Munich Personal RePEc Archive

Determining Pakistan’s Financial

Ali, Amjad

European School of Administration and Management (ESAM),

2022

Online at https://mpra.ub.uni-muenchen.de/116097/
MPRA Paper No. 116097, posted 24 Jan 2023 14:16 UTC
 Determining Pakistan's Financial Dependency: The Role of Financial
Globalization and Corruption
Amjad Ali1
ABSTRACT

This article has analyzed the role of financial globalization and corruption in determining financial

dependency in Pakistan from 1980 to 2020. For checking the stationary of the data Augmented

Dickey-Fuller and Zivot-Andrew structural break unit root tests. For examining the cointegration

autoregressive distributed lag method has been applied. The results explain that the level of

corruption has a positive and significant impact on financial dependency in Pakistan. Financial

globalization has a negative and significant impact on financial dependency in Pakistan. The

estimated outcomes explain that the unemployment rate and balance of payments have a positive

and significant impact on financial dependency in Pakistan. The findings of this article suggest

that for the reduction of financial dependency, the government of Pakistan should increase

financial globalization and depresses corruption, unemployment, and balance of payments.

Keywords: Financial dependency, financial globalization, corruption, budget deficit

JEL Codes: D73, F36, F38, H61

1. INTRODUCTION

Since, the beginning of the 21st century, financial dependence has become a rampant source among

developing countries to meet the necessary financial needs. Historically, the dynamic of financial

dependency is attached to war financing and business cycle fluctuations, whereas budget surpluses

and deficits are instrumental. Traditionally, rationalization and tax-smoothing consider the best

way to reduce financial dependency (Barro, 1979; Ali & Naeem, 2017). But the rising trend of

1
European School of Administration and Management (ESAM), France: Lahore School of Accountancy and Finance, University of Lahore,
Pakistan

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financial dependency since the 1980s’, has surprised policymakers when rationalization and tax-

smoothing failed badly. Moreover, the recent hike in globalization also highlighted the intensity

of financial dependency.

Before the recent financial crisis, the world developed a high tolerance for the issue of financial

dependency. This is probably due to the relatively calm times in the global economy in the 20

years preceding the crisis, especially at the beginning of the 21st century in the presence of a global

saving glut and very low-interest rates. This made reliance on debts a preferable option for several

countries and unsurprisingly high increases in both government and external debts were observed.

The debt levels in several advanced economies exceed 100% of GDP and lower but progressively

growing debt levels in less developed countries. It seems as if the world had forgotten the debt

crisis of the 1980s and its severe consequences for economies. Following the debt crisis of the

1980s, many studies investigated the issue of high debts and their sustainability, but primarily

focused on developing economies and with little relevance for advanced countries. Several studies

have shown the danger of high and increasing indebtedness for less developed countries. In the

context of developing economies, various theoretical contributions argued that in the long run, the

expected effects of high levels of debt on economic activity are principally negative. While it is

recognized that there is also a possibility of a positive impact of debts on economic growth.

Theoretically, higher public debts may be considered as endangering the private debts through the

crowding out effect and thus reduce expectedly more productive private investment, and in

consequence, reduce the potential long-run economic growth. In addition, there may be also an

effect on the long-term interest rate (which is expected to increase under the pressure of increasing

public debt), again it may reduce the long-term growth, with a possibility even of a non-linear

effect. Thus, in theory, both positive and negative effects of debt are possible. However, the

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extensive literature emphasizes the negative relationship between economic growth and debt e.g.,

Reinhart and Rogoff (2011), and Ali (2015, 2018).

Financial globalization is understood as the integration of a country’s local financial system with

international financial markets and institutions. This integration typically requires that

governments liberalize the domestic financial sector and the capital account. Integration takes

place when liberalized economies experience an increase in cross-country capital movement,

including active participation of local borrowers and lenders in international markets and

widespread use of international financial intermediaries (Ali & Rehman, 2015; Ali & Audi, 2018).

Although developed countries are the most active participants in the financial globalization

process, developing countries (primarily middle-income countries) have also started to participate.

Historically, financial globalization is not a new phenomenon, but the current depth and breadth

of financial globalization are unprecedented. Capital flows have existed for a long time. In fact,

according to some measures, the extent of capital mobility and capital flows a hundred years ago

is comparable to today’s. In the past, few countries and sectors had participated in financial

globalization. Capital flows tended to follow the migration and were generally directed towards

supporting trade flows. Mostly, capital flows took the form of bonds and they are long-term in

nature. International investment is dominated by a small number of freestanding companies, and

financial intermediations are concentrated on a few family groups. The international system is still

dominated by the gold standard, or gold-backed national currencies (Taylor, 1996; Obstfeld &

Taylor, 1998; Baldwin & Martin, 1999; Collins, 1999; Bordo et al., 1999; Eichengreen & Mody,

2000; World Bank, 2000; Ali & Ahmad, 2014; Ali and Audi, 2016; Ali & Bibi, 2017).

Developing countries like Pakistan are inclined to attract foreign resources to meet the domestic

needs of physical capital (Ali et al., 2016; Ali & Zulfiqar, 2018; Ali & Senturk, 2019; Audi et al.,

3
2021; Ahmad et al., 2022; Audi et al., 2022; Ali et al., 2022; Audi et al., 2022). The inflow of these

financial resources is supposed to increase investment and economic growth, but there are only a

few success stories regarding financial dependency and economic growth. With other developing

countries in South Asia, Pakistan has received a significant amount of financial resources, but their

role is critical to explain as these countries are still poor and deprived. The financial indebtedness

of Pakistan doesn’t show us an attractive picture, as the average debt stock was 32.4 share of GDP

during the 1970s which further increased to 38 percent of GDP in the 1990s, still Pakistan has the

highest debt rate in the region. This growing foreign dependency provides a signal for Pakistan, if

the present trend is still going Pakistan is likely to default. This scenario increases the importance

of financial dependency to study, as Pakistan needs better management of foreign financial

resource inflow.

