The Causal Relationship between Trade Openness and Government Size: Evidence from Saudi Arabia Khalid H. A. Al-Qudair Associate Professor, Department of Economics, College of Administrative Sciences King Saud University, Riyadh, Saudi Arabia العالقة بين االنفتاح التجاري وحجم الحكومة في المملكة العربية السعودية د.خالد بن حمد بن عبدهللا القدير ملخص البحث: يهدف البحث إلى دراسة طبيعة العالقة بين االنفتاح التجاري وحجم القطاع الحكومي في المملكةةة العرةيةةة السةةعودية فةةي ايجةةا الطومةةا باسةةتكدام نمةةو التكامةةا المرةةترتح وتحديةةد اتجةةا العالق ةةة الس ةةببية ب ةةين االنفت ةةاح التج ةةاري وحج ةةم القط ةةاع الحك ةةومي ف ةةي ايج ةةا الطوم ةةا والق ةةير باسةةتكدام نمةةو متجهةةاح ت ةةحي الكطةةاخ وقةةد دك اكتبةةار التكامةةا المرةةترت لةةى وجةةود القةةة توازنيةةة طوملةةة ايجةةا بةةين االنفتةةاح التجةةاري وحجةةم القطةةاع الحكةةوميخ كمةةا و ة اكتبةةار السةةببية في ايجا الطومةا نن ننةات القةة سةببية اح اتجةا واحةد تتجةن مةن االنفتةاح التجةاري الةى حجةم القطاع الحكومي وليس العكسخ كما نو اكتبار السببية في ايجا الق ير ننن ال توجد القة سببية بين االنفتاح التجاري وحجم القطاع الحكوميخ وب فة امةح يمكن القوك نن النتائج تؤمةد فر ية التعويض التي تؤكد ان ننةات القةة سةببية موجبةة تتجةن مةن االنفتةاح التجةاري الةى حجةم القطاع الحكومي في ايجا الطوما وليس في ايجا الق يرخ -2 - The Causal Relationship between Trade Openness and Government Size: Evidence from Saudi Arabia Khalid H. A. Al-Qudair Abstract: This study examines the long run equilibrium relationship between trade openness and government size in the Kingdom of Saudi Arabia using Cointegration technique and the direction of causality relationship in the long and short runs between the variables utilizing the Vector Error Correction Model (VECM). The Cointegration test indicated the existence of the long run equilibrium relationship between trade openness and government size. The causality test indicated that there is a unidirectional causal relationship that runs from trade openness to government size in the long run not vice versa. In addition, the causality test indicates the absence of short run causality between trade openness and government Size. Over all, it may be concluded that the results provide support to the compensation hypothesis that entails a positive causality that is running from the trade openness to the government size in the log run not in the short run. -3 - I. Introduction The direction of causality relationship between different time series has become recently the concern of many studies using advanced econometric techniques. The trade openness and government size are two major macroeconomic variables that influence most economic variables; especially, economic growth. Many studies have focused their attention on the causal relationship between trade openness and economic growth, while other studies have focused on the causal relationship between government size and economic growth. Recently, attention has been shifted to the causal relationship between trade openness and government size. The purpose of this paper is to investigate the causal relationship between trade openness and government size in the Kingdom of Saudi Arabia over the period 1970-2001. The evidence in either direction has important policy implications. The rest of the paper is organized as follows. Section II presents a review of the relevant theoretical and empirical works. Section III is devoted to the methodology used to test the relationship between trade openness and government size, while Section IV describes the data and discusses the empirical findings. Finally, Section V concludes. II. Theoretical Background and Previous Empirical works The effect of government size, on one hand, and trade openness, on the other, on economic growth is a major concern of different empirical studies in macroeconomics, pubic finance, and international trade. Economists recognize the role of government expenditure in the economy in order to fulfill its vital functions. However, the role of government expenditure in promoting economic growth was not widely accepted until Keynes published The General Theory of Employment, Interest, and Money in 1936. Given the inefficiency of private demand, expansionary fiscal policy can fill the gap between the aggregate -4 - demand and aggregate supply. The Keynesian income policies were; then, used extensively in the Western Hemisphere in order to implement different economic and social programs. However, these policies were questioned as they failed to overcome the unemployment problem and contributed in accelerating inflation. In fact, some studies including Landau (1983), Kormendi and Meguire (1985), and Peden and Bradley (1989) among others found that government expenditure has a negative effect on economic growth. Government through its involvement in economical, social, legal, security and other programs has a negative effect on economic growth. The large government sector may crowed out private investment and increase the inefficiency in the economy which in turn has an adverse effect on economic growth. Recently, the debate over the role of government expenditure in economic activities has shifted to the effect of government size on economic growth. Landau (1983), Peden and Bradley (1989), Barro (1989, 1997), Gwartney, Lawson, and Holcombe (1998) have argued that the expansion of government expenditure beyond a certain level has a negative effect on economic growth. However, Rubinson (1977), Ghali (1998), and Rosen and Weinberg (1998) found that a larger government size promotes economic growth. Moreover, Karras (1994) found that public and private consumption are complementary. Moreover, he argued that the relationship depends on government size. As government size increases, government consumption turns to be substitutable to the private consumption rather than complementary. Karras (1996) argued that the impact of government expenditure on private consumption depends on government size. As government size increases, government consumption turns to be substitutable to the private consumption rather than complementary. Furthermore, Karras estimated the optimal size of government for the world as a whole to be approximately twenty-three percent of GDP. On the other hand, Grossman (1988) found that government expenditure in the U.S. has a positive effect on economic growth, while the government size has negative effect on economic growth With regard to the effect of trade on economic growth, the theory of Comparative Advantage asserts that specialization in certain goods along with free -5 - trade will allow all parties, which are involving in trade, to reach a higher level of welfare through efficient allocation of resources. Krueger (1978), and Edwards (1997), among others, have found that more trade stimulates economic growth. In the context of the new growth theory, Grossman and Helpman (1991) argued that trade openness enables countries to increase their stock of capital and resources which in turn would improve their productivities and utilize their available resources. Considerable works have been done on the relationship between trade openness and economic growth. These studies include: Bhala and Lau (1991) who found that trade openness has a positive effect on economic growth. Sinha and Sinha (1996) found that although there is a long-run relationship between trade openness and GDP in India, the two time series are independent. Anoruo and Ahmad, (1997) found evidence for bi-directional causality between economic growth and openness in the ASEAN countries. Al-hoqubani (2004) investigated the nature of the relationship between openness and economic growth in Saudi Arabia. The findings of the study indicated that there is a unidirectional causality that runs from economic growth to trade openness. As has been mentioned in the introduction, in recent years economists have shifted their attention to the causal relationship between government size and trade openness. One view asserts that trade openness Granger cause government size. Alesina and Perotti (1997) advocated the efficiency hypothesis which suggests that free trade, along with the economic globalization, are the driving forces of government expenditure. Both government expenditure and taxes have to rise in order to overcome the adverse effects of international competitiveness on domestic economy. Rodrik (1997, 1998) investigated the nature of the relationship between trade openness and government size using cross-country data. He found that there is a unidirectional causality that runs from trade openness to government size. Rodrik argues that this evidence suggests that there may be a degree of complementary between markets and governments. Moreover, he suggests that the causal relationship between trade-openness and government size can be explained by compensation -6 - hypothesis. More dependency on foreign trade means that domestic economy is dependent to some extent on the development of its trading partners, which in turn give incentives for government to provide social insurance against international competitiveness. Balle and Vaidya (2002) has found that public welfare and health services expenditures are positively correlated with the level of the United States’s trade openness. This suggests that trade openness in the U.S. has resulted in state governments responding to the adverse effects of increased international trade activity by providing greater social insurance. Molana, Montagna, and Violato (2004) have tested the compensation hypothesis that a positive causality is running from trade-openness to government size using time series data for 23 industrialized OECD countries over the 1948-1998 periods. Their findings do not support the hypothesis. III. Methodology The causal relationship between trade openness and government size known as Granger causality is concerned with the relevance of past information of each one of variables in predicting the value of the other (Granger, 1969, 1988). The causality test relationship between the trade openness and government size requires three steps. First, the time series would be analyzed in order to determine the order of integration. Second, the long run relationship between the trade openness and the government size is investigated. Finally, the short run dynamics as well as the causality relationship in the short run and the long run between the trade openness and the government size would be investigated. -7 - Unit Root Test: Most of time series have unit root as many studies indicated including Nelson and Plosser (1982), and as proved by Stock and Watson (1988) and Campbell and Perron (1991) among others that most of the time series are non-stationary. The presence of a unit root in any time series means that the mean and variance are not independent of time. Conventional regression techniques based