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Applied Economics Letters, 2006, 13, 763768

Balance of payments constrained


growth model: an examination of
Thirlwalls Hypothesis using
McCombies Individual Country
Method
Gairuzazmi M. Ghani
Department of Economics, Kuliyyah of Economics and Management
Sciences, IIUM, Jalan Gombak, 53100 Kuala Lumpur, Malaysia
E-mail: gairuzazmi@iiu.edu.my

The balance of payments constrained growth (BOP) model is tested using


the McCombies cross-country and individual country test for 90
developed and developing countries for the period 1980 to 2000, and the
McCombies test is extended using export elasticity. If in the long run, the
growth of exports is equal to the growth of imports and the affect of prices
are not statistically significant, the estimated import elasticity from time
series regression should not be statistically different from the BOP implied
import elasticity, this also implied that the estimated export elasticity, also
should not be statistically different from the BOP implied export elasticity.
However, the finding shows that for only about 45% of the countries
under study the individual country test is accepted even though
cross-country analysis support the BOP model. Furthermore, for some
countries where its estimated and implied import elasticity are not
statistically different, its estimated and implied export elasticity are
statistically different and vice-versa.

I. Introduction
The Thirlwall (1979) balance of payments constrained growth (BOP) model postulates that the
balance of payments position of a country is the main
constraint on economic growth, because it imposes
a limit on demand to which supply can adapt. The
model has been tested extensively by regressing the

model predicted growth rate on actual growth rate,


and tested for a unit slope and zero constant.
McCombie (1989) suggested the method after
criticizing McGregor and Swales (1985) testing
method.1 McCombie also suggests testing every
country predicted growth rate individually. Here,
we test the BOP model using McCombies individual
country test for 90 developed and developing

McGregor and Swales (1985) suggest that the model can be tested by regressing the actual domestic growth rate on the
predicted growth rate, and test whether the regression coefficient is equal to unity and the constant term is equal to zero.
McCombie criticizes McGregor and Swales on the grounds that the independent variable is itself calculated using estimated
parameters and hence is subject to errors.
Applied Economics Letters ISSN 13504851 print/ISSN 14664291 online 2006 Taylor & Francis
http://www.tandf.co.uk/journals
DOI: 10.1080/13504850500404886

763

G. M. Ghani

764
countries for the period 1980 to 2000, and we extend
the McCombies individual country test using export
elasticity.

export demand are a function of income and relative


prices.
Import demand function is:
ln IMit 0 1 ln Ycit 2 ln RMPit it

II. McCombies Individual Country Method


McCombies test determines whether the actual
and predicted growth rates are statistically different
for individual country by comparing the estimated
income elasticity of demand for imports, i from time
series regression and the implied import elasticity,  i
from the BOP model. To apply this test to the sample
of countries under consideration, the implied balance
of payments equilibrium income elasticity of demand
for imports is calculated as:
xi
 i c
yi

where xi is the growth of exports and yci is domestic


income growth.
The comparison is conducted by calculating the
t-statistic for the null hypothesis that  i is equal to i.
If  i is statistically not different from i, it follows
that the actual and predicted growth rates are not
statistically different from each other.
Since the BOP model consist of both import and
export elasticity, the test is extended using export
elasticity. If in the long run, exports growth is equal
to imports growth and effects from prices are not
statistically significant then there should also be no
different between estimated export elasticity "i, and
implied export elasticity "i . The implied balance of
payments equilibrium income elasticity of demand
for exports is calculated as:

where IMit is ith countrys real imports during year t,


calculated using the value of total imports of goods
and services deflated by the unit value of imports.
Country Is real income (real GDP) is Ycit . RMPit
is the relative price of imports calculated as ratio of
the unit value of imports relative to GDP deflator,
and uit is error term.
Export demand function is:
ln EXit 0 1 ln Ywit 2 ln RXPit it

where EXit is the ith countrys real exports in time t,


calculated using the value of total exports of goods
and services deflated by the unit value of exports.
Foreign real income (foreign real GDP) Ywit is the
weighted sum of the GDP index (1985 100) for the
countrys top 15 trading partners (importing countries), weighted by the 1985 export share.
ln Ywit