2. LITERATURE REVIEW

A sufficient amount of studies related to the optimal choice considered financial dependency as a

part of the business cycle (Barro, 1979; Lucas and Stokey, 1983; Aiyagari et al., 2002; Angeletos,

2002; Chari et al., 1994; Marcet and Scott, 2009; Sulehri & Ali, 2020). Aiyagari and McGrattan

(1998) and Shin and Sohn (2006) highlight the importance of physical capital in the process of

economic growth. In these studies, the role of government is to provide safety when agents are

subject to uninsurable idiosyncratic risk. The government accumulates debt to crowd out private

capital, which is inefficiently high due to precautionary savings. Krusell and Rios-Rull (1999),

Corbae et al., (2009), and Bachmann and Bayer (2013) mention that government expenditures on

transfer payments force the government to rely on external sources of finances. Alesina and

Tabellini (1990), Persson and Svensson (1989), Battaglini and Coate (2008), Caballero and Yared

4
(2008), Ilzetzki (2011), Aguiar and Amador (2016) and Song et al., (2012) further mention that it

is political economy, which decides the pattern of external dependency of a nation. Klein and

Marmor (2006) and Azzimonti et al., (2014) point out that tax structure plays important role in

determining the external dependency and fiscal deficit of the country. Chang (2008) explains that

international liberalization of capital markets changes the borrowing pattern of developing

countries. Backus and Kehoe (1989), Mendoza and Tesar (2005), and Quadrini (2005) mention

that developing countries cannot find a balanced budget with the help of developed countries and

financial institutions. Siddiqui and Malik (2001) claim that foreign resource inflow increased

resource availability and as a result, it contributes to economic growth. Caballero et al., (2008),

Mendoza et al., (2009), and Angeletos and Panousi (2011) mention that cross-country domestic

heterogeneity in financial markets disturbed the financial self-sufficiency of developing countries

and their position in the international financial market.

Over the years, the lack of financial resources urges the governments of Pakistan to rely on foreign

financial resources. The domestic financial markets in Pakistan are trying to cope with this issue,

and Pakistan opted for the era of liberalization to integrate its markets both domestically and

internationally. In the process of self-sufficiency in financial resources, Pakistan is a financial

dependency on developed countries (Uppal, 1993; Malik et al., 2006). Empirical evidence reveals

that the domestic investment strategies of Pakistan also do not favor to opt more globalized

economic system (Farid et al., 1995; Hussain et al, 2002; Hameed et al., 2006). These issues urge

us to study the impact of financial globalization on financial dependency in Pakistan.

Availability of financial resources is one of the main requirements in the process of economic

growth, but developing countries like Pakistan have lesser financial resources. Developing

countries are characterized by low economic growth, high poverty, fewer natural resources, and

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high dependency on developed countries. An elite corrupt class comprised of few people is

controlling the whole resources of these countries (Jaffrey, 2002). In this globalized era, financial

dependency has become a topic of discussion among policymakers, and the emergence of the IMF,

the World Bank, and WTO has lightened up the world with globalized finances. Now, developing

countries rely on debt and foreign aid to meet their financial requirements. Historically, highly

indebted economies have effectively responded with a variety of policy approaches, and three

different options are available in this regard. First, a growth-supporting policy mix is inevitable

for debt reduction and fiscal consolidation. Second, fiscal consolidation must emphasize persistent

structural reforms to public finances over temporary or short-lived fiscal measures. Third, reducing

public debt is bounded to be time taking, especially in the context of a weak external environment.

Since 1951, domestic savings in Pakistan are not been enough for domestic investment, and the

investment has been substantially funded by foreign resources (Ahmad and Amjad, 1984). Over

time domestic financial markets in Pakistan have become more integrated with both the world

economy and Pakistan’s real domestic economy over the era of globalization. This evidence has

made Pakistan an interesting case to study, so, this study has examined the impact of financial

globalization and corruption on financial dependency in the case of Pakistan. This type of study is

hardly available in the existing literature. Being novel in nature, this study is a healthy contribution

to the respective literature.

3. THEORETICAL LINKS TO EMPIRICAL MODEL

The concept of dependency theory was first introduced during the late 1960s, but it got much

importance with the work of Ahiakpor (1985). It points out that today’s developed countries also

face similar situations in past, so with the help of developed countries, developing countries can

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achieve a higher level of economic growth. Thus, financial dependency refers that when a country

is unable to meet its required financial needs domestically, it should rely on developed countries

or international financial institutions i.e. the World Bank and IMF. Normally, financial

dependency has been witnessed by developing countries, as these countries have low economic

growth, high levels of poverty, inefficient utilization of natural resources, and high inflation rate

(Jaffrey, 2002). Khapoya (2015) mentions that imperialism is the main cause of financial

dependence in African countries, the West had colonized these countries and snatched their natural

resources. The leadership of developing and colonized countries are still brainwashed and inspired

by developed countries. It is observed that due to leadership dependency, the level of corruption

is increasing the financial dependency among developing countries (Gyimah-Brempong, 2001).

