Causality between trade and economic growth in a least developed economy: Evidence from Nepal

Widening trade deficit has been a matter of serious concern in any policy debate in Nepal. With continuous increase in the gap between growth of export and that of import, Nepal’s increased trade imbalance is likely to jeopardize the country’s macroeconomic stability. In this context, understanding systematic relationships between international trade and economic growth aspects of Nepal would guide policy makers to formulate appropriate policies. This study is the first attempt to examine the causal relationships among real gross domestic product (GDP), exports, and imports for the case of Nepal. Utilizing annual data from 1965 to 2011, we investigate the causal relationships among the variables in a cointegration framework. We employ two methods for testing cointegration, the autoregressive distributed lag (ARDL) approach and the trivariate Johansen approach, and consistently find existence of one cointegrating relationship among real GDP, exports, and imports. Moreover, the empirical tests show that the estimated long-run parameters are stable over time. Applying multivariate Granger causality tests based on error correction and vector autoregression models, we find unidirectional causality running from export to GDP both in the short- and the long-run, thus supporting the export-led growth (ELG) hypothesis. Although imports are found to Granger cause GDP, the long-run estimates show significantly negative effect of imports on GDP implying a negative causality. In this context, trade policies that substitute imports seem more pertinent for Nepal. The results highlight necessity of fostering exports, which would require establishment of proper infrastructure, both physical and institutional, for trade and investment capital for industrialization focusing on commodities that have comparative and competitive advantages. Moreover, fulfillment of domestic demand with less reliance on imported goods and increment of productivity in all sectors of the economy is crucial. Overall, effective implementation of policies that boost exports and maintain healthy trade balance are likely to improve the Nepalese economy in both the short- and the long-run.