on non-stationary time series produce spurious regression and statistics may simply indicate only correlated trends rather than a true relationship (Granger and Newbold, 1974). One of the most widely used unit root test is the Augmented Dickey-Fuller (ADF) unit root test (Dickey and Fuller, 1979, 1981). Alternatively, Phillips (1987) and Phillips and Perron (1988), PP, have proposed a nonparametric method to correct a wide variety of serial correlation and heteroskedasticity. Perron (1989, 1990) demonstrates that if a time series exhibits stationary fluctuations around a trend or a level containing a structural break, then unit root tests will erroneously conclude that there is a unit root. The unit root test and the order of the integration would be preformed on both the original series of the trade openness and the government size and their differences using the PP unit root test. Cointegration Test: The Johansen (1988) and Johansen and Juselius (1990) proposed a procedure to test for cointegration which is preferable to the Engle-Granger (1987) procedure since it allows feedback effects among the variables under investigation. The procedure is based on likelihood ratio (LR) test to determine the number of Cointegrating vectors in the regression. -8 - Error Correction Model and Causality Tests: Having established the long run equilibrium relationship between the trade openness and the government size, the short run adjustments are estimated using the Vector Error Correction Model (VECM). The error correction model is based on the two following equations: m n i 1 j 1 Opent 0 1et 1 i Opent i j Govsizet j t m n i 1 j 1 Govsizet 0 1ut 1 i Govsizet i j Opent j ut (1) (2) Where et 1 and t 1 represent the error-correction terms lagged residuals from the cointegration relations that will capture the speed of the short run adjustments toward the long run equilibrium. Furthermore, the VECM, equations (1) and (2), allows to test for short run as well as the long run causality between the trade openness and the government size. The short run causality is based on a standard F-test statistics to test jointly the significance of the coefficients of the explanatory variable in their first differences. The long run causality is based on a standard t-test. IV. The Empirical Findings The variables that are used in the model to investigate the nature of the relationship between the openness and the government size in Saudi Arabia are: Trade Openness (Open) measured by real total trade/ real GDP and government size (Govsize) measured by real government consumption/ real GDP in natural log forms. The annual data employed in this study covers the period from 1970-2001 obtained from the 38th annual report of Saudi Arabian Monetary Agency. -9 - Properties of the Time Series: The first step in constructing the cointegration model and testing the Granger causality relationship is to test the stationarity of the series over time and to determine the degree of integration based on PP unit root test. The analysis of time series showed that the time series of the trade openness (Open) and the government size (Govsize) are not stationary at their levels at the 5% level of significance. However, the series are stationary at their first differences at the 5% level of significance, which indicate that the series are integrated of degree one (I (1)). Table (1): PP Unit Root Test First difference with intercept and Trend First difference with intercept Level with intercept and trend Level with intercept Variable -4.07 -4.18 -2.43 -1.22 Open -8.72 -8.49 -2.71 -2.24 Govsize Critical values: Intercept Intercept and Trend At (1%) level of Significance -3.66 -4.29 At (5%) level of significance -2.96 -3.57 At (10%) level of significance -2.62 -3.22 Cointegration Test: Since the series of Open and Govsize are integrated of degree one i.e. I (1), they may be cointegrated if there exist some linear combination of the series that can be tested for stationarity i.e. (I (0)). Johansen (1988) and Johansen–Juselius (1990) procedure is used to test for Cointegration between Open and Govsize. Table (2) presents the result of the Johansen – Juselius cointegration technique in order to examine the existence of the long run relationship between Open and Govsize. Table (2) presents the result of Johansen–Juselius test where the null hypothesis of no cointegration between Open and Govsize is rejected at the (5%) level of significance. However, the null -10- hypothesis of the existence of at most one cointegration equation is accepted at (5%) level of significance. This result indicates that there exists at least one cointegration equation between the two time series. Table (2): Johansen Cointegration Test Eigenvalues Likelihood Ratio 5% Critical Value 1% Critical Value Null hypothesis "No. of CE" 0.51 26.52 19.96 24.60 None 0.17 5.59 9.24 12.97 At most one The Vector Error Correction Model (VECM): Since the cointegration test revealed that there exists a long run equilibrium relationship between Open and Govsize, following Johansen– Juselius (1990), we can use a vector error-correction model (VECM) in which an unconstrained VAR is used in order to investigate the short run dynamics and to assess the direction of Granger causality in both the short and the long run as well. The inclusion of the error terms in the Granger causality test equations (1) and (2) will enable us to distinguish between