The internal and external conditions of developing countries like Pakistan impact the utilization of

economic surplus and reduce the chances to overcome the financial dependency of these countries.

Developing countries are still confused between capitalism and socialism (Adil, 2007). Financial

globalization is a greater contributor to the financial dependency of developing countries because

it smooths the routes to the extraction of economic resources towards national and international

peripheral societies. The opponents of globalization, consider it a loophole where developed

countries exploit developing countries. Some internal factors are responsible for financial

dependency i.e. poor investment, lack of motivation, political instability, outdated cultural

practices, corruption, and overpopulation.

There is a direct or traditional channel through which financial globalization impacts financial

dependency. The neoclassical growth theory explains that financial globalization leads to an inflow

of capital in developing countries from developed countries when there are higher returns attached

to this capital. It is assumed that financial inflow should complement limited savings in developing

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countries and the level of investment can be increased in these countries. Certain types of financial

inflows are attached to technological spillovers and managerial and organizational expertise. There

are collateral benefits are attached to financial flows, which drive economic growth, improvement

of institutions, development of domestic financial sectors, and betterment in macroeconomic

policies (Levine, 2005; Kose et al., 2006; Mishkin, 2006, 2008; Senturk & Ali, 2022). Stulz (2005)

explains that financial globalization reduces different agency issues by decreasing the cost of

outside finance, it is beneficial for firms that have less capital. Based on mentioned studies, the

function of this study model becomes as:

FINDt=f(CORRt, FINGt, DEFICITt, UNEMt, BOPt,) (1)

FIND=Financial dependency (For the measurement of financial dependency, an index has been

constructed with the help of Principle Component Analysis (PCA). For the construction of the

financial dependency index, total debt, foreign aid and official development assistance have been

used.)

COR=Corruption level (The level of corruption has been measured by the corruption perception

index constructed by Transparency International. It is the composite index of different indicators

based on 13 surveys and corruption assessments and the data of selected variables have been

collected from a variety of reputed institutions.)

FGLB=Financial Globalization (Financial globalization index has been measured by the KOF

index, for the measurement of financial globalization, this index has leading indicators i.e. private

credit to GDP, de facto trade openness, the standard deviation of CPI inflation, and government

revenue from tariff.)

DEFICIT= Budget deficit (Budget deficit measures the difference between government revenue

and government expenditure. If the revenues are greater than the expenditures, it is budget surplus.)

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UNEM=unemployment rate (Unemployment rate measures the percentage of the total labor force

willing to work but cannot find work.)

BOP=Balance of Payment (Balance of payments measures the difference between receipts and

payments of a country to the rest of the world. If the receipts are higher than the payments, the

balance of payments is in surplus but if the receipts are less than the payments balance of payments

is in deficit.)

t= time-period (1980-2020)

From the above functional form, we can drive the econometric model:

FINDt=α+β1CORt+β2FINGt+β3DEFICITt+β4UNEMt+ β5BOPt +Ut (2)

All the variables are explained above:

α= intercept/constant coefficient

β’s= slope coefficient

U= error term

This study is going to examine the impact of financial globalization on financial dependency in

the case of Pakistan. The empirical analysis taken will be taken from 1980 to 2020. Data on

selected variables will be taken from the World Bank, Ministry of Finance Pakistan, and State

Bank of Pakistan. KOF index of financial globalization will be taken from Gutenberg University,

and corruption data will be taken from Transparency International.

4. ECONOMETRIC METHODOLOGY

In empirical studies, applying the tools of econometrics is a very important part of the study. The

macroeconomic data have the issues of time trends, these time trends make the estimated results

biased (Nelson and Plosser, 1982; Lumsdaine and Papell, 1997). The existence of a time trend

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makes the time series data non-stationarity and data has unit root issues. There are many

procedures available that check the unit root issue in the data, these unit root tests help the

researcher to check the reliability of the data. Stationary data have impermanent shocks and series

convergence in the long-run equilibrium path. But non-stationary time series never converge in

the long-run equilibrium path, and the estimated results of this data are not reliable. While

explaining the non-stationary data, Dickey and Fuller (1979) point out that there are positive or

negative shocks in the data. Before any further analysis, the removal of these shocks is necessary.

There are many unit root tests are available that help to remove unit root issues in the time series

data. For checking the stationarity of our time series data, the present study has used Augmented

Dickey-Fuller (ADF) (1981). The functional form of ADF becomes as:

q
X t = X t −1 +   j X t − j + e1t (3)
j =1

q
X t =  + X t −1 +   j X t − j + e2t (4)
j =1

q
X t =  + t + X t −1 +   j X t − j + e3t (5)
j =1

4.1.ZIVOT AND ANDREW STRUCTURAL BREAKS UNIT ROOT TEST

The problem with PP, DF-GLS, and ADF is that these tests don’t highlight the existence or non-

existence of structural breaks in the data. Zivot and Andrews (2002) propose a unit root test to

solve this issue. Zivot and Andrew's test proceeds with three model models to test for a unit root;

model A uses a one-time change in the level of series; model B allows for a one time-change in

the slope of the trend function; model C combines one-time changes in the level and the slope of

trend function of the series.