aij ln Ycjt

j 1, . . . , 15

The export share from country i to country j is aij,


where j is the index for country i top 15 trading
partners.
RXPit is calculated as PXit/PXWit, where PXit is
country is unit value of exports in year t and PXWit
is the weighted average of the export unit value for
the region that country belongs to. Hence,
PXWit

bk PXkt

"i

mi
ywi

where mi is growth of imports and ywi is foreign


growth. This is clear from Equation 3, by crossmultiplying Thirlwalls law:
yci

"i ywi
yc i mi
) "i i w w
i
yi
yi

III. Methodology, Specifications, and Data


In order to estimate trade elasticities we follow
Houthakker and Magee (1969), where import and

where bk is country ks export share and PXkt is


country ks export unit value, where k is the index
for countries in the region that country i belongs to.
Here the countries are divided into four regions,
Industrialized, Asian, African and Latin American
countries.
Unlike Houthakker and Magee (1969) who used
26 countries to estimate foreign income, only 15
countries are used as an indicator for foreign income
because these countries constitute a significant
amount of trade share (for some smaller countries
the top 10 trading partners constitute a significant
amount of their trade share). We also use the regional
trade weighted price index instead of Houthakker and

Balance of payments constrained growth model

765

Magee two stage export price procedures2 because if


the Houthakker and Magee procedure is followed
most developing countries will be competing with
industrial countries, which is not true. Using regional
export prices, countries compete with similar countries, instead of top exporters to the importing
country. For instance, if Houthakker and Magee
procedure is followed, a developing country with a
large share of export to the United States will be
competing with other developed countries (because
top exporters to the USA are developed countries),
instead of other developing countries. Using the
regional trade weighted price index countries compete
with each other regionally.
To conduct cointegration analysis, we start with
the augmented DickeyFuller (ADF) unit root test
for each of the variables in the trade equations. Next
we use the Johansen (1991, 1995) procedure to test for
the existence of cointegration.
All regressions for the ADF test are estimated with
either one lag and a time trend, or one lag without
time trend depending on data behavior. ADF unit
root tests show that the majority of the series are not
stationary.
The Johansen cointegration test is conducted using
the trace statistics assuming a trend and intercept (for
the majority of countries) for a VAR of lag length
four and a VAR of lag length chosen using the
Hannan Quinn Information criteria. The null hypothesis of no cointegration is rejected for the majority
of cases.
To estimate trade elasticities, Stock and Watsons
(1993) dynamic Ordinary Least Squares (DOLS) is
used. Monte Carlo experiments show that the DOLS
estimator performs well relative to the other asymptotically efficient estimators including the fully
modified estimator of Phillips and Hansen (1990).
The DOLS regressions were carried out by adding
one lead and lag of differenced explanatory variables
to a static cointegration regression so as to eliminate
2

small sample bias resulting from correlation between


the error term and the explanatory variables. The
error terms in the DOLS procedure are, however,
serially correlated. The standard errors are therefore
estimated using Newey and Wests (1987) adjustment.
Annual data used are from the World
Development Indicators 2003 CD-ROM, and IMFs
Direction of Trade Statistics for bilateral trade data
(used in calculating trade weighted averages).
The estimation results for export and import
elasticities, and results from McCombies individual
country test are reported in Appendix A.

IV. Test Results


Before testing the countries individually, the BOP
model is tested using McCombies cross-section
regression analysis. Table 1 shows the regression
results for predicted growth y as a function of actual
growth y, the results show that constant terms are not
statistically different from zero and the coefficients
for y are not different from unity. Predicted growth is
calculated as y xi =i .
Appendix A reports the results for individual
country test.3 For import elasticity, 36 out of 80
countries (countries with statistically significant
import elasticity), there are no statistical differences
between estimated and implied import elasticity. For
export elasticity, 41 out of 80 countries (countries
with statistically significant export elasticity), the
estimated and implied export elasticity are not
statistically different. However, for some countries
where its estimated and implied import elasticity are
not statistically different, its estimated and implied
export elasticity are statistically different and viceversa. Only for 19 out of 74 countries (countries with
statistically significant import and export elasticity)
both of the estimated trade elasticities are not

Houthakkers two step procedures for foreign export price:


