Effect of oil prices on trade balance: New insights into the cointegration relationship from Pakistan

Global oil price shock waves and continuous trade imbalance have raised serious alarms among the policy makers around the world, because of its aggressive impacts for the net oil‐importing economies. The objective of this study is to investigate the impact of rising oil prices on the trade balance of Pakistan by using ARDL approach. Further, this study explores the causality direction between trade balance and oil price shocks in the context of Pakistan over a period of 1975–2010. The result shows that there is a significant negative relationship among oil prices, exchange rate and trade balance in Pakistan, i.e., if there is 1% increase in oil prices and exchange rate, the trade balance decreases by 0.382% and 0.342% respectively. This infers that oil prices and exchange rate induces trade imbalance in Pakistan. In addition, there is a positive relationship between output gap and trade balance which infers inefficient resource allocation and utilization in production. In the short run, there is a positive relationship among exchange rate, output gap and trade balance in Pakistan which shows that an increase in oil prices increases the net income flow in terms of huge cost payments for imports and increases the trade deficit in an economy. The result of Granger causality indicates that there is a bidirectional causality between oil prices and exchange rate in Pakistan which infers that Pakistan has to invest in alternative energy projects to reduce its dependence on oil imports, while there is a unidirectional causality running from oil prices to trade imbalance. This implies that the high oil prices are more appropriate than output gap because it covered all range cause of trade imbalance. The usage of oil in both forms as a fuel and energy can be substituted by solar energy, hydropower, coal energy, and wind energy and high oil demand can be reduced by the establishment of transport infrastructure. The intense need is to redefine and adopt practical step in energy conservation. Regulations, standards, and targets are important in order to provide direction of efficient level of utilization of oil as a fuel.