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 𝑘
Model A; 𝛥𝑦 = 𝑐 + 𝛼𝑦𝑡−1 + 𝛽𝑡 + 𝛾𝐷𝑈𝑡 + ∑ 𝑑𝑗 𝛥𝑦𝑡−𝑗 + Ɛ𝑡 (6)
𝑗=1

𝑘
Model B; 𝛥𝑦 = 𝑐 + 𝛼𝑦𝑡−1 + 𝛽𝑡 + Ɵ𝐷𝑇𝑡 + ∑ 𝑑𝑗 𝛥𝑦𝑡−𝑗 + Ɛ𝑡 (7)
𝑗=1

𝑘
Model C; 𝛥𝑦 = 𝑐 + 𝛼𝑦𝑡−1 + 𝛽𝑡 + Ɵ𝐷𝑇𝑡 + 𝛾𝐷𝑈𝑡 + ∑ 𝑑𝑗 𝛥𝑦𝑡−𝑗 + Ɛ𝑡 (8)
𝑗=1

where DUt is an indicator dummy variable for a mean shift occurring at each possible break-date

(TB) while DTt is the corresponding trend shift variable. Formally,

1−−−−−−𝑖𝑓 𝑡>𝑇𝐵
𝐷𝑈𝑡 = {0−−−−−−− 𝑜𝑡ℎ𝑒𝑟𝑤𝑖𝑠𝑒 and

𝑡−𝑇𝐵−−−−−−𝑖𝑓 𝑡>𝑇𝐵
𝐷𝑇𝑡 = {0−−−−−−− 𝑜𝑡ℎ𝑒𝑟𝑤𝑖𝑠𝑒

α=0 is the null hypothesis for the above three equations, this reveals the series contains a unit root

with a drift that excludes any structural break, while the alternative hypothesis α<0 implies that

the series is a trend-stationary process with a one-time break occurring at an unknown point in

time. The Zivot and Andrews test consider every point as a potential break-date (TB) and runs a

regression for every possible break-date sequentially. From amongst all possible break-points

̅̅̅̅) the date which minimizes the one-sided

̂(=α −1) =1. According to Zivot and Andrews, the presence of the endpoints
t-statistic for testing α

causes the asymptotic distribution of the statistics to diverge towards infinity. Therefore, some

regions must be chosen such that the endpoints of the sample are not included. Zivot and Andrews

suggest the ‘trimming region’ be specified as (0.15T, 0.85T). Perron and Qu (2007) suggest that

most economic time series can be adequately modeled using either model A or model C. As a

result, the subsequent literature has primarily applied model A and/or model C. In another study,

Pesaran et al., (1999) show that if one uses model A, when in fact the break occurs according to

model C then there will be a substantial loss in power. However, if a break is characterized

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according to model A, but model C has been used then the loss in power is minor, suggesting that

model C is superior to model A. Based on these observations, we choose model C for our analysis

of unit roots.

4.2.AUTOREGRESSIVE DISTRIBUTIVE LAG MODEL TO CO-INTEGRATION

Following applied econometrics, numerous techniques are available which examine the

cointegration among the variables of the model. Well-known techniques are Engle-Granger's

(1987) technique based on error term, Johansen and Juselius's (1990) and Johansen's (1991/1992)

techniques based on Maximum Likelihood. The common thing with all these traditional

techniques, these techniques required identical order of integration for examining the cointegration

among the variables of the model. These traditional techniques become invalid in the presence of

mixed or different orders of integration among the variables of the model. Moreover, these

techniques are unable to present unbiased estimates in the presence of structural breaks. In this

advanced age, the structural changes in the economies are changing the whole socioeconomic and

institutional scenarios of the economies, and with the help of traditional techniques, we are unable

to examine unbiased results (Perron, 1989, 1997; Leybourne and Newbold, 2003). Pesaran and

Pesaran (1997), Pesaran et al., (1999), and Pesaran et al., (2001) have developed a new technique

of cointegration which is ARDL (Autoregressive Distributive Lag).

Following the procedure of the ARDL technique, this technique has some advantages over the old

and outdated techniques of cointegration. First, ARDL can be used in the presence of mixed order

of integration among the variables of the model (Pesaran et al., 1999). Moreover, ARDL can be

applied to either variables that have the same order of integration or mixed order (Pesaran et al.,

1999). Second, ARDL can provide better estimates in the case when we have a small sample size

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of the data set (Mah, 2000) but the old techniques are unable to provide better estimates in the case

of a small data set. Third, the ARDL procedure allows the researcher to use a sufficient number of

lags in the modeling process of final estimates (Laurenceson and Chai, 2003). Third, ARDL

provides valid and sufficient information about structural breaks in the time series variable.

Pesaran and Pesaran (1999) mention that “appropriate modification of the orders of the ARDL

model is sufficient to simultaneously correct for residual serial correlation and the problem of

endogenous variables”.

The Unrestricted Vector Error Correction Model is used as the bases for the ARDL procedure and

ARDL has unique properties for long-run and short-run equilibrium rather than old methods of

cointegration (Pattichis, 1999). Pesaran et al., (1997), after four years Pesaran et al., (2001) point

out that during a few cases, the long-run correlation of the variables can be examined with the help

of the ARDL. As we have selected the required lag order for ARDL, the OLS procedure can be

utilized for estimation and identification. Now we can estimate valid coefficients and inferences

in the presence of long-run co-integration. Alam and Quazi (2003) point out that ARDL analysis

can be possible even when we have endogenous variables in the model as well. ARDL can be used

for mixed order of integration among the variables of the model. But in the presence of all the

good qualities ARDL is unable to provide valid estimates if either variable is stationary at the 2nd

difference. ARDL procedure can be applied as follows:

 lnYt = 1 + 2t + 3 lnYt −1+ 4 lnXt −1+ 5 lnZt −1+ ....

p p p
+  h  lnYt − h +   j  lnXt − j +  k  lnZt − k + .... + uit (9)
h =1 j =0 k =0

Here the dependent variable is ln Yt ; time presented with t ; the lag of the dependent variable can

be presented with ln Yt −1 ; the first independent variable is presented by lnXt ; the second

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independent variable is presented by lnZt and so on. The rate of change can be measured with the

help of  . First, we will examine the direction of the relationship for the variables in the case of

Pakistan with the help of the F test and W test. F-statistic and W-test decide the order of integration

for the variables, here we can use either time trend or intercept for the analysis procedure.