short run and long run causality. -11- Table (3): Estimates for VECM Regression Regresses et 1 Ln Open Ln Govsize -0.005 (-0.76) t 1 -0.06 (-4.73) Ln Open -1 0.26 0.26 (1.34) (0.65) -0.14 0.26 (- 0.67) (0.41) -0.04 - 0.15 (-0.53) (- 0.43) -0.09 -0.19 (-1.30) (-0.48) R2 0.14 0.56 F 1.01 7.82 S. E. 0.09 0.17 Log likelihood 32.38 12.45 Ln Open-2 Ln Govsize-1 Ln Govsize-2 (Terms in brackets are t – ratios). Short Run Dynamics: Table (3) presents the VECM estimations. The lagged error term coefficient (et 1 ) is statistically insignificant, while the coefficient of ( t 1 ) is negative and statistically significant. The value of t 1 indicates the speed of adjustment of any disequilibrium towards the long-run equilibrium. six percent of the disequilibrium in Govsize is corrected each year. Moreover, the significant error term in the Govsize equation supports the existence of a long run equilibrium relationship between Open and Govsize. -12- Long and Short Run Causality Tests: Table (3) presents the results of both the short run Granger causality test based on a standard F-test statistics that tests jointly the significance of the coefficients of the explanatory variables in their first differences as well as the long run Granger causality test based on a standard t test statistics that test the significance of the error terms lagged one period. Long run Causality Test: The coefficient of the error term in the Open equation (1) based on t-test statistics from the VECM is statistically insignificant which means that the error term (et 1 ) does not contribute in explaining the changes in Open equation. However, the causality test based on the standard t test statistics from the VECM indicates that causality runs from Open to Govsize since the coefficient of the error term in Govsize equation (2) is statistically significant and negative based on standard t-test which means that the error term ( t 1 ) contributes in explaining the changes in Govsize. Therefore, there is unidirectional causality running from openness (Open) to Government size (Govsize) in the long run. Short Run Causality Test: The coefficients of the explanatory variables in their first differences in the Open equation are jointly statistically insignificant based on F-test statistics. Although, the coefficients of the explanatory variable in their first differences in the Govsize equation are jointly statistically significant based on standard F-test statistics, none of the coefficients of the explanatory variables based on t-test statistics are statistically significant. The significance explanatory variables based on F-test statistics in the Govsize equation do not mean that Open Granger cause Govsize, but rather a reflection of the significance of the error term ( t 1 ). Therefore, there is no -13- causality between Open and Govsize in the short run. In order to confirm the result of the short-run causality between Open and Govsize based on VECM estimates, a standard Granger causality test is run based on F-statistics. Table (4) presents pairwise Granger causality test that confirm the earlier finding based on VECM estimates of the absence of short run causality between Open and Govsize. Table (4): Results of Pairwise Granger Causality Test: number of lags = 2 Null hypothesis F-statistics Probability Δ Openness does not Granger cause 0.06 0.94 0.38 0.69 Δ Govsize Δ Govsize does not Granger cause Δ Openness V. Conclusion The goal of this paper is to investigate the long run relationship between the openness and the government size in the Kingdom of Saudi Arabia using cointegration technique and the short run dynamics as well the direction of causality in both the long and the short run based on ECVM. Data properties were analyzed to determine their stationarity using the PP unit root test which indicated that the series of Open and Govsize are I (1). The cointegration test based on Johansen - Juselius technique indicates that although the two time series of Open and Govsize may be in disequilibrium in the short run, there is a long run equilibrium relationship between them. The long run causality test based on the standard t test statistics from the VECM indicates that there is a unidirectional causality runs from Open to Govsize not vice versa. -14- The short run causality test between Openness and Government size based on F-test statistics from the VECM indicated the short run causality. Pairwise Granger causality test confirmed the absence of the short run causality based on VECM estimates. The policy implication of the results suggests that although the international trade represents a considerable component of GDP, the government expenditure in Saudi Arabia does not provide social insurance to the domestic economy against international competitiveness in the short run. However, the government expenditure in Saudi Arabia increases in the long run as a result of international trade in order to overcome the negative effects of international competitiveness. Over all, it can be concluded that the results provide support to the compensation hypothesis that entails a positive causality running from trade openness to government size in the log run not in the short run. -15- References Alesina, A. and Perotti,R., (1997)., "The Welfare State and Competitiveness", American Economic Review, 87, PP. 921-39. Al-hoqubani, M.,(2002)." 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