X X
aij
ik PXkt
PXWit
j

i 1; . . . , 26

k 1; . . . , 25
First a price index is constructed for each of the top 26 markets of country i using the export prices of 25 other top exporters
to that market weighted by their share of exports in a particular year. Then the resulting 26 price indexes are combined with
the same weights used to calculate the foreign GDP for country i. Hence each exporter has a price index comparing the
exporters price with the weighted average of the export prices of its 25 competitors in each of the 26 markets. If this procedure
is used, developing countries will compete with industrial countries that are not true. Houthakker and Magee (1969) use
these procedures to estimate trade elasticities for industrial countries, hence developing countries is not a big issue.
3
Hussain (1999) shows that 17 out of 29 African countries and 5 out of 11 Asian countries the implied import elasticity is not
statistically different from estimated import elasticity. Using elasticity estimation from Wu (2003) it was found that 9 out of 34
the implied import elasticity is not statistically different from estimated import elasticity and 15 out of 34 the implied export
elasticity is not statistically different from estimated export elasticity.

G. M. Ghani

766
Table 1. The balance of payments constrained model predicted growth rate against the actual
domestic growth rate (19802000)
Industrial

y 0:004 1:17y
0:71

Asia

y 0:025 0:82y
1:39

Africa
Latin America

y 0:013 0:62y
2:09

All Countries

0:85

0:79

jtj 0.604*

R 0.32

jtj 0.372*

R2 0.33

jtj 1.78*

R 0.38

2:90

y 0:004 1:11y

jtj 0.849*

2:75

y 0:009 1:15y
0:63

R2 0.63

5:84

R 0.53

jtj 0.515*

9:02

Notes: t-statistics are given in parenthesis.


jtj is the absolute value of the t-statistics based on the null hypothesis that the coefficient on
Y is unity.
The superscript * denotes that the null hypothesis cannot be rejected at the 95% level of
confidence.

statistically different from their implied trade


elasticities.
The low acceptance for the individual country test
may be caused by capital flows which balanced the
balance of payments account (Thirlwall and Hussain,
1982, Hussain, 1999) hence affecting the individual
country result;4 but capital flow is not included in this
study because growth rate of capital flows fluctuated
widely, shifting between deficit and surplus hence
making the calculation of growth rate impossible for
many of the countries. The acceptance of the crosscountry regression5 reinforced the idea that capital
flows equalized the balance of payments thus in a
cross-country regression current account surpluses
and deficits cancel out each other. Thus, individual
country test need not to be accepted for the balance
of payments to constraint domestic growth.

V. Conclusion
Even though the cross-section analysis supports the
BOP growth model, only about 45% of the countries,
estimated and implied elasticities are statistically not
different. Moreover, for some countries where its
estimated and implied import elasticity are not
statistically different, its estimated and implied
export elasticity are statistically different and viceversa. In order for BOP to hold for individual
countries, both of the implied import and export
elasticity need to be statistically indifferent from its
estimated elasticities. If one of the conditions does

not hold it casts doubt on the acceptance of the


hypothesis. However, the low acceptance of an
individual country test does not mean that the
balance of payments that is constrained is not
important. The cross-country test show a highly
significant relation between the ratio of export
growth and import elasticity and the domestic
growth rate, where countries with larger ratio grow
faster than countries with smaller ratio. The low
acceptance for the individual country test may be
caused by capital flows which balanced the balance of
payments account hence affecting the individual
countrys results.

References
Houthakker, H. and Magee, S. (1969) Income and price
elasticities in world trade, Review of Economic and
Statistics, 51, 11125.
Hussain, M. N. (1999) The balance-of-payments constraints and growth rate differences among African
and East Asian economies, African Development
Review, 11, 10337.
Johansen, S. (1991) Estimation and hypothesis of cointegration vectors in Gaussian vector autoregression
models, Econometrica, 59, 155180.
McCombie, J. S. L. (1989) Thirlwalls law and balance of
payments constrained growth a comment on the
debate, Applied Economics, 21, 61129.
McGregor, P. G. and Swales, J. K. (1985) Professor
Thirlwall and balance of payments constrained
growth, Applied Economics, 17, 1732.
Newey, W. K. and West, K. D. (1987) A simple, positive
semi-definite, heteroskedasticity and autocorrelation
consistent covariance matrix, Econometrica, 55, 7038.

4
Hussains (1999) extended model (including capital flows) accepted that implied and estimated import elasticity are not
statistically different for 23 of out 29 cases for African countries and 6 out of 11 cases for Asian countries.
5
Using the strong form of Thirlwalls law, i.e. yci "i ywi =i (Perraton and Turner, 1999) does not change the result.

Balance of payments constrained growth model


Perraton, J. and Turner, P. (1999) Estimates of industrial
country export and import demand functions: implications for Thirlwalls Law, Applied Economics Letters,
6, 7237.
Phillips, P. C. B. and Hansen, B. (1990) Statistical
inference in instrumental variables regression
with I(1) processes, Review of Economic Studies, 57,
99125.
Stock, J. H. and Watson, M. W. (1993) A simple estimator
of cointegrating vectors in higher order integrated
systems, Econometrica, 61, 783820.

767
Thirlwall, A. P. (1979) Balance of payments constraint as
an explanation of international growth rate differences, Banca Nazionale del Lavoro Quarterly Review,
128, 4453.
Thirlwall, A. P. and Hussain, M. N. (1982) The balance of
payments constraint, capital flows and growth rate
differences between developing countries, Oxford
Economic Papers, 34, 498510.
Wu, Y. (2003) Growth, expansion of markets and income
elasticities in world trade, Georgetown University
Working Paper.

Appendix A
Estimated income elasticity

Implied income elasticity

Test results

Country

Import

Import

Import

Australia
Austria
Belgium
Canada
Denmark
Finland
France
Germany
Greece
Israel
Ireland
Italy
Japan
Netherlands
New Zealand
Norway
Portugal
Sweden
Switzerland
Great Britain
United States
Spain

1.825
2.980
1.937
2.497
2.270
2.218
2.482
2.539
1.516
1.530
1.615
3.042
2.743
2.009
1.828
1.635
2.526
3.123
1.472
1.419
2.396
3.201

2.151
3.337
2.084
2.061
2.041
3.160
2.647
1.596
2.172
1.025
4.511
2.807
1.097
2.669
1.634
2.939
2.654
1.938
1.465
1.782
2.601
3.801

2.158
1.966
2.106
2.492
2.263
2.425
2.531
1.606
2.673
1.186
2.163
2.683
1.455
2.086
2.311
1.955
2.100
2.969
2.200
1.892
2.279
2.457

1.956
2.607
1.909
2.111
1.873
4.912
2.209
1.905
2.562
1.383
3.445
2.421
1.443
2.350
1.747
1.988
3.481
1.765
1.560
2.193
2.550
3.926

4.387
4.925
1.839*
0.053*
0.065*
0.630*
0.175*
2.312
2.449
1.294*
8.703
1.768*
6.574
0.504*
3.613
1.826*
1.631*
0.657*
3.438
0.907*
0.657*
4.954

1.157*
4.176
2.231
0.593*
1.179*
2.063*
4.204
2.151
3.516
3.152
4.046
2.967
4.960
1.842*
1.792*
2.895
3.957
1.376*
0.916*
4.326
0.377*
0.629*

Bangladesh
China
Hong Kong
India
Indonesia
Israel
Korea
Malaysia
Pakistan
Papua N. Guinea
Philippines
Singapore
Sri Lanka
Syria
Thailand

1.499
1.349
1.469
1.580
0.985
1.821
1.366
1.648
0.733
0.495
3.273
1.227
1.206
0.385*
1.665

3.418
3.577
2.174
3.717
1.596
2.369
3.641
2.794
2.656
2.279
1.561
2.298
1.979
4.280
2.896

2.496
1.431
2.166
1.689
1.002
1.455
1.618
1.733
1.309
1.325
2.650
1.627
1.406
2.490
1.804

2.628
3.248
2.525
2.371
1.551
2.363
3.515
2.583
1.013
0.027
1.986
2.282
1.885
0.286
2.809

6.443
2.083*
4.549
0.769*
0.091*
1.372*
1.138*
3.646
6.725
4.263
3.819
5.850
3.251
5.032
2.568

2.164
0.900*
0.835*
2.133
0.133*
0.051*
1.079*
3.976
10.703
7.630
1.115*
0.102*
0.519*
17.608
0.476*

Algeria
Benin
Burkina Faso
Burundi
Cameroon

0.295*
0.741
0.752
0.449*
1.481

1.378
1.585
0.323*
0.752*
0.646*

1.891
0.107
0.190
5.165
4.252

1.583
0.195
0.832
0.520
0.671

Export

Export

3.135
4.028
5.362
15.632
12.661

Export

49.427
9.143
2.063*
0.456*
1.040*
(continued)

G. M. Ghani

768
Appendix A Continued
Estimated income elasticity

Implied income elasticity

Test results

Country

Import

Export

Import

Export

Import

Export

Chad
Zaire
Congo
Cote dIvoire
Egypt
Ethiopia
Gabon
Gambia
Ghana
Kenya
Madagascar
Malawi
Mali
Mauritania
Mauritius
Morocco
Mozambique
Niger
Nigeria
Senegal
Sierra Leone
South Africa
Togo
Tunisia
Uganda
Zambia
Zimbabwe

1.573
1.218
1.018*
0.317*
0.333
0.762
0.133*
0.999
2.491
1.264
2.540
1.011
1.040
0.090*
1.025
1.251
0.942
1.745
0.996
0.469
0.507*
1.797
0.246*
0.848
1.418
0.951
2.757

0.019*
1.628
1.194
1.052
2.620
1.195
2.325
1.247
4.926
1.503
1.406
1.567
4.968
0.012*
2.558
2.734
1.383
0.211*
2.550
0.722
1.639*
1.543
0.300
2.728
3.611
0.084*
3.283

0.757
0.275
2.153
1.243
1.180
0.854
1.783
0.417
1.860
1.357
1.780
1.049
2.645
0.005
1.365
1.981
1.848
0.225
1.061
0.923
5.965
2.719
0.238
1.392
1.490
0.685
2.263

0.357
1.118
0.533
0.015
0.174
1.115
0.548
0.049
2.834
1.897
0.010
0.457
2.499
0.059
3.247
2.370
0.261
2.433
1.247
0.551
2.880
1.345
0.217
1.482
2.603
0.508
5.516

1.571*
3.502
2.897
2.363
14.782
0.230*
5.580
2.696
1.660*
0.360*
2.991
0.103*
7.366
0.332*
2.198
3.922
4.515
2.619
0.179*
3.676
10.332
1.966*
1.239*
4.979
0.731*
3.835
1.965*

0.393*
0.982*
17.403
7.994
21.124
0.138*
17.732
2.170
3.784
2.151
9.965
4.992
4.517
0.119*
4.404
4.032
2.872
4.958
15.559
1.906*
3.999
2.551
0.477*
4.203
0.768*
5.832
1.435*

3.582
1.518
2.217
1.475
1.627
1.787
1.828
0.894
2.720
2.233
2.405*
1.353
1.009
4.590
1.840
1.444
3.090
1.347
2.146
2.575
1.549

3.768
1.925
2.157
3.190
2.933
3.795
2.477
1.674
2.081
2.288
0.774*
0.635
2.330
3.811
0.791
0.121*
3.028
1.112
0.740
3.137
1.728

2.749
1.949
2.587
1.427
2.014
2.033
1.742
2.409
1.586
1.110
3.163
0.466
1.452
3.914
3.920
0.065
2.806
2.867
6.329
2.260
2.350

5.089
2.542
2.388
2.846
2.717
3.131
2.038
0.297
2.811
1.867
2.073
1.042
1.788
3.002
0.540
0.773
3.349
1.552
0.234
3.091
1.010

3.653
3.115
0.805*
0.702*
2.564
1.652*
0.138*
7.023
2.922
2.860
2.431
6.427
1.196*
1.817*
7.982
7.728
0.712*
5.813
11.464
0.371*
2.721

1.766*
3.358
1.537*
3.159
1.417*
2.283
2.100*
5.240
1.012*
2.007*
1.628*
3.046
1.818*
2.379
0.537*
1.730*
0.732*
0.894*
3.272
0.185*
4.389

Argentina
Bolivia
Brazil
Chile
Colombia
Costa Rica
Dominican Rep.
Ecuador
El Salvador
Guatemala
Haiti
Honduras
Jamaica
Mexico
Nicaragua
Panama
Paraguay
Peru
Trinidad & Tobago
Uruguay
Venezuela

Test results are the value of the i-statistic based on the null hypothesis that estimated elasticity is equal to implied elasticity.
*For estimated elasticity Indicates that estimated elasticity is not statistically significant at 95% significant level.
*For test result Indicates that implied elasticity is statistically different from estimated elasticity.

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