Estimated F-Statistic and W-test are used for the comparison of tabulated values of Pesaran and

Pesaran (1997) or Pesaran et al., (2001) which was further revised by Narayan (2005). In case the

calculated F-test statistic and W-test are higher than the upper bound value, we can reject the null

hypothesis and conclude that there is cointegration among the variables of the model. But in case

the calculated F-test statistic and W-test statistic are not greater than the upper bound value. Then

we can conclude that there is no cointegration among the variables of the model. On the other

hand, if the calculated F-test statistic lies between the lower and upper bound, we can conclude

that the relationship is inconclusive. The procedure to write null and alternative hypothesis of the

ARDL bound test is as follow:

H0 : 3 = 4 = 5 = 0 (no co-integration among the variables)

H A : 3  4  5  0 (co-integration among variables)

After that we found a long relationship among the variables, we can use VECM (Vector Error

Correction Model) for examining the short-run relationship among the variables. VECM procedure

can be explained as:

p p p
 lnYit = 1 + 2t +  h lnYit −h +   j  lnXt − j +  k  lnZit − k + ECTt −1 + ut (10)
h =1 j =0 k =0

Lagged error correction can be presented by ECTt −1 ; all the other variables that have been

explained in the earlier equation. The results of the error correction term explain the speed of

adjustment from the short run towards the long run. To determine the goodness of fit of the ARDL

14
model, diagnostic tests are conducted. The diagnostic or sensitivity tests examine autoregressive

conditional heteroscedasticity, serial correlation, normality, and heteroscedasticity associated with

the model.

5. RESULTS AND DISCUSSION

This part of the study is comprised of empirical results and discussion. The results of descriptive

statistics have been given in table 1. The results present the mean, median, maximum, minimum,

and standard deviation of the selected variables of the model. The estimated outcomes show that

financial dependency, level of corruption, budget deficit, and unemployment rate are negatively

skewed, whereas financial globalization and balance of payment are positively skewed. All the

selected variables have positive Kurtosis values over the selected period. The estimated Jarque-

Bera value probability values of the selected variables are insignificant which reveals that the

selected data of all the variables is normally distributed.

Table-1
Descriptive Statistic
FIND CORR FING DEFICIT UNEM BOP
Mean 0.778866 2.273333 43.08333 6.253889 5.596667 6.338889
Median 0.659390 2.250000 43.00000 6.320000 5.750000 6.000000
Maximum 0.306321 3.000000 54.00000 9.100000 8.270000 12.80000
Minimum 1.871715 1.000000 34.00000 2.300000 3.050000 1.300000
Std. Dev. 0.633666 0.497514 4.783155 1.716782 1.473866 3.075937
Skewness -0.069079 -0.249614 0.354502 -0.262352 -0.035744 0.207340
Kurtosis 2.014677 2.718253 2.704903 2.306675 2.424844 2.018734

Jarque-Bera 1.484923 0.492916 0.884654 1.134021 0.503872 1.702263

Sum -28.03919 81.84000 1551.000 225.1400 201.4800 228.2000

Observations 40 40 40 40 40 40

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The estimated results of the correlation matrix have been given in table 2. The results show that

financial dependency has a positive and significant correlation with the level of corruption in the

case of Pakistan, whereas financial dependency has a negative and significant correlation with

financial globalization. The estimates show that the budget deficit has a negative but insignificant

correlation with financial dependency in Pakistan. The unemployment rate has a positive and

insignificant correlation with financial dependency, whereas financial dependency has a positive

and significant correlation with the balance of payments in the case of Pakistan. The results show

that corruption has a negative and significant correlation with financial globalization, whereas it

has a positive and significant correlation with the balance of payments in the case of Pakistan. The

results reveal that budget deficit and unemployment rate have a positive but insignificant

correlation with corruption in the case of Pakistan over the selected period. The outcomes show

that financial globalization has a negative and significant correlation with the budget deficit and

balance of payments but it has a positive and significant correlation with the unemployment rate

in the case of Pakistan. The budget deficit has a negative and significant correlation with the

unemployment rate but it has a positive but insignificant correlation with the balance of payments.

The results reveal that there is a negative and significant correlation between the balance of

payments and the unemployment rate in the case of Pakistan. The results of the main model show

that most of the independent variables have a significant correlation with the dependent variable

i.e. financial dependency of Pakistan. The overall results of the correlation matrix show that most

of the explanatory variables have significant correlation but not very high correlation which

becomes the issue of multicollinearity. So, there is no issue of multicollinearity among the

explanatory variables of the model.

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 Table-2
Correlation Matrix
Variables FIND CORR FING DEFICIT UNEM BOP
FIND 1.000000
CORR 0.691912*** 1.000000
FING -0.372567** -0.480736*** 1.000000
DEFICIT -0.125370 0.149719 -0.543242*** 1.000000
UNEM 0.244210 0.027805 0.381656** -0.603529*** 1.000000
BOP 0.467100*** 0.399568** -0.489969*** 0.252009 -0.432249*** 1.000000
***,**,* represent significant 1 percent, 5 percent, and 10 percent respectively.

