Bulletin of Energy Economics. Energy Consumption and Economic Growth in Pakistan

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1 Bulletin of Energy Economics Energy Consumption and Economic Growth in Pakistan Muhammad Zeshan* a, Vaqar Ahmed a a Sustainable Development Policy Institute, Islamabad, Pakistan Abstract The present study investigates the impact of energy consumption on real GDP, capital stock, and labor force using annual data for the period of For empirical analysis, it employs the Structural Vector Auto-regression (SVAR) framework. The results reveal that economic growth increases the demand for labor force, but this rise is not sustainable. Same is the case for other factors such as capital stock and energy. We see that greater energy inputs are required to facilitate the new additions to capital stock. Further, an exogenous shock to capital stock and labor force stimulates the economic activity temporarily. Rising capital stock also demands greater units of labor as productive activity expands in the economy. The research work recommends the government to focus on its supply-line. A certain and affordable power supply is the need of time. Keywords: Energy, Growth, Pakistan JEL Classifications: Q4, O1 I. Introduction The causal linkages between energy consumption and economic growth are of great interest to policy makers owing to their significance in the policy making process. The first empirical support of the topic in hand was provided by Kraft and Kraft [1]. It finds a unidirectional causal relationship from economic growth to energy consumption. This research work motivated various other empirical studies to identify such causal links (Apergis and Payne [2], Abosedra et al. [3]). It is believed that energy consumption is an important ingredient of economic growth, it is the key to stimulating macroeconomic growth. If there is empirical support of growth hypothesis, restricting the energy consumption can adversely affect the growth process 1. In contrast, if there is empirical support for the conservation hypothesis, the policy makers support the energy conservation policies 2. Nonetheless, the existing empirical literature does not provide enough evidence to establish a universal causal relationship between energy consumption and economic growth (Karanfil [4]). Policy makers face various obstacles during the policy making process (Ozturk [5], Payne [6]). Karanfil [4] states that ignoring the potential variables in the empirical research produces misleading causality relationships. Hence, in order to minimize the potential variable gap, many empirical studies starting using other indicators such as labor employment, CO 2 emissions, exports, urbanization, financial development, and foreign direct investment (Shahbaz et al. [7], Shahbaz and Lean [8], Ciarreta and Zarraga [9], Chandran et al. [1], Lean and Smyth [11], Sadorsky [12] and Tang, [13]). I.I Pakistan s Context The historical macro-economic scenario in Pakistan reveals a declining real GDP growth rate; the real GDP growth rate has been the highest during the 198s and the lowest during 199s. The fixed investment to GDP ratio remained stable during 198s and 199s, but it declined during 2s. The Corresponding Author s zeshan@sdpi.org 1 A unidirectional causality from energy consumption to the economic growth is known as the growth hypothesis. 2 A unidirectional causality from economic growth to the energy consumption is known as the conservation hypothesis

2 growth rate in labor force has been more negative during 197s, 198s and 2s. However, the GDP deflator shows a rising trend indicating the persistent inflationary trend. Finally, energy intensity indicated by energy consumption to GDP ratio remains the same during the period of analysis. Table-1: Economic Growth and Energy Consumption Trends Time 197s 198s 199s 2s Real GDP Growth Fixed Investment to GDP ratio Labor Force Growth GDP Deflator Energy Consumption to GDP Ratio Source: World Development Indicators The growth rates of capital stock and real GDP portray a positive relationship and same is the case with growth rates of labor force and the real GDP. Nonetheless, the relationship is much stronger between the capital stock and the real GDP. The analysis reveals that initially, there was a weak relationship between labor force and capital stock which improved in the later years. It is observed that growth in labor force, capital stock and real GDP were at their minimum level in the years 21, 21 nd 1971 respectively. It was at the peak during the year 27, 26 and 198 respectively. Their average growth rates for all of the period of analysis are 2.9 percent,.89 percent and 2.26 percent respectively. Decomposing it for each decade, it reveals that the labor force was increasing rapidly during the 197s while the capital stock, real GDP and energy consumption were performing their finest job in the 198s, see Figure 1-3 and Table-2 for more details Figure-1 Capital Stock and Real GDP Source: World Development Indicators and Author s Calculations Figure- 2 Labor Force and Real GDP K G L G 3 In these figures K, G, L and ENC stand for capital stock, economic growth, labor force and energy consumption respectively

