog of 0.29 is 1.34.
6. The RIR is in the level form and the agricultural GDP is in the natural logarithmic form.
The antilog of 0.015 is 1.02.

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Appendix Impact
of financial
liberalization
Variables Liberalization year

(1) Islamization (IS) 1980

(2) Interest rate deregulation (IR) 1995 207
(3) Credit control (CC) 1992
(4) Stock market reforms (SMR) 1991
5) Prudential regulations (PR) 1994
(6) Privatization of financial institutions (P) 1991
(7) Removal of entry barriers (REB) 1993
(8) Non-performing loans (NPL) 1990 Table AI.
(9) External account liberalization (EAC) 1994 Description and
(10) Debt management reforms (DMR) 1990 implementation data of
(11) Open-market operation (OM) 1995 policy variables

Eigenvalues 9.255985 0.852483 0.553191

Variance prop. 0.841453 0.077498 0.05029
Variables Eigenvector-1 Eigenvector-2 Eigenvector-3
IS 0.18444 0.7137 2 0.6727
IR 0.3029 20.3090 2 0.2657
CC 0.31698 0.0148 0.1423
SMR 0.31483 0.1482 0.2718
PR 0.31297 20.2458 2 0.1737
P 0.31483 0.1482 2 0.2718 Table AII.
REB 0.31638 20.1219 2 0.0159 Eigenvalues and
NPL 0.30641 0.2447 0.2978 eigenvectors of the
EAC 0.31297 20.2458 2 0.1737 correlation matrix of
DMR 0.30641 0.2447 0.2978 financial liberalization
OM 0.3029 20.3090 2 0.2657 policy variables
 3,2

208
CAER

Table AIII.
Description and

policy variables
implementation data of
Year IS IR CC SMR PR P REB NPL EAC DMR OM

1971 0 0 0 0 0 0 0 0 0 0 0
1972 0 0 0 0 0 0 0 0 0 0 0
1973 0 0 0 0 0 0 0 0 0 0 0
1974 0 0 0 0 0 0 0 0 0 0 0
1975 0 0 0 0 0 0 0 0 0 0 0
1976 0 0 0 0 0 0 0 0 0 0 0
1977 0 0 0 0 0 0 0 0 0 0 0
1978 0 0 0 0 0 0 0 0 0 0 0
1979 0 0 0 0 0 0 0 0 0 0 0
1980 1 0 0 0 0 0 0 0 0 0 0
1981 1 0 0 0 0 0 0 0 0 0 0
1982 1 0 0 0 0 0 0 0 0 0 0
1983 1 0 0 0 0 0 0 0 0 0 0
1984 1 0 0 0 0 0 0 0 0 0 0
1985 1 0 0 0 0 0 0 0 0 0 0
1986 1 0 0 0 0 0 0 0 0 0 0
1987 1 0 0 0 0 0 0 0 0 0 0
1988 1 0 0 0 0 0 0 0 0 0 0
1989 1 0 0 0 0 0 0 0 0 0 0
1990 1 0 0 0 0 0 0 1 0 1 0
1991 1 0 0 1 0 1 0 1 0 1 0
1992 1 0 1 1 0 1 0 1 0 1 0
1993 1 0 1 1 0 1 1 1 0 1 0
1994 1 0 1 1 1 1 1 1 1 1 0
1995 1 1 1 1 1 1 1 1 1 1 1
1996 1 1 1 1 1 1 1 1 1 1 1
1997 1 1 1 1 1 1 1 1 1 1 1
1998 1 1 1 1 1 1 1 1 1 1 1
1999 1 1 1 1 1 1 1 1 1 1 1
2000 1 1 1 1 1 1 1 1 1 1 1
2001 1 1 1 1 1 1 1 1 1 1 1
2002 1 1 1 1 1 1 1 1 1 1 1
2003 1 1 1 1 1 1 1 1 1 1 1
2004 1 1 1 1 1 1 1 1 1 1 1
2005 1 1 1 1 1 1 1 1 1 1 1
2006 1 1 1 1 1 1 1 1 1 1 1
2007 1 1 1 1 1 1 1 1 1 1 1
About the authors Impact
Qazi Muhammad Adnan Hye is Visiting Faculty at the Institute of Business Management (IoBM)
and a Research Scholar at the Applied Economics Research Centre, University of Karachi, of financial
Karachi, Pakistan. He received his MAS in Economics from the Applied Economics Research liberalization
Centre, University of Karachi and MA in Economics from Islamia University of Bhawalpur,
Pakistan. He has nine publications in various national and international refereed journals. He has
also presented three conference papers in Pakistan.
Shahida Wizarat is Head, Economics Department, IoBM, Karachi, Pakistan. She has been 209
involved in research, teaching and administration. Her areas of interest are industrial economics
focusing on industrial productivity, its determinants; concentration and profitability;
development economic issues; economic policies; debt and its management. Dr Shahida Wizarat
obtained her PhD in Economics from the University of East Anglia, Norwich, England, where she
studied on a British Council Scholarship. Earlier, she gained her MA in Economics from Vanderbilt
University, Nashville, Tennessee, USA, while on a Rotary Foundation Graduate Fellowship. She is
the author of 45 research papers and articles published in journals of international repute in
Pakistan and abroad. She has organized, attended and read papers in several international and
national conferences. She has served as the Editor of the Pakistan Journal of Applied Economics
and Director of the Applied Economics Research Centre, University of Karachi, and has served on
the BODs of the KSE and is on advisory boards and research councils of several organizations and
universities. She is working on two books on economic policies in Pakistan and drivers of growth
for countries over the period 1980-2006 using panel data. Shahida Wizarat is the corresponding
author and can be contacted at: shahida.wizarat@iobm.edu.pk

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