For checking the unit root problem in the data, this study has applied the Augmented Dickey-Fuller

unit root test. The results of ADF have been given in table 3. The results show that only the level

of corruption is stationary at level. At the first difference, all the selected variables become

stationary, so the null hypothesis of non-stationary is rejected at the first difference for all the

selected variables. Normally time series data has a time trend, so we have checked the unit root

issue in the presence of a time trend. The results of ADF in the presence of time trends show that

financial globalization is stationary at a level. The results show that all the selected variables in

the presence of a time trend become stationary at the first difference and the null hypothesis of

non-stationary is rejected. The results of the ADF unit root test reveal that there is mixed order of

integration among the selected variables of the model, this is the best situation to use the

autoregressive distributed lag model to examine the cointegration among the variables of the

model.

Table-3
Augmented Dickey-Fuller Unit Root Test
Variables I(0) I(1) I(0) @Time Trend I(1) @Time Trend
FIND -1.851718 -6.909915*** -4.795301*** -6.946409***
CORR -2.808259* -6.021501*** -3.087831 -5.890252***
FING -2.178454 -8.715159*** -2.485120 -8.775853***
DEFICIT -2.219777 -6.544053*** -2.124912 -6.545255***
UNEM -1.796526 -5.868698*** -1.359098 -6.049437***
BOP -1.759962 -5.534930*** -2.287427 -5.794094***
***,**,* represent significant 1 percent, 5 percent, and 10 percent respectively.

17
For checking the structural break in the data, this study has applied the Zivot-Andrew structural

break unit root test. The estimated results of the Zivot-Andrew structural break have been given in

table 4. The results show that in the presence of a structural break, no variable of the model is

stationary at level, but at the first difference, financial dependency, level of corruption, financial

globalization, budget deficit, unemployment rate, and balance of payments are stationary with

structural breaks, 2002, 1998, 2001, 2013, 2005 and 2000 respectively. The estimated outcomes

show that in the presence of time trends and structural breaks financial globalization and level of

corruption are stationary at level. The estimated results show that with time trend all selected

variables become stationary at first difference with different structural breaks. The overall results

of the Zivot-Andrew structural break reveal that in the presence of different structural breaks, there

is mixed order of integration among the selected variables which is a suitable situation to apply

the ARDL method of cointegration.

Table-4
Zivot-Andrews Unit Root Test (with Structural-Break)
Variables I(0) I(1) I(0) @Time Trend I(1) @Time Trend
FIND 1.299738(2000) -4.221678***(2002) -6.08421*** (2001) -4.242922*(2001)
CORR -2.094345(1999) -3.463186*(1998) -5.681489***(2001) -3.947343*(2001)
FING -3.239350(2007) -5.237157***(2001) -4.174400(2007) -6.962503***(2007)
DEFICIT -2.612361(1998) -5.931104***(2013) -2.899916(1998) -4.318376*(1999)
UNEM -0.154058(2005) -4.055652*(2005) -0.418005(2005) -4.717809**(2005)
BOP -1.799899(1997) -4.833668***(2000) -3.501160(1997) -4.084782*(2004)
***,**,* represent significant 1 percent, 5 percent, and 10 percent respectively. Parentheses ()
present structural break.

Lag selection is considered one of the prerequisites to examine the cointegration among the

variables. Keeping the number of variables and the number of observations in our view and lags

required for the co-integration test, a maximum of two lags are allowed for the Vector Auto-

Regressive process. The results of the estimated lag order selection criteria have been given in

table 5. Here results of logL, LR, FPE, AIC, SC, and HQ have been given. Thus, by following the

18
LR, FPE, SC, and HQ lag selection criterion maximum lag length 1 has been selected for running

the autoregressive distributed lag method of cointegration.

Table-5
Lag Order Selection Criteria
Lag LogL LR FPE AIC SC HQ
0 -307.7290 NA 7.291617 19.01388 19.28597 19.10543
1 -222.8234 133.7906* 0.391364* 16.04990 17.95455* 16.69076*
2 -194.2256 34.66393 0.772165 16.49852 20.03572 17.68868
3 -141.4346 44.79240 0.558584 15.48088* 20.65064 17.22035
* indicates lag order selected by the criterion
LR: sequential modified LR test statistic (each test at 5% level)
FPE: Final prediction error
AIC: Akaike information criterion
SC: Schwarz information criterion
HQ: Hannan-Quinn information criterion

This study is going to examine the impact of financial globalization and corruption on financial

dependency in the case of Pakistan from 1980 to 2020. For examining the cointegration among the

variables of the model autoregressive distributed lag model is applied. The results of the estimated

bound tests have been given in table 6. W-statistic and F-statistic are used for testing no

cointegration among the variables as the null hypothesis. As the null hypothesis i.e. there is no

cointegration among the variables of the model. The calculated F-statistic (4.0321) is greater than

the upper bound (3.7320) tabulated value of Pesaran, Shin, and Smith (2001) at 10 percent and the

calculated W-statistic (24.1926) is greater than the upper bound (22.3922) tabulated value of

Pesaran, Shin and Smith (2001) at 10 percent. So, the null hypothesis of no cointegration can be

rejected, and an alternative hypothesis is accepted which confirms the existence of cointegration

among the variables of the selected model. This confirms that financial dependency, level of

corruption, financial globalization, budget deficit, unemployment rate, and balance of payments

have a long-run association in the case of Pakistan.

19
 Table-6
ARDL Bounds Testing Approach
Dependent Variable FIND
ARDL(1,1,1,0,1,0)
Critical Value F-Statistics 4.0321 W-statistic 24.1926
Lower Bound Upper Bound Lower Bound Upper Bound
95% 3.0301 4.4242 18.1807 26.5450
90% 2.5175 3.7320 15.1051 22.3922

The long-run results of the study have been given in table 7. The estimated outcomes show that

the level of corruption has a positive and significant impact on financial dependency, the value of

the coefficient shows that a 1 percent increase in the level of corruption brings (.64566) percent

increase in financial dependency in the case of Pakistan over the selected period. The estimated

results are consistent with Petrou et al., (2014). Several other studies highlight that corruption can

damage the economy by putting it under the pressure of internal and external financial dependency

(Mauro, 1995; Kisunko, & Kapoor, 1999; Campos et al., 1999; Mauro, 1995; Mauro, 1997;

Johnson et al., 1997; Wei, 2000; Friedman et al., 2000; Abed & Davoodi, 2002; Mo, 2001; Tanzi

& Davoodi, 1998; Lambsdoff, 2003; Depken & Lafountain, 2006; Schneider, 2005; Schneider et

al., 2010; Petrou, 2014; Van et al., 2016; Van et al., 2018). Corruption increases the cost of every

project which encourages public spending and the government can arrange funds from foreign aid

and foreign debt at the same time. Depken & Lafountain (2006) mention that the level of corruption

decides the amount of foreign aid and foreign debt in the country, thus, it is favorable for

developing countries to control corruption to overcome financial dependency. Following the

historical background, we have witnessed that there is a rising trend in corruption and all types of

financial assistance in the case of Pakistan. Under such circumstances, it can be supposed that

Pakistan would accumulate a larger financial dependency over the year in the presence of a high

level of corruption.

20
The results in table 7 show that financial globalization has a negative and significant impact on

financial dependency, the coefficient shows that a 1 percent increase in financial globalization

decreases financial dependency by (-.37964) percent in the case of Pakistan. These findings are

consistent with Kono & Schuknecht (1999). There is considerable progress has been witnessed in

liberalization since the 1980s in the case of developed and developing countries (Kenen, 2001;

Kumar & Debroy, 1999; Gavin, 2001). Broadly speaking, the developed and industrialized

countries rely on the multilateral process of economic and financial integration under the panels

of WTO, IFM, and the World bank. The economic logic behind this integration is the removal of

hurdles to the flow of goods, services, and capital. Following this integration, the countries invest

and provide efficient financing both long-term and short-term. An open and efficient financial

system at the domestic and international level is the key factor to handle this integration, this

further reduces the level of foreign debt and foreign aid among the countries (Dobson & Jacquet,

1998; Cooper et al., 1999; Dailami, 1999; Drabek & Laird, 2001). Under such circumstances, it is

favorable for developing countries to adopt financial globalization to overcome financial

dependency (Berg et al., 2005).

The estimated results in table 7 show that the budget deficit has a negative but insignificant impact

on financial dependency in the case of Pakistan. Kato & Hagendorff (2010) and Ibrahim & Alqaydi

(2013) mention that it is not a fiscal deficit that urges developing countries to go for financial

assistance, and most of the developing countries have an insignificant relationship between budget

deficit and financial dependency.

The results of table 7 show that the unemployment rate has a positive and significant impact on

financial dependency, the coefficient shows that a 1 percent increase in the unemployment rate

brings (.21776) percent increase in financial dependency in Pakistan. These findings are consistent

21
with Bianchi et al., (2016). Cahyadin & Ratwianingsih (2020) find a bidirectional causal

relationship between unemployment and external debt in the case of developing countries. It has

been found that on one side, higher employment simulates economic growth, on the other side

higher employment is one of the main sources for getting finances for all types of expenditures

(Blanchard & Perotti, 2002; Jermann & Quadrini, 2012; Yue et al., 2015). In the presence of high

unemployment, a country cannot achieve its targets. In the case of developing countries, it is high

unemployment that becomes the main cause of low domestic financial sources (Altvater, 1988).

Under such conditions level of the unemployment rate is positively related to financial dependency

in the case of developing countries like Pakistan.

Table-7
Dependent variable is FIND; ARDL (1,1,1,0,1,0); Time Period 1980-2020
Long Run Results Short Run Results
Regressor Coefficients Co-efficients
CORR .64566*** .43248
FING -.037964* .0025797
DEFICIT -.034907 -.032849
UNEM .21776*** .12986
BOP .081176** .076391*
C -2.1178 -
ECT - -.94106***
R-Squared .7652; R-Bar-Squared .68070; S.E. of Regression .35994; F-Stat. F(9,25)
9.0536[.000]; Mean of Dependent Variable -.76455; S.D. of Dependent Variable .63698;
Residual Sum of Squares 3.2389; Equation Log-likelihood -8.0108; Akaike Info. Criterion -
18.010; Schwarz Bayesian Criterion -25.787; DW-statistic 2.446

The results of table 7 show that the balance of payment has a positive and significant impact on

financial dependency, the coefficient reveals that a 1 percent increase in the balance of payment

increases financial dependency by (.081176) percent in the case of Pakistan. These findings are

consistent with Thirlwall (2012). Thirlwall (1979) points out that when international capital flows

and interest payments balance out, to meet international transactions the small open economy relies

on external sources. Balance of payments in terms of sustainable ratio deficit in trade to income,

22
this situation encourages small open economies to accumulate foreign debt (Moreno-Brid, 1998;

Barbosa-Filho, 2001; Gouvêa & Lima, 2010; Romero & McCombie, 2016). Thus, developing

countries like Pakistan are caught in a foreign financial dependency trap.

The short-run dynamics of the model have been given in table 7. The results show that level of

corruption, financial globalization, budget deficit, and unemployment rate have an insignificant

impact on financial dependency in the case of Pakistan during the short run. These findings are not

consistent with the long-run findings in table 7. The estimated results of table 7 show that the

balance of payment has a positive and significant impact on financial dependency, the coefficient

shows that a 1 percent increase in the balance of payments (.076391) percent increase occurred in

the financial dependency of Pakistan during the short run.

The significant negative value (-.94106) of ECM is theoretically correct and refers to short-run

convergence into the long run. Moreover, a significant negative value of ECM refers to the

adjustment speed from the short run towards the long run. The estimated coefficient highlights that

the short run needs one year around one month to converge in the long run. The estimates show

that short variations in the previous year are corrected by (94.106) percent very next year in the

case of Pakistan. The lower part of table 7 presents some of the diagnostic tests. The estimated R-

square value shows that more than 76 percent of variations in the dependent variable are due to

selected explanatory variables of the model. The significant F-stat explains that the selected model

is good-fit. The value of the DW statistic shows that there is no issue of autocorrelation in the

selected data series, as its value is greater than 2.

The other diagnostic tests have been given in table 8. The null hypotheses for these diagnostic tests

are; there is no serial correlation in the data; the model has no functional form issue; data has no

normality issue; there is homoscedasticity. So, we accept the null hypothesis of all the diagnostic

23
tests. The results show that there is no issue of serial correlation, the model has the correct

functional form, with normally distributed data, and there is no issue of heteroscedasticity in the

data.

Table-8
Diagnostic Tests
Test Statistics LM-Version F-Version
A-Serial Correlation CHSQ(1) 6.0329[.114]*F(1,24) 4.9984[.135]*
B-Functional Form CHSQ(1) .86296[.353]*F(1,24) .60670[.444]*
C-Normality CHSQ(2) 1.0150[.602]* Not- applicable
D-Heteroscedasticity CHSQ(1) 1.8524[.174]*F(1,33) 1.8441[.184]*
A: Lagrange multiplier test of residual serial correlation
B: Ramsey's RESET test using the square of the fitted values
C: Based on a test of Skewness and kurtosis of residuals
D: Based on the regression of squared residuals on squared fitted values

While discussing the diagnostic tests, the stability of the model is also considered very vital. It

enables the researcher to understand whether the selected and estimated model shifts or not over

the selected period. Hansen points out that time series estimate biases arise due to the

misspecification of the model. In this study, we have applied the Cumulative Sum (CUSUM) and

the Cumulative Sum of the Squares (CUSUMsq) tests to overview the long-run and short-run

stability of the selected model (Brown et al., 1975). The estimated Cumulative Sum (CUSUM)

and the Cumulative Sum of the Squares (CUSUMsq) have been given in figure 1 and figure 2. The

results show that both the Cumulative Sum (CUSUM) and the Cumulative Sum of the Squares

(CUSUMsq) lied between critical lines and do not go outside the critical lines. The estimates reveal

that our selected model is correctly theorized.

24
 Figure-1

Plot of Cumulative Sum of Recursive Residuals

20

10

-10

-20
1985 1994 2003 2012 2019
The straight lines represent critical bounds at 5% significance level

Figure-2

Plot of Cumulative Sum of Squares of Recursive Residuals

1.4

1.2

1.0

0.8

0.6

0.4

0.2

0.0

-0.2

-0.4
1985 1994 2003 2012 2019
The straight lines represent critical bounds at 5% significance level

6. CONCLUSIONS AND POLICY SUGGESTIONS

results and discussion. The results explain that the level of corruption has a positive and significant

25
impact on financial dependency in Pakistan. It has been found that developing countries are facing

a rising level of corruption and Pakistan stands 120 out of 180 United Nations members, so,

Pakistan is also facing severe financial dependency on developed countries and other financial

institutions i.e., IMF. Financial globalization has a negative and significant impact on financial

dependency in Pakistan. The estimated outcomes explain that the unemployment rate and balance

of payments have a positive and significant impact on financial dependency in Pakistan. Based on

the findings, corruption is encouraging financial dependency, this suggests that for the reduction

of financial dependency, corruption must be discouraged in developing countries like Pakistan.

However, the reduction of corruption is attached to better public institutions and governance, so

institutional reforms can reduce the level of corruption which further lowers the financial

dependency in Pakistan. The results reveal that financial globalization is discouraging financial

dependency, this suggests that for reducing financial dependency, developing countries like

Pakistan should encourage foreign investment. As this would increase the level of physical capital

which is not attached to foreign aid and debt, thus level of financial dependency will be depressed.

The estimated outcomes show that unemployment has a positive and significant impact on

financial dependency. This suggests that in the presence of high unemployment, the domestic

financial resources cannot meet the required financial needs, which will encourage financial

dependency among developing countries. So, for the reduction of financial dependency, the

government of Pakistan must reduce the level of unemployment. The findings show that the

balance of payment has a positive and significant impact on financial dependency. This reveals

that if the balance of payment is negative in the presence of fewer exports, to meet this, the country

has to rely on foreign financial resources. Thus, for the reduction of financial dependency,

developing countries have to improve their balance of payments. The overall findings suggest that

26
for the reduction of financial dependency, the government of Pakistan should increase financial

globalization and depress corruption, unemployment, and balance of payments.

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