3 Source: World Development Indicators Table-2: Average Growth Rates Decade Labor Force Capital Stock Real GDP Energy Consumption 197s s s s Source: World Development Indicators and Author s Calculations Up to 198, there is a weak relationship between the growth rates of energy consumption and the real GDP which might be the result of policy inconsistency. The subsequent periods illustrate the positive association between the two variables. Same pattern is followed between capital stock and the energy consumption, and between labor force and energy consumption. The average growth in energy consumption is 1.63 percent while decomposed analysis reveals that it was the highest during 198s and was at its minimum level during 2s (see Figures 4-6 and Table-2 for details). 8 6 Figure-4 Real GDP and Energy Consumption Source: World Development Indicators G ENC Figure-5 Capital Stock and Energy Consumption Source: World Development Indicators K ENC The previous discussion points out two important messages. First, there is a lack of association among many macroeconomic variables before 198s. Second, growth in most of the variable was at peak during 198s. In 197s, economist were quite uncertain about the accuracy of policy making rules, they were - 1 -

4 more concerned about the higher employment rate even if there was some rise in inflation, the so called Phillips curve hypothesis. 1 Figure-6 Labor Force and Energy Consumption Source: World Development Indicators L ENC The policy making process was much volatile as it was subject to frequent changes. Paul Volcker the governor of Federal Reserve at that time endeavored to alter the policy objective, it initiated to target the inflation rather than employment. This practice resulted in some problems in initial stages but later on this policy rule brought the historical decline in inflation. The central bank of Pakistan also followed the same inflation targeting rule now. Pakistan pursued a series of market-oriented adjustment programs to reform its economic structure in 198s. International financial institutions, International Monetary Fund (IMF) and other bilateral donors, provided the sufficient resources so that Pakistan could enhance its macroeconomic stability through the promotion of private sector and the development of export-led industries, and improvement in the social sector indicators such as education, health, population control measures. Mahmood et al. [14] argues that economic performance of Pakistan was quite well until 198s, it might be the response of the shift from the nationalization in the 197s towards a more liberal, deregulate and denationalized country. II. Review of Literature A number of studies are available on the causal relationship between the energy consumption and economic growth in the form of country specific. For the organizational convenience, Table-3 presents review of literature in two panels. Table-3 presents the analysis of the country specific cases as follows: Table-3. Summary of Selected Empirical Studies No. Author(s) Period Country Methodology Causality Direction 1 Ang [15] Malaysia Cointegration, VEC GDP EC 2 Soytas and Sari [16] Turkey Toda Yamamoto causality test GDP EC 3 Ang [17] France Cointegration, VECM EC GDP 4 Ho and Siu [18] Hong Kong Cointegration, VEC EC GDP 5 Lee [19] Taiwan Cointegration, VEC EC GDP 6 Lee and Chang [2] Taiwan Granger causality test, Cointegration, VECM EC GDP 7 Jobert and Karanfil [21] Turkey Granger causality test GDP EC 8 Zamani [22] Iran Granger causality test, Cointegration, VECM GDP EC 9 Lise and Van-Montfort [23] Turkey Cointegration GDP EC 1 Belloumi [24] Tunisia Granger causality test, VECM EC GDP 11 Karanfil [25] Turkey Granger causality test, Cointegration GDP EC 12 Halicioglu [26] Turkey Granger causality test, ARDL, Co-integration GDP EC 13 Erdal et al. [27] Turkey Granger causality test, Cointegration EC GDP 14 Bowden and Payne [28] USA Toda Yamamoto causality test EC GDP 15 Payne [29] USA Toda Yamamoto causality test GDP EC 16 Zhang and Cheng [3] China Granger causality test GDP EC Note: GDP EC indicates causality running from economic growth to energy consumption, EC GDP shows that energy consumption Granger causes economic growth, EC GDP reports the feedback effect between energy consumption and economic growth and GDP EC means no causality is found between both variables

5 III. Methodology and Data The SAVR is the basic tool to gauge the structural parameters in an econometric framework. The importance of the structural estimates is evident as these estimates are the most robust in a sense that they are not subject to Lucas critique. Sims [31] encountered the Lucas critique by assuming all variables endogenous in the econometric model. It gave birth to reduced form VAR which could be estimated with the help of the Ordinary Least Squares (OLS). The impulse responses (IRs) and the variance decomposition portray the dynamic monuments of the variables in the VAR system. The estimation of the structural VAR was used to complete in two stages. In the first stage, the reduced form VAR is estimated. In the second stage, the parameters of the reduced form VAR are employed to construct the structural parameters. However this practice results in identification problem, as the structural parameters are greater in number than the reduced form parameters. This problem is solved by imposing the reasonable restrictions on the parameters for the identification purpose. The structural parameters provide the information that can be used in applied work and policy implications. Our basic model in simple VAR framework is as follows: RX t 1X t 1 t (1) Where ' Xt ' is the vector carrying all the time series variables. ' Xt 1' represents the matrix having the lagged values of all the time series variables. 'R' matrix stands for the coefficients that have contemporaneous correlation with the variables. ' and ' indicates the vector of intercepts and the matrix of the lagged ' ' 1 coefficient of the time series variables respectively. Finally, ' t ' stands for the vector of pure innovations, white noised disturbances. It becomes: X t 1 X t 1 e t (2) where; 1 R 1 1 R 1 e R 1 t and E( e it ) ; ( i 1,2,... n) E 2 2 ( e it ) E( e1 t, e1 t 1 ) E( e2t, ekt 1 ) E( e1 t, e2t ) not necessarily zero. Equation-2 specifies simple VAR in reduce form. It can be preceded further for the structural VAR. If the right hand side of the equation yields the identical series, Ordinary Least Square (OLS) system of equations will provide the robust results. In contrast, for any other composition of the series, it requires the Seemingly Unrelated (SUR) structure for estimation. To obtain the structural VAR, it requires the 2 restrictions to be imposed on the system. We impose the following restrictions on the system, energy 2 n n

6 consumption cannot contemporaneously affect the real output and other factors of production, capital stock is allowed to have a contemporaneous correlation with labor force and energy consumption and not with real GDP, while labor force is not allowed to have a contemporaneous correlation with just the real GDP and the capital stock. The present study employs four variables including energy consumption, real GDP, capital stock, and labor force. It uses annual data for the period , all the data is in real terms denominated in millions with 2 as base year. The World Development Indicators and the International Financial Statistics are the data sources. IV. Results and their Interpretation The SVAR impulse responses for real GDP, capital stock, labor force and the energy consumption are denoted by D(LG), D(LK), D(LL), and D(LENC) respectively. All the impulse responses are based on 1year time horizon. All the time series are in 1st difference because they are integrated of order one as per Schwarz Bayesian (SBC) criteria. Further, there is the absence of any cointegrating relationship among them. A one standard deviation shock to real GDP results in the higher demand for labor force, but this rise is not permanent in nature. It tends to converse after the period of 2 years. Same is the case with capital stock and energy consumption. This shock also has the positive impact on capital stock and energy consumption. Both of these variables rise because they are complements in the production process, but this rise is also temporary in nature and both revert to their mean after the period of 2 years. One important finding is that higher level of energy is required to facilitate the new capital stock. Hence, this specifies the existence of growth hypothesis in Pakistan as energy consumption is expected to rise due to rising capital stock. An unexpected rise in the capital stock results in higher real GDP growth which persists for the near two years. This rise in real GDP is temporary and real GDP reverts back to its mean after some time. On the other hand, there is contemporaneous rise in labor force in response to this shock. More labor units are required to accommodate this expansion in the business and to operate the new machines. This rise is also temporary in nature and labor force comes back to its mean in an early period as compared to real GDP. It specifies that labor force converges quickly as compared to real GDP. This fact is true because of the presence of inertia in real GDP which delays its mean reversion. The mounting capital stock also raises energy demand in the short-run. Although there is not any noticeable ascend in the energy consumption in the initial periods but demand for energy climbs with the lag of 3 years. Decomposing the variance in real GDP reveals a significant evidence of inertia in real GDP during the first year. Real GDP itself is responsible for most of its variation while labor force produces around 7.8 percent variation in real GDP. After the period of 4 years, most of the variation in real GDP is brought by labor force whereas energy consumption and capital stock are responsible for the least variation in real GDP. Decomposing the variance in labor force reveals the presence of inertia in as most of the variation in labor force is caused by labor force itself. Real GDP fetched the 19.6 percent variation in labor force; capital stock carried 7.5 percent variation and energy consumption brought only.33 percent variation in the Labor Force. Our results are consistent with the impulse responses, that labor force is unable to produce any significant response in energy consumption and vice versa. The composition of variation changes after 4 years, and capital stock and energy consumption exchange their positions. A shock to real GDP causes most of the variation in energy consumption while labor force, energy consumption and capital stock follow in the same sequence. Finally decomposing the variance in capital stock reveals that most of the variation in capital stock is produced by capital stock itself while real GDP produces the second highest; see Table-4 for details in Appendix. V. Conclusion and Policy Implications Across the globe, policy makers face various problems while making a national policy on energy and same is the case in Pakistan. However, the present study endeavors to establish an empirical evidence of

7 the causal relationships in energy sector of Pakistan. From 1971 to 1983, it finds deteriorating macroeconomic conditions and lack of systematic relationship between energy consumption, GDP growth, labor force and capital stock. However the situation becomes somehow better during the preceding years. The present study aims to discover causal relationship among the four macroeconomic variables in Pakistan including energy consumption, real GDP, capital stock, and labor force. It uses annual data for the period of The SVAR results reveal that economic growth increases the demand for labor force, but this rise is not sustainable. Same is the response of capital stock and energy consumption to such a shock. It indicates that more energy inputs are required to facilitate the new capital stock. It is clear that the rise in energy consumption due to rising economic activity needs energy conservation strategy in Pakistan. An exogenous shock to capital stock stimulates economic activity temporarily. Same is the response of labor force to such a shock, rising capital stock demands more units of labor as production activity expands in economy. The mounting capital stock also raises the energy demand in short-run. Though the rise in energy consumption is very large, but demand for energy rises up to the next three years. Our results suggest that Pakistan s production structure remains energy-intensive. The government needs to devise means through which affordable and certain supply of power can be ensured to the various productive sectors of the economy. Pakistan loses around PKR 15 billion per year in line losses and power theft. A reduction in these preventable losses through prudent accountability measures can provide some additional operating cost for generating power. A deregulated energy sector would bring more efficiency in the energy market. There is a need to urgently attract private investment in power generation and distribution companies. Currently the energy sector governance is very fragmented and there is multiplicity of government departments focusing on similar issues. There are 22 government departments implementing the power policy. Consolidating these energy departments into one single ministry or energy authority would reduce transactions cost and facilitate greater coordination. Pakistan has the highest reserves of coal and a potential of hydro sector to produce 6 MW. This potential can only be harnessed if an enabling environment is provided for the foreign investment to arrive in Pakistan. Reference: [1]. Kraft, J., Kraft, A. (1978). On the relationship between energy and GNP. Journal of Energy Development 3, [2]. Apergis, N., Payne, J. E. (29). Energy consumption and economic growth in Central America: evidence from a panel cointegration and error correction model. Energy Economics 31, [3]. Abosedra, S., Dah, A., Ghosh, S. (29). Electricity consumption and economic growth, the case of Lebanon. Applied Energy 86, [4]. Karanfil, F. (29). How many times again will we examine the energy-income nexus using a limited range of traditional econometric tools? Energy Policy 37, [5]. Ozturk, I. (21). A literature survey on energy-growth nexus. Energy Policy 38, [6]. Payne, J. E. (21). A survey of the electricity consumption-growth literature. Applied Energy 87, [7]. Shahbaz, M., Zeshan, M., Afza, T. (212). Is energy consumption effective to spur economic growth in Pakistan? New evidence from bounds test to level relationships and Granger causality tests. Economic Modelling 29, [8]. Shahbaz, M., Lean, H. H. (212b). The dynamics of electricity consumption and economic growth: A revisit study of their causality in Pakistan. Energy 39, [9]. Ciarreta, A., Zarraga, A. (21). Economic growth-electricity consumption causality in 12 European countries: A dynamic panel data approach. Energy Policy 38, [1]. Chandran, V.G.R., Sharma, S., Madhavan, K. (21). Electricity consumption-growth nexus: the case of Malaysia. Energy Policy 38,

8 [11]. Lean, H.H., Smyth, R. (21). Multivariate Granger causality between electricity generation, exports, prices and GDP in Malaysia. Energy 35, [12]. Sadorsky, P. (21). The impact of financial development on energy consumption in emerging economies. Energy Policy 38, [13]. Tang, C. F. (29). Electricity consumption, income, foreign direct investment, and population in Malaysia: New evidence from multivariate framework analysis. Journal of Economic Studies 36, [14]. Mahmood, T., Rehman, H., Rauf S. A. (28). Evaluation of macroeconomic policies of Pakistan (195-28). Journal of Political Studies 17, [15]. Ang, J. B. (28). Economic development, pollutant emissions and energy consumption in Malaysia. Journal of Policy Modeling 3, [16]. Soytas, U., Sari, R. (29). Energy consumption, economic growth, and carbon emissions: challenges faced by an EU candidate member. Ecological Economics 68, [17]. Ang, J. B. (27). CO 2 emissions, energy consumption, and output in France. Energy Policy 35, [18]. Ho, C-Y., Siu, K.W. (27). A dynamic equilibrium of electricity consumption and GDP in Hong Kong: an empirical investigation. Energy Policy 35, [19]. Lee, C. C. (25). Energy consumption and GDP in developing countries: a cointegrated panel analysis. Energy Economics 27, [2]. Lee, C. C., Chang, C. P. (27a). The impact of energy consumption on economic growth: evidence from linear and nonlinear models in Taiwan. Energy 32, [21]. Jobert, T., Karanfil, F. (27). Sectoral energy consumption by source and economic growth in Turkey. Energy Policy 35, [22]. Zamani, M. (27). Energy Consumption and Economic Activities in Iran. Energy Economics 29, [23]. Lise, W., Van-Montfort, K. (27). Energy consumption and GDP in Turkey: is there a cointegration relationship? Energy Economics 29, [24]. Belloumi, M. (29). Energy consumption and GDP in Tunisia: cointegration and causality analysis. Energy Policy 37, [25]. Karanfil, F. (28). Energy consumption and economic growth revisited: does the size of unrecorded economy matter? Energy Policy 36, [26]. Halicioglu, F. (29). An econometric study of CO2 emissions, energy consumption, income and foreign trade in Turkey. Energy Policy 37, [27]. Erdal, G., Erdal, H., Esengun, K. (28). The causality between energy consumption and economic growth in Turkey. Energy Policy 36, [28]. Bowden, N., Payne, J. E. (29). The causal relationship between US energy consumption and real output: a disaggregated analysis. Journal of Policy Modeling 31, [29]. Payne, J. E. (29). On the dynamics of energy consumption and output in the US. Applied Energy 86, [3]. Zhang, X.P., Cheng, X. M. (29). Energy consumption, carbon emissions and economic growth in China. Ecological Economics 68, [31]. Sims, C.A., 198. Macroeconomics and reality. Econometrica 48,

9 Appendix: Figure-7 Response to Structural Innovation to real GDP Response of D(LK) to Shock real GDP Response of D(LL) to Shock real GDP Response of D(LENC) to Shock real GDP These Impulse Responses are based on the 1 year time horizon. The dashed red lines show the two standard deviation error band

10 Figure-8 Response to Structural Innovation to Capital Stock Response of D(LG) to Shock Capital Stock Response of D(LL) to Shock Capital Stock Response of D(LENC) to Shock Capital Stock These Impulse Responses are based on the 1 year time horizon. The dashed red lines show the two standard deviation error band

11 Figure-9 Response to Structural Innovation to Labor Force Response of D(LG) to Shock Labor Force Response of D(LK) to Shock Labor Force Response of D(LENC) to Shock Labor Force -.15 These Impulse Responses are based on the 1 year time horizon. The dashed red lines show the two standard deviation error band

12 Figure-1 Response to Structural Innovation to Energy Comsumption Response of D(LG) to Shock Energy Comsumption Response of D(LK) to Shock Energy Comsumption Response of D(LL) to Shock Energy Comsumption These Impulse Responses are based on the 1 year time horizon. The dashed red lines show the two standard deviation error band

13 Panel: A Table-4. Variance Decomposition Approach real GDP Labor Force Period Shock1 Shock2 Shock3 Shock4 Shock1 Shock2 Shock3 Shock Shock1-4 stands for real GDP, Capital Stock, Labor Force and Energy Consumption respectively. Panel: B Energy Consumption Capital Stock Period Shock1 Shock2 Shock3 Shock4 Shock1 Shock2 Shock3 Shock Shock1-4 stands for real GDP, Capital Stock, Labor Force and Energy